What is Stablecoin?

Bridging the Gap Between Traditional Financial System and Cryptocurrency

Since September 2018, “Stablecoin” has been a topic that was constantly brought to the spotlight. Now it’s time for us to revisit its journey of stable coin development.

What is Stablecoin?

For blockchain enthusiasts, we are more than familiar with such concepts. However, the general public might need a further explanation. Here, we would like to briefly introduce “What is Stablecoin” in plain English.

For cryptocurrencies like Bitcoin, there’s high volatility associated with its price action as it’s hard to reach a balance with the existence of multi-parties, each trying to take control. The root cause can be explained as: due to their deflationary design, Bitcoin, along with other coins that have a fixed number of total issuance, cannot serve the purposes of the preservation of value and the medium of exchange at the same time. So Stablecoins were initially created as an instrument or medium for cryptocurrency traders to safely preserve value in the volatile cryptocurrency market.

Even though stablecoins are one type of cryptocurrency, they are designed to preserve stable values. There are FOUR major characteristics associated with stablecoins, we will attempt to provide you a better understanding by drawing the comparables to fiat payment systems like Paypal, Samsung Pay and etc.

1. 24/7 Global Uninterruptible Visit

Not much to say here. Similar to the current fiat system, which operates 24/7 uninterruptedly, you can transfer or exchange stablecoins whenever you want.

2. Expedited Transfer

Stablecoins should work as emails, not being restricted by distance, border, or the service providers. Backed by blockchain technology, the expedited transfer can be realized. One highlight is international transfer. Especially for transferring large amounts, Paypal or Samsung Pay takes several days to settle as lots of intermediaries need to be involved. Stablecoins, on the other hand, complete the entire transfer process within minutes. Thus, stablecoins have the potential to become a truly globalized, borderless currency.

At the current stage, you can already send emails to other addresses with different service providers, sending to a Yahoo address through a Gmail, for example. However, in the fiat payment system, PayPal users are not able to send payment to Samsung Pay users directly, at least not yet. This is due to the fact that the current fiat payment applications lack the capability to directly transfer and settle on the opennetwork. Bitcoin is the first case of the internet currency. As stablecoins are established upon the standards of open-sourced and decentralization, transactions can be enabled between stablecoins and any application with the same standards. If the stablecoin is issued with ERC-20, then transfers can happen between any digital wallets that are compatible with the ERC-20 Standard. Users are no longer restricted by the wallet they chose or the service providers of Dapps.

3. Micro and Macro Payment

This is a more interesting topic. Small or Micro-payment are actually not the best use case for stablecoins based on Ethereum. Nearly all attempts end up in the increase of the gas fee, higher cost, lower transaction speed, and…epic failure. But on the other hand, stablecoins do provide a convenient way for macro payments. As the maximum amount can be sent through Paypal per transaction is $60k, you can send millions or even tens of millions to any address through Stablecoins.

Even though Macro transfer can be a great use case, compared to Bitcoin, there’s a problem with fairly centralized stablecoin as it is hard to know when the transaction is actually settled. As with Bitcoin, we know that the transfer is completed with the confirmation of multiple nodes. For centralized stablecoins, however, there’s a possibility for the contract being frozen or cancelled. We haven’t seen any of that for now, but that might happen if the local government confirms that the correlated addresses involve darknet, money laundry, or drug dealing etc. We haven’t heard from any of the issuers regarding how the stablecoins shall be used, but centralization brings potential threats. Anonymity and privacy won’t be the focus. Whether stablecoins will be used in macro transferring is still a question mark.

4. Programmable Money

Programmable money brings traditional financial products new possibilities. With Ethereum, we saw the combination of cryptocurrency and smart contracts give birth to the truly programmable money. Based on which, we saw the ICO and primary market frenzy in 2017. The problems are also prominent. As most blockchain entrepreneurs are not familiar with the financial market, along with the volatility with ETH, they are suffering huge asset management risk due to insufficient risk management skills. Consequently, blockchain financial products will become more competitive if they are based on a cryptocurrency with greater stability.

Such volatility also presents a huge challenge for cryptocurrency entering into the debt market, as there’s huge credit risk associated with that.

With stablecoins, people may be able to issue programmable debt based on stablecoins, which are in turn based on the Ethereum chain. In such a case, interests and principals will be paid through the smart contracts, which will bring significant change to the $247 trillion global debt market.

What does stablecoin mean for different players?

