Over the last five years, blockchain has demonstrated the potential to disrupt almost every sector. The global fintech industry aims to build a revolutionary decentralized transparent payment system that uses digital currencies as a means of exchange.
The financial sector will benefit most from this emerging tech, but the prices of the first generation of digital assets, like Bitcoin and Ethereum, are highly volatile, speculative assets. For cryptocurrencies to replace fiat currencies as the future of money, they must have stable prices. This is what led to the creation of stablecoins. In this article, we will discuss what stablecoins are, the various types of stablecoins, and their importance. We shall also look at the recent interest of governments in issuing their digital currencies backed by their native currencies.
Stablecoins, rather than cryptocurrencies, might be the future of money
Table of contents:
Finding the right application for blockchain
As the name suggests, stablecoins differ from mainstream but highly volatile cryptocurrencies, like Bitcoin, Ripple, and Ethereum, in their focus on price stability. In achieving stability from the beginning, stablecoins aim to prevent a scenario like that experienced by Laszlo Hanyecz in 2010.
Hanyecz is an American software programmer who bought two pizzas using 10,000 bitcoins (at a time when one bitcoin was a fraction of a cent). Currently, this transaction would be worth $100 million. Hanyecz wanted to prove a point — this was the first time someone accepted bitcoin as a medium of exchange, but the now-famous story has also become a symbol of the drawbacks of using volatile currency for regular purchases.
Stablecoins allow buyers and sellers to lock in prices. They have their prices pegged to real-world assets, like the U.S. dollars, precious metals, commodities, or property to name a few. Because of their stability, stablecoins are the ideal tools that can link blockchain networks with traditional economies. They help users streamline payments through automation while maintaining liquidity, security, and transparency.
The issue of connecting the blockchain ecosystem with the traditional banking system has persisted for a long time now, but, with the introduction of stablecoins, businesses and the masses will soon be relying on these digital assets to make cross-border payments. Stablecoins bring the benefits of cryptocurrencies with an added advantage of price stability, which is attractive for users looking for cost-effective, instant, and safer means of transactions in day-to-day spending.
Types of stablecoins
These stablecoins are backed by a fiat currency, like the US dollars. The issuing firm holds real-world assets in a financial institution or partners with a third-party financial provider to keep money on their behalf. The tokens act as a claim of the underlying assets. The same applies to a scenario where commodities, such as precious metals, and bonds back the coins.
Fiat-collateralized stablecoins were the first stablecoins and the easiest to understand for crypto newbies since they are the most common onboarding tools into the crypto space. They are simple, elegant, and more easily trusted by retail users compared to other digital currencies. However, the coins are mostly issued by centralized companies with their governance mechanisms, and in the case of full custody integration, they are vulnerable to fraud.
Besides, not all fiat currencies are stable, as their underlying fiat may not be stable themselves. For instance, the US dollar is backed by gold reserves whose value keeps on appreciating and depreciating. A consumer must have faith in the US dollar to use a USD backed stablecoin, like Tether, TrueUSD, USDCoin, and Gemini Dollar.
This type of stablecoins is backed by a class of other decentralized crypto-assets. The advantage of this collateralization method is that it is decentralized; hence, it is not susceptible to a central point of failure. The disadvantage is that despite their blend of assets thought to minimize volatility, in the current crypto markets influenced by whales, any combination of digital assets will be considered unstable.
The typical use case is MakerDAI. It managed to maintain its peg in 2018 despite an 80% decline in Ether’s value as the only collateral.
These stablecoins achieve stability through algorithms, implying that they are actually not pegged to any tangible asset. Instead, users trust the system, expecting that the coins will appreciate, just like Bitcoin. Non-collateralized stablecoins are designed with two protocols: a stablecoin and a bond, promising profits if the currency increases in value. By buying the bond with the stablecoin, its supply is reduced.
