The money must meet the following economic properties: being store of value, unit of account and medium of exchange, according to accepted economic theory.
To have these properties, it must have the following qualities: durability, divisibility, portability, acceptability, limited supply, and uniformity.
Cryptocurrencies, in general, meet the characteristics to a greater or lesser extent, some more than others. This, beyond the legal discussion that could be presented here, on whether or not they are accepted by the countries as a means of payment.
Within the economic properties to be considered money, the unit of account, with its characteristic of uniformity in time, is the main obstacle. Volatility, that is, the instability of its price with respect to fiat money, is a reality of these times, at the beginning of the crypto industry.
To solve this problem, stablecoins were created. In this way, stablecoins seek to maintain the characteristics and advantages of cryptocurrencies, in terms of their autonomy, decentralization and scarcity, and at the same time represent assets with a certain stability proven in their valuation.
To maintain this stability (or rather, very little variability in its market price), you need a reference and a support for it.
What Backs a Stablecoin?
The safeguard relationship is made with other financial assets, with fiat currencies, with raw materials, and even with a basket of crypto assets.
These backup strategies are what help to achieve that purpose of stability.
It could be said that stablecoins are a tokenization of the backup or reserve funds on which they are based.
This is the most common backup method for stablecoins. Generally, the crypto active is backed by guaranteeing each token of the network in the same proportion (1:1).
Currencies such as the US dollar, the Euro or the Japanese yen are used. This means that for each token, its value will be guaranteed by one unit of fiat currency.
Here there is a contradiction in the blockchain industry, because cryptocurrencies are oriented not to depend on a centralized entity as fiat currencies do, and in this way, being tied to a currency of a State, that quality is lost.
In addition, they are generally deposited in bank accounts, another variable that subtracts decentralization.
On the other hand, the transparency of your reservations is no small matter. This type of stablecoin needs to raise capital to project wide adoption, and therefore they have a large amount of issuance and need your support. Periodic audit processes must be carried out by independent consultants.
Examples of this type of stablecoins are: USD Coin (USDC), Binance USD (BUSD), TrueUSD (TUSD) and Tether (USDT). Most are backed by the US dollar and managed by central entity companies, but there is also STASIS EURO (EURS), an ERC / EIP20 token, a stablecoin backed in Euros, on the Ethereum network.
The case of Tether (USDT) is one of the most successful. In the market since 2014, with a current working capital of USD 73 billion, and with a daily volume of USD 6 billion.
This is another fairly common form of backing for stablecoins, which backs the value of the stablecoin using commodities. Among these are gold, silver, diamond or oil. The backup ratio can be as simple as (1:1), or it can depend on inexpensive formulas.
For example, Digix Gold Token, is a stablecoin that states that each gram of gold is equal to one DGX token, and is divisible up to 0.001 grams. In this way it manages to provide the crypto asset with a balance in its price. In this case, the gold is also held in bullion as a reserve. This allows them to be certified and audited by a trusted third party, providing assurance of their endorsement. Another gold-backed coin is PAX Gold (PAGX).
This method consists of supporting a token with the reserves of another cryptocurrency or a basket of them.
This is another widely used stabilization scheme, which is usually very complex, since a sophisticated economic system designed in an algorithm is used to stabilize prices. This seeks to protect the price of the stablecoin with respect to the variation in the value of the backing cryptoasset.
This system has the vision of getting rid of the centralism of supporting the stablecoin using fiat currencies or commodities.
One proposed solution is to grant the token a double endorsement by the other cryptoasset, that is, a (1:2) ratio, since even with the price variations the reserve cryptocurrency suffers, the token can maintain the desired stability.
Most of the stablecoins that use this method are tokens of the ERC-20 type.
An example of this system is DAI. The DAI price is pegged to the US dollar and is backed by the value of Ether and a wide portfolio of tokens on this blockchain, which are deposited in smart contract vaults each time a new DAI is mined. For its issuance, it must be backed with capital that is used to generate DAI, in some of the currencies accepted as collateral by the Maker protocol, such as BAT, USDC, wBTC, TUSD, KNC, ZRX, MANA and ETH.
Its issuance and development is managed by the Maker protocol and the autonomous decentralized organization of MakerDAO.
