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Saturday, November 27, 2021

Blockchain Guide: What is a stablecoin?

There is no classic, unanimous, and generally accepted definition for stablecoins. To know what it is, we must start from the concept of cryptocurrencies. Cryptocurrencies are digital assets that are created for the purpose of developing a financial ecosystem that escapes the control of traditional institutions like banks. However, cryptocurrencies are volatile. Their prices go up and down… without giving notice! 

Stablecoins, on the other hand, do not follow the same mode of operation as cryptocurrencies. Of course, these are digital assets – therefore cryptocurrencies – but they are not volatile . Backed by other elements like fiat currencies, commodities and other electronic currencies, stablecoins remain stable. Their course does not vary (almost). 

How is it possible ? The answer is quite simple and can be found at the previous line: stablecoins are based on other digital currencies. Let’s explain ourselves.

How do stablecoins work? 

For a stablecoin to retain its value over the long term, several factors come into play. In fact, each project defines the strategy that suits it best. Therefore, not all methods have the same advantages and disadvantages.

The stablecoin based on fiat money  

The most common method is that of stablecoin which relies on fiat currency. In general, this fiat currency is either the euro (€) or the dollar ($). However, other currencies can also be used, notably the Japanese yen. Either way, no matter which currency you leverage, the mode of action remains almost the same.

Let us take a concrete example to illustrate. Take the case of a stablecoin that relies on the dollar. For each coin issued, the issuer claims to hold the corresponding $ 1 in a bank account. In this way, it ensures that the company can exchange the corresponding classic currency against the stablecoin and vice versa. In rare cases, some projects may rely on multiple fiat currencies. It all depends on their characteristics. 

Stablecoins that rely on commodities 

Stablecoins can also rely on commodities. Generally, the preferred materials are gold, petroleum, diamonds and silver. The operation is identical to that of stablecoins which rely on fiat currencies. Each token is backed by a corresponding given unit. (Multiplication of blockchains: the new DeFi paradigm)

Here too we will take an example. Let us illustrate our remarks with Digix Gold. It is a stablecoin which considers that every gram of gold is equivalent to a DGX token . Thus, there is a balance in the price of the digital asset . At the same time, gold is held as a reserve in bullion. This allows the bars to be audited and certified by a trusted third party. 

Stablecoins without collateral

Some stablecoins do not rely on fiat currencies or commodities. They are said to have no collateral . In their case, it is a smart contract that takes care of the monetary production. This approach ensures that the value of stablecoin remains stable. Concretely, how does it work? The smart contract buys cryptocurrencies in circulation when the price is too low. Then it issues new ones when the price goes up.  (Revelations on Tether (USDT), Celsius threatened?)

With stablecoins without collateral, it is relatively difficult to predict the future. Indeed, while some projects have been successful, others have failed because of the difficulties encountered with regard to regulatory measures. The Basis project is proof of this. It was supposed to be based on a system of three tokens: one stable and the other two used to balance its price . Unfortunately, not everything went as planned. Consequence: the project is dead!

Now that we have a correct understanding of how stablecoins work, we can ask ourselves two questions. The first is: why were stablecoins created? Another question then comes to mind: who is behind stablecoins? Here are our responses.

Why do stablecoins exist? 

Several reasons justify the existence of stablecoins. The first is the need to reduce the volatility of digital assets . Since they follow the value of other assets, theoretically, they are more stable than the latter. But they can also serve as a means for traders who wish to protect themselves from market movements.

The costs of converting cryptocurrencies into fiat currencies are generally high. They can require a considerable investment. Fortunately, stablecoins help reduce these fees. Indeed, they make it possible to avoid making a direct conversion of electronic currencies into fiat currencies. This results in considerable savings.

A final reason why stablecoins exist is that they are used to reduce taxationSince there is no conversion that is done to a fiat currency, stablecoins help lower fees. That said, it all depends on the rules of the different countries.

Who issues stablecoins? 

Over the past few years, the stablecoin market has been taken by storm by many players. On the one hand, there are private companies that take good initiatives. For example, JP Morgan bank launched the JPM Coin. (Brazil, the next domino for Bitcoin?)

The goal of this project is to accelerate transactions carried out internationally. It then presents itself as a direct competitor to the SWIFT system which is currently the most widely used. In the process, remember that there is the Libra project developed by Facebook . It is supposed to be backed by a basket of fiat currencies  : $, €, £, Singapore dollar and Yen .

If stablecoins born on the initiative of private companies are advantageous, they have a limit. In the majority of cases, they have little resonance with the ideals of decentralization relating to cryptocurrencies. It is also to solve this problem that stablecoins aiming at greater decentralization, but anchoring to the $ have emerged. This is the case with the MakerDAO project . 

Outside of private companies , more and more state cryptocurrency projects are emerging. Several states, such as China and the United States, want to take advantage of the benefits that stablecoins offer. At the same time, however, other states fear their monetary sovereignty will crumble. Finally, on a larger scale, it should be noted that Europe is considering the possibility of creating a form of digital euro. 

Stablecoins are cryptocurrencies that operate very differently from traditional digital assets. While the latter see their price vary according to the evolution of the market, the stablecoins, them, remain stable. Their value does not (almost) change, because these assets are pegged either to cryptocurrencies, or to commodities or to fiat currencies.

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