Non-collateralized coins are the most innovative stablecoins and also the most complex to thrive. A good example is the Basis Project. However, hybrids have been developed to leverage fiat and crypto-collateralized models, like the Reserve and Carbon coins.
Why are stablecoins important?
Stablecoins have undeniably steered in a new dawn, especially for early adopters of blockchain and crypto traders. As their stability continues to attract institutional investors and governments, more entrants are expected to join forces. This is how the stablecoin market looked from 2014 to 2019.
Their application has been embraced for various reasons, such as:
They encourage crypto adoption
The first digital currencies, like Bitcoin and Ethereum, were hard to comprehend and difficult to appreciate and adopt. Technical terminologies and explanations made many people think that they were for geeks only.
It was challenging to prove their application of buying goods and services in the real-world. However, stablecoins- particularly the fiat-collateralized model- are quite different. When you tell people that stablecoins are a type of digital currencies, it is easy to visualize them. Besides, since they are pegged to the value of real-world assets, such as the US Dollar, it is easy to trust and embrace them.
They calm volatility
As the term suggests, stablecoins are designed to have price stability. The main reason for their creation is to minimize price swings prevalent in mainstream cryptocurrencies. All the three types of stablecoins have shown a lot of potential. But, the fiat-collateralized stablecoins are the biggest winners so far. For example, a coin like Tether has already achieved much success in this regard.
Crypto-collateralized stablecoins have not yet been widely embraced because of the underlying issues with cryptocurrencies generally being highly volatile. It is, therefore, challenging to convince people that a coin will be stable, yet it’s pegged to unstable assets.
Value is straightforward
Stablecoins, particularly the fiat-collateralized ones, are easily valued. It is as easy as getting an account balance and using the dollar sign to comprehend or communicate the price. For instance, if you have 5,000 Gemini Dollars in your wallet, you basically have $5,000 in possession. The easy it is to value a digital asset, the easier it is to embrace them in day-to-day spending and cross-border payments. For instance, if you want to buy an iPhone valued at $1,500, you only need 1,500 USDT. This implies that to facilitate payment at the point of sale, only a stablecoin payment option is required for the retail outlets. Once developers consider such aspects, everything else will follow suit.
They are cost-effective and immediate
Being a blockchain-based form of money transfer, stablecoins bear many benefits of electronic money transfer, such as instant and cost-effective money transactions. Consider a situation where it costs you $4 to do a cross-border transaction. These charges cover labor costs, power bills, and audits for human error. Blockchain eliminates central entities automate manual tasks so you will only be charged about $1. Unlike bank transfers that take several hours to days to be completed, your transaction will be processed instantly. That is how JP Morgan is facilitating cross-border payments using their JPM Stablecoin .
The case for central bank digital currencies (CBDCs)
CBDCs have been a primary subject for blockchain enthusiasts, futurists, governments, and lawmakers for some time now. They have evolved from a topic of interest to a high-potential tool for governments to address better the severe economic effects of the Corona Virus and beyond. Lawmakers, including politicians and central banks, are uncertain where, how, and which tools to leverage to save their economies as they deal with the pandemic and prepare for the imminent. This has led to a heightened interest in crypto innovation for the coming decade.
Currently, the global economy requires a payment system with which you can make payments instantly, cost-effectively, and without intermediaries, like Visa and MasterCard. China is already piloting its “digital yuan,” with the US, Great Britain, France, South Korea, and other nations making tremendous efforts in developing their digital currencies backed by their native currencies.
Already 20% of the 66 banks have shown interest in issuing their digital currencies in the next ten years. With all these efforts happening quickly under closed doors, it appears inevitable that state-issued stablecoins will be prevalent in the next few years and eventually replace their fiat counterparts.
In general, stablecoins are revolutionary tools with huge potential to revolutionize the future of finance fundamentally. With blockchain as the underlying technology, they can scale rapidly globally and disrupt the traditional payment systems. Stablecoins are already thought-provoking people’s understanding of money, generating a paradox environment where they will thrive as the main currency.