Supply and Demand Stablecoins
Stablecoins under this figure do not have direct endorsement or guarantee of any asset that helps them stabilize their price. They use a model called “Seigniorage shares”, with smart contracts to perform the function of a Central Bank, by which a fixed value is established, and if the value is far from the established price, the company that owns the currency issues or buys the tokens in circulation, so that it returns to the established price.
An example of this type of stablecoin is NUBITS and USDX. However, the operation istas stablecoins is strongly criticized for their lack of decentralization. In addition, they are strongly linked to the current securities norms in many countries. For example, the BASIS platform ceased its functions due to SEC regulations.
You can see a list of stablecoins on CoinMarketCap.
Public vs Private Stablecoins
Stablecoins can also be classified into public and private, depending on the participation in their issuance. The private ones are those issued in a permissive way, by certain authorized actors, the public ones are those issued with free participation, like most of the ones I told you so far.
To date, public blockchains have been the pioneers in the development of stablecoins.
Who could issue private stablecoins? Companies for their commercial or financial use within an exclusive scope, such as a bank with its clients, or also a government, through its Central Bank, the well-known CBDC (Central Bank Digital Currency ).
The issuance of private banking stablecoins does not yet exist in the financial market, although I believe we will see them soon.
For example, a major commercial bank, MUFG (Mitsubishi UFJ Financial Group). His plan is to roll out a stablecoin that is pegged (1:1) to the Japanese yen. The MUFG stablecoin will be released in select quantities to clients in Japan.
Another example of stablecoin development in the private sphere is the launch of a US dollar stablecoin by Circle. This is a payments company backed by Goldman Sachs, with the support of Coinbase. Circle USDC, runs on the Ethereum blockchain, and is intended to be used by clients for payments and transactions within the cryptocurrency space.
Central Banks face legal barriers to offer fiduciary digital currencies in the blockchain format, but we see how there are already countries that have adapted their standards for issuance.
Central Bank Digital Currencies
Many tend to confuse CBDCs with stablecoins, which are tokens pegged to the market value of a fiat currency, encoded with open source algorithms that run on a public, permissionless and decentralized blockchain, whereas CBDCs are cryptocurrencies of permissioned blockchains and centralized in one authority.
CBDCs are not pegged to the parity of a fiat currency like stablecoins, but are the same fiat currency in a digital version.
Central Banks are increasingly investigating the possibility of creating digital versions of national currencies, recognizing the potential to combine the opportunities offered by distributed ledger technology with the existing trust inherent in national fiat currencies.
The Central Bank would initially issue a digital currency (CBDC), which would then circulate among banks, businesses and consumers without further intervention from the central entity.
The advantages offered by a stable and digital form of cash are especially evident in the realm of central banks as an alternative to bank deposits. For example, a CBDC offers an alternative to the outdated and expensive wholesale payments technology used by many central banks. It also has the potential to be used as a monetary policy tool to improve the transmission of official interest rates to the real economy, allowing central banks to react more quickly and effectively to economic challenges.
However, there are risks in CBDCs since due to their speed of circulation, in a crisis, bank depositors could turn to CBDC, rapidly draining commercial bank deposits, and threatening their lending activity.
On the other hand, the privacy of users, citizens, would be affected, since monetary traceability would be totally transparent, in terms of date, place, amount, and owner of the expense, thus incorporating a kind of mass surveillance system that violates people’s rights.
Eight countries have their own well-developed CBDCs: Bahamas, with the Sand Dollar; China, with the Digital Yuan (ECNY); the DCash the Eastern Caribbean Central Bank (ECCB) for Saint Kitts and Nevis, Antigua and Barbuda, Saint Lucia, and Grenada; Sweden, with the eKrona (still in development); Nigeria, with the eNaira.
The crypto industry needs a stable medium of exchange, as a unit of account, for financial and commercial use in the ecosystem that is developing.
While stability does not mean invariance, the price variation of stablecoins is not that significant.
They offer great liquidity thanks to tokenization. This is especially true when stablecoins base their stability on commodities, facilitating better price formation.
The need for third parties, such as suppliers, custodians and the project itself show this centralization. The scheme of most stablecoins is highly centralized, especially those backed by fiat currencies and commodities. Not so, for those who are in a basket of cryptocurrencies.
In a future article, I will talk about the stablecoin ecosystem in Cardano.