The cryptocurrency market is highly volatile with cryptocurrencies like bitcoin and ether sometimes experiencing a 10-20 per cent increase or decline in one day according to AI and blockchain expert Sherman Lee.
To fix this volatility, stable coins such as tether have been created, giving investors an option between traditional cryptocurrencies and fiat currencies. The market stability of such coins is provided by the fact that they are pegged to stable assets such as gold, oil or the USD as is the case with tether.
This means that stable coins not only use the underlying blockchain technology, a decentralized network, and a distributed ledger, but also have an asset backing. Unlike cryptocurrencies, stable coins do not rely on utility and acceptance alone for their value.
“Additional traits that will assist the wider adoption of any stable coin are simplicity along with the elegance of concept, easy integration points for partners, and the ability for an exchange to work with. However, stability is key. Short-term stability is important for transactions and long-term stability is important for holding.” Said Lee.
The Issuance of Stable Coins
The value of a stable coin represents the ownership of a stable asset, which means that even though the market dips, the coin will still be worth the amount of the stable asset it represents. For instance, 1 tether is equal to 1 USD no matter what happens to the crypto market.
The most usual way to run a pegged asset is where an issuing authority offers a given amount of coins for purchase with a “corresponding amount of the assets backing them vaulted for storage.”
When investors want to exchange their stable coins for the asset, they simply go to the issuing authority to get it done.
The Different Types of Stable Coins
There are different types of stable coins namely fully collateralized, partly collateralized, and uncollateralized.
For fully collateralized coins, the issuing authority requires to have reserves for the backing asset that are equal or higher than the amount of coins in circulation. An example of a fully collateralized stable coin is tether (USDT).
With partly collateralized coins, the issuer holds 50 percent of the value of coins in circulation while the issuing authority depends “on controlling the token supply relative to demand to keep the value of the asset stable.”
Uncollateralized coins are not backed by any asset but by the expectation that they will retain a certain value.
According to CCN, the authority/platform issues the uncollateralized coins together with crypto bonds and crypto shares. Bonds are used for contracting supply, where they “incentivize users to spend their coins in exchange for interest to the bondholders.”
Basis is a classic example of an uncollateralized stable coin.
An economics professor at UC Berkeley, Barry Eichengreen, criticized fully collateralized stable coins in The Guardian for the costly nature of the model to organisations that have to store reserves of the backing asset.
On partly collateralized stable coins, Eichengreen said fear, uncertainty, and doubt (FUD) could be disastrous for the coins. In such a situation, the issuer would have to buy back the coins with the reserves to prevent a price free-fall. However, since reserves are limited, investors will scramble to get out, which could “lead to the collapse of the peg.”
Eichengreen has also criticized the model of uncollateralized stable coins because issuers can only service “the bonds when the platform grows, which is not guaranteed.”
On the other hand, issuing more bonds could result in the free-fall of the bond price, hence triggering the issuance of more bonds. According to CCN, this makes it difficult to meet interest obligations.
Some other examples of stable coins include MakerDAO, Havven, Basecoin, Carbon, Sweetbridge, Kowala, Satbly, and BitShares. Tether is the largest stable coin which ranks eighth on CoinMarketCap based on its market capitalization.
Stable coins are a good alternative for investors who want to safeguard their investments from frequent and extreme price fluctuations. These coins are a tool of risk mitigation for traders and investors.