In 2010, two Papa John’s pizzas cost 10,000 Bitcoins – around 41 US dollars. Today, a $41 purchase would cost just a tiny fraction of one Bitcoin (0.0390 as of August 2019), and 10,000 bitcoins might be worth well over 100 million dollars (or well under, depending on the day). Holding your money in cryptocurrency can be a real rollercoaster, which is why stablecoins have gotten increasingly popular over the last several years.
Stablecoins are cryptocurrencies designed specifically to prevent big changes in their value, usually by tying themselves to another asset, like the U.S dollar or gold. This makes them much more predictable than Bitcoin or altcoins, which makes buying pizza much less likely to lose you millions of future dollars. Not all of them work the same way, though, and stability doesn’t necessarily equal safety.
Also read: What’s Up With Facebook’s New Libra Cryptocurrency?
Fiat-backed stablecoins
If you know just one stablecoin, it’s probably either Tether or TrueUSD. These and several others, like Paxos Standard, Gemini Dollar, and even Libra are “fiat-backed,” which means that for every unit of cryptocurrency issued on these blockchains, some amount of national currency (dollar, euro, pound, yen, etc.) is being stored somewhere. For every TrueUSD token, for example, there is one US dollar sitting in an account that the token can be redeemed for at any time.
This is simple and effective but also highly-centralized, meaning you really need to trust the company issuing the tokens. Without independent audits, there’s no guarantee that they’re not just printing themselves free money and using it to buy other assets that have actual value. Not all companies are fully transparent about their finances, which could mean your 1 USD stablecoin is not worth 1 USD.
Commodity-backed
Commodity-backed stablecoins are backed by some amount of a non-currency asset. Digix Gold Tokens are one of the most popular examples, with each token backed by one gram of gold stored in a vault in Singapore – and yes, they’ll actually give you the gold if you show up with your coins. If you could sell one gram of gold for 50 USD, your coin is worth 50 USD. Alternatively, you can go with Tiberius (a combination of precious metals) or SwissRealCoin (a portfolio of real estate in Switzerland).
Of course, storing real assets somewhere also isn’t without its risks, as the company can lie or the assets might be damaged or devalued in some way.
Also read: 6 Tips for Safe Cryptocurrency Investment
Crypto-backed (backed by cryptocurrency)
Yes, creating a stable coin backed by an unstable asset seems a little crazy, but while it gets pretty complicated, it can actually work. Take Dai, which is pegged to the US dollar and depends on Ethereum for its value. It “overcollateralizes” by requiring you to deposit more Ethereum than you get in Dai, which will be sold off if the value of Ethereum threatens to drop below the dollar value of your Dai. For example:
- You deposit $200 worth of Ethereum and borrow 100 Dai, meaning you have 200% collateral.
- Your Ethereum is locked up in the Dai system until you repay 100 Dai (plus a small “stability fee” that keeps the network running).
- You can store or trade the Dai as you wish. It’s always around one USD regardless of what happens to the price of Ethereum.
- However, if the value of the Ethereum you initially deposited drops below a certain threshold (say, your $200 is now only worth $120), your locked-up Ethereum will be automatically sold to make sure that the Dai you currently hold can’t possibly be worth less than $100.
It’s a complex system with a lot more twists, turns, and exceptions, but it works and has the advantage of being decentralized.
Seigniorage Shares
This is probably the most complex (and perhaps least popular) type of stablecoin, since it’s backed by nothing at all, and depends on algorithms to respond to changes in supply and demand in order to maintain its value.
Imagine that one of these coins is worth $1 when it’s stable, but a news article pumps demand up and it starts selling for $1.10. To push the price down, the algorithm would mint new coins until the supply and the demand reached equilibrium at a dollar. Soon, though, people forget about the coin and demand drops, leaving the price at $0.9, so the algorithm does the opposite, buying back coins to raise the price. To do this, instead of offering users real money, it might offer “shares” that promise them a portion of the system’s profits in the future.
In one sentence: an algorithm automatically buys and sells coins to keep the price stable. The biggest project, Basis, has shut down due to regulatory issues, but Carbon and several others are still experimenting with the system.
Also read: 6 Strategies for Safe Cryptocurrency Trading
Why use stablecoins?
Stablecoins are useful for crypto day traders looking to lock in their gains overnight, but they’re also nice if you want to pay for your coffee without looking at a price chart or to send someone money without the value changing while the transaction is processing.
Cryptocurrency swings are great for speculators, but they make pricing, lending, and long-term commitments a lot harder, and going in and out of stable national currencies comes with its own set of problems. Sure, you could just go buy US dollars, but turning those into Bitcoin can be a bit of a process. A stablecoin that’s worth a dollar travels far more easily in the crypto-space and can act as an easily-accessible store of value in an otherwise kind of crazy world.
Image credits: Scale of justice, supply-demand-equilibrium, Gold bullion bars
Andrew Braun is a lifelong tech enthusiast with a wide range of interests, including travel, economics, math, data analysis, fitness, and more. He is an advocate of cryptocurrencies and other decentralized technologies, and hopes to see new generations of innovation continue to outdo each other.
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