Stablecoins: the Humble Coins that Fuel the DeFi Revolution

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What are stablecoins?

Stablecoins are designed to address one of the persistent criticisms leveled at cryptocurrencies – their considerable price volatility. While the volatility problem has become somewhat milder amid the ongoing maturation of the market, the crypto space still experiences wild price swings quite frequently.

This lack of price stability severely limits the potential of crypto currencies as a viable payment option. This is where stablecoins come in.

While we can distinguish several stablecoin types based on their design, they all adhere to one core principle – they are designed to have a fixed value, which makes them resistant to price volatility. To achieve that, stablecoins are typically backed by some sort of a reserve asset, for example a fiat currency, a commodity or even another crypto asset. Meanwhile, recent advancements in blockchain development have enabled the creation of a new breed of stable crypto assets that rely on algorithms to keep their value stable.

Types of stablecoins

Fiat-backed

These stablecoins are pegged to a particular fiat currency, for example, the US dollar. This requires the token to be collateralized by sufficient holdings of the chosen reserved currency to ensure that the token maintains the targeted value relative to that currency. For example, if the goal is to have a stablecoin with value that is equal to the US dollar, that stablecoin needs to be fully collateralized by USD holdings.

A fiat-backed stablecoin is extremely resistant to crypto price volatility and quite useful for payments and money transfers. However, it is important to make sure that the stablecoin issuer really has sufficient holdings to back the token.

Some of the most prominent fiat-backed stablecoins today are issued by crypto exchange operators. Those include Coinbase’s USDC, Binance’s BUSD and the Gemini dollar.

Commodity-backed

This next approach uses the same principle, but utilizes commodities for reserve assets. Perhaps due to their status as investment safe havens, precious metals like gold are typically used as reserve assets.

Stablecoins can also be blacked by other crypto assets and while this does not strictly fall into the commodity-backed category, it is a somewhat similar concept.

Algorithmic

The previous two methods use centralized approach and collateralization, which is somewhat at odds with the spirit of blockchain technology. This has led to the development of a type of stablecoins that embrace decentralization and the ‘code is law’ mantra and let algorithms handle their value. In a nutshell, stablecoin algorithms maintain a fixed token value by selling tokens when their price is lower than the targeted value and supplying new tokens when the price is higher. This method enables functional decentralized stablecoin solutions, but you need to make sure that the algorithm is trusted.

Benefits of stablecoins

Due to their unique nature, stablecoins are naturally positioned to be a bridge between the cryptocurrency world and traditional finance. They benefit from their cryptocurrency nature, but remain resistant to the price volatility typically associated with crypto assets. As mentioned above, this makes them a better option for online payments than traditional cryptocurrencies. At the same time, they benefit from the cryptographically-powered security afforded by blockchain technology. In addition, they are easily transferable over the Internet, which makes them ideal for cross-border payments and transfers.

Stablecoins’ unique properties make them very desirable to crypto users, which creates ways for people to earn interest on their stablecoin holdings. In addition, the fact that most stablecoins essentially are ERC-20 tokens means that they can be easily swapped for ETH and other Ethereum tokens. Those two characteristics make stablecoins an important part of the dApp ecosystem on Ethereum. Especially in DeFi (decentralized finance), there are many dApps that rely heavily on such crypto assets.

Stablecoins in DeFi

The main application of stablecoins in DeFi revolves around their ability to generate passive income for users, an ability that stems directly from their stable value. While a DeFi user could deposit any crypto asset into a DeFi protocol, the price volatility of a typical cryptocurrency means that the income the user gets is wildly inconsistent. As we saw above, stablecoins are perfectly positioned to solve that problem. Indeed, activities like yield farming and liquidity mining are economically viable largely thanks to stablecoins. For that reason, they have a variety of uses in the DeFi space. For example, stablecoins are a major source of liquidity for some of the most prominent DeFi services such as crypto trading and lending and borrowing. But they can also be used in more creative ways.

One of the more interesting applications of stablecoins is synthetic assets. The term refers to crypto assets that are designed as a digital representation of real-world assets. To do this you first need to create a basket of stablecoins that represents the price of a synthetic asset. The price can then be managed by an algorithm, which adds or removes stablecoins to match the changes in the price of thesytethic asset’s real world counterpart.

Real-world impact

Synthetic assets are only one example of how stablecoins can, and already do, impact the real world. We also saw how the fact they are Internet-native, combined with their resistance to volatility, makes them an extremely convenient option for online payments and transfers of value. This creates opportunities for stablecoins to have a much more direct and immediate impact on the global economy than other types of crypto assets, a fact that hasn’t gone unnoticed by regulators around the world.

In 2020, the Financial Stability Board, an international body that monitors the global financial system, issued a statement, warning about the potential risks that “global stablecoin (GSC) arrangements” could pose to the global economy.

Stablecoins are also a major focus of the proposed “Markets in Crypto Assets” regulation, which aims to devise a regulatory framework at the EU level.

A ‘stable’ revolution

The regulatory attention is a clear acknowledgment of the important role stablecoins are set to play in the continued maturation of the blockchain space. A role that has become even more pronounced as the DeFi boom has brought a new wave of excitement to the blockchain space. In contrast, stablecoins can be considered as one of the more mundane applications of blockchain technology. However, it is their ability to support flashier blockchain products that makes the stablecoin revolution indisputable.

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