One common question from people who’s new to the cryptocurrency is that: will Bitcoin or other cryptocurrency be accepted by normal vendors? As for now, stablecoin’s application in micropayment is limited by insufficient infrastructure and licensing issues, thus we haven’t seen massive adoption. Circle is dedicated to solving those obstacles through USDC. We are expected to see a more integrated application in the future. Unlike Bitcoin, which involves volatile exchange rate issues, micro-payment shall be an ideal use case for stablecoins.

Now comes to the primary market investors. Stablecoins might serve as a better way of fundraising, compared with BTC and ETH. As analyzed above, projects raised by ETH or BTC face huge market risk. With the stable price, programmable features, stablecoins might become the next vehicle for fundraising in the primary market.

As for traders and arbitrageurs in the secondary market, stablecoins played an important role, for example, Tether is serving as a tool for fast settlement. It also works as a necessary part for market makers and quant teams of triangular arbitrage strategies. Due to the volatility in the crypto market, traders load up stablecoins when perceiving the depreciation of value in other crypto assets. Stablecoins like Tether facilitate the entire trading process, making traders more comfortable in allocating assets on cryptocurrency without worrying about loss of value.

Regarding another heated topic, Security Token, will we see any change on the demand of stablecoins while more institutions start entering the game? The combination of smart contracts and stablecoins may fundamentally change how investors trade and how companies raise capital. People may use stablecoins to invest in the company’s Security Token instead of equities, while such security tokens will integrate smart contracts, paying investors stablecoins through pre-programmed terms and schedules. As a result, it is able to reduce the market risk for both parties.

The Category of Stablecoins

In the previous article, we only explained in a vague concept <What Is Stablecoin>. In this article, we will enter a few more stablecoins tracks and know the three main stablecoin categories that exist today.

Haaseb Qureshi, in his article《Stablecoins: designing a price-stable cryptocurrency》, proposed a classification of stable coins, which we have used for reference in this article as the basis for the following analysis.

Fiat-collateralized stablecoin

Features:

The concept is very easy to understand, that is, depositing a certain amount of dollars into the bank and then issuing the same amount of stablecoins through the blockchain;
It is the most stable, scalable and by far got the most traction stablecoin category.
Regardless of the fluctuations in the cryptocurrency world, the Fiatcollateralized stablecoin is 100% stable. For Example, for USD stablecoins, the stablecoin can be redeemed as US dollars, and the ratio of stablecoin to fiat currency (US dollar) is always 1:1;
Centralization, depending on the solvency and honesty of the issuer, if it’s not transparent, it is easy to cause market panic (recently happened to Tether), and many new Fiatcollateralized stablecoins have increased transparency;
Regulatory pressure is high, will be subject to the constraints of the local government, and need to count on the third-party trustable institutions to increase credibility.

Crypto-collateralized stablecoins

Features：

This category of stablecoins is trying to get out of the fiatcurrency and use pure cryptocurrency as collateral;
The concept of Crypto-collateralized stablecoin is relatively complicated, and it takes time to understand. It will not be explained in this article. If you want to know more about how Crypto-collateralized stablecoin works, you can refer to this article 《Maker for Dummies: A Plain English Explanation of the Dai Stablecoin》;
It is transparent, decentralized and in line with the spirit of cryptocurrency, it is decentralized and censorship resistant;
The sceptic says that this type of stablecoins is more susceptible to price instability, and that they will be destroyed spontaneously by the sharp fall of prices, which may cause imbalance between supply and demand and break the stability.

Growth-Collateralized Stablecoin

Features:

This classification is very difficult to define, and the proposed solution is also the most complex and abstract. The white paper can be very confusing, and we doubt whether a Doctor in Economics can understand it. Some concepts are theoretical and haven’t tested out in practice long enough;
There is no need to propose a collateral concept because the US dollar was originally linked to gold, but after the collapse of “Bretton Woods“, there was no collateral relationship between the US dollar and gold. This is the origin of the Growth-Collateralized or non-collateralized Stablecoin, which using the future growth of the entire system as a collateral and using algorithms to adjust supply and demand to achieve stability;
Regardless of its complex design, the above two types of stablecoins will serve as the foundation for this type of stablecoin design for a long time.
This category of stablecoins also could be decentralized and censorship resistant;

The past several years laid out a clear pathway for the development of stablecoins. In sum, we believe that stablecoins will serve as an irreplaceable part of crypto industry’s future.

Conclusion

While the target users for stablecoins are cryptocurrency enthusiasts and speculators in the trading market. Now, most stablecoin issuers also have the ambitions to expand the use cases into remittances, payments and serve as the on and off ramps for financial institutions.

Hope the above explanation gives you an idea of what is stablecoin and how stablecoins works under different circumstances. In the future articles, we will have more knowledge to share with you regarding stablecoins.

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