You might be still a noob to crypto and the broader field of DeFi (Decentralized Finance) but alongside of Bitcoin and Ethereum you might have encountered the word 'stablecoin'. As you have heard from the media and news, crypto can bring wild swings in the prices of your assets. As someone dabbling in trading cryptocurrencies, one day you feel close to being a millionaire (Lambo ordered), the other day you go back to work (Lambo cancelled). This is called price volatility and is caused by the fact that prices of cryptocurrencies are permanently (24/7) determined by the interaction of buyers and sellers in a market. While these price movements are a nice opportunity for trading (or speculation), they are slightly problematic regarding the goal of saving or using crypto as a non-volatile store of value.
In other words (confessing to using the terms of economics now), a fundamental challenge of cryptocurrency volatility can be seen in their inability to fulfill the three classical functions of money:
Act as a medium of exchange
Serve as a unit of account
Offer a store of value
Since all of these functions are disrupted by high price volatility, the crypto space has developed a special type of currency, called 'stablecoins'. These are cryptocurrencies designed to maintain a stable value and mitigate the problem of price volatility. Stablecoins can thus be defined as digital assets designed to manage price fluctuations through a linkage to assets with more stable valuations. In contrast to other cryptocurrencies, the defining characteristic is their built-in mechanism for price stability.
Although the primary function of stablecoins is to provide stability amid the price volatility inherent in cryptocurrencies, they also fulfill a variety of additional roles. First and foremost, they act as a bridge between conventional finance and the crypto economy. Typically, all deposits and withdrawals between traditional bank accounts (or credit cards) and (de-) centralized crypto exchanges are mediated through the purchase or sale of stablecoins. Another essential function of stablecoins is their interoperability across different blockchains, as they offer high operational flexibility, particularly within the decentralized finance (DeFi) sector.
In DeFi, most purchases, sales, or exchanges of cryptocurrencies on decentralized exchanges are executed using stablecoins, and a significant portion of the liquidity pools is typically composed of a stablecoin (or the respective native coin of the blockchain, such as Ethereum, Solana, Optimism, etc.). Another significant property of stablecoins is that they simplify performance assessments and return calculations, as the outcome is more easily interpretable when benchmarked against a familiar unit, such as the US dollar. Thus, stablecoins effectively import the unit of account function of a national currency.
Originating from the fundamental idea of combining the benefits of cryptocurrencies with the stability of traditional currencies, several stablecoin variants have emerged within the crypto market over time. In essence, four significant types of stablecoin pegs (and collateral) can be identified, although hybrid forms are also conceivable:
Fiat-collateralized stablecoins: The most prominent and widely used form involves pegging to a traditional fiat currency, such as the US dollar or the Euro.
Crypto-collateralized stablecoins: In this model, the stablecoin is backed by other cryptocurrencies. A well-known example is DAI, which is collateralized with Ethereum (ETH).
Commodity-collateralized stablecoins: Certain stablecoins are pegged to the value of tangible assets such as precious metals. For example, PAXG is a cryptocurrency pegged to the price of gold.
Algorithmic stablecoins: In this case, no external collateral is used. Instead, programmed algorithms and smart contracts automatically balance supply and demand to maintain price stability. The most notable example in this category, although it failed dramatically, has been Terra/Luna.
Imagine an art gallery where the value of the artworks can fluctuate wildly, much like the price of cryptocurrencies. Now, let's introduce a new type of artwork that is designed to maintain a stable value, regardless of the fluctuations in the rest of the gallery, e.g., you can always buy or sell a Picasso for $ 1 million. This is a pegged value: Just as our Picasso has a consistent value, stablecoins are designed to maintain a stable value, typically pegged to a fiat currency like the US Dollar (e.g., 1 USDC is always meant to be equal to $1.00). To ensure the stable value of our Picasso artwork, the gallery must maintain a reserve of highly liquid assets, such as US dollars in cash, which can be used to buy or sell the artwork as needed to maintain its price. For a cryptocurrency to be considered 'stable', it must always guarantee that users can redeem their tokens for the underlying value.
In case of price movements due to the forces of demand and supply, if the price of our stable artwork (Picasso) starts to deviate from its intended value ($ 1 million), art dealers (in economics called arbitrageurs) will step in to buy or sell the artwork until the price returns to its stable value ($ 1 million). In the crypto world, traders do the same thing with stablecoins, buying or selling them on exchanges to keep the price stable. In the art gallery, patrons might use our stable artwork as a medium of exchange, a unit of account, or a store of value. The same principle applies to stablecoins in the cryptocurrency world. They provide a stable store of value and a medium of exchange, making them useful for transactions, savings, and as a hedge against the volatility of other cryptocurrencies.
In summary, stablecoins are like a stable artwork (Picasso) in a volatile art gallery (prices for the work of different artists), providing a consistent value amidst the fluctuations of other cryptocurrencies. They are backed by reserves, maintained by arbitrage, and come in various types, each with its own unique characteristics. Essentially, they promise to function as cryptocurrencies that can guarantee a fixed redemption value. One of the latest developments in this dynamic market is the emergence of stablecoins, which are designed to offer a yield (e.g., Ethena USD, Solayer USD, Syrup USD).
Happy Week, ALANA Adventurers!
This article was authored by Nils Otter, a DAO member of The ALANA Project.
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