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What are stablecoins and how do they work?

by | Oct 9, 2018

Stablecoins are coins that try to peg their value to other assets in one way or the other to obtain price stability. Their primary use is to improve the usability of a cryptocurrency, because cryptocurrencies are very volatile at this present time. Stablecoins are also used to hedge against price volatility by crypto traders. By far the most popular but also the most notorious stablecoin is USD Tether (USDT). Because of its controversy and the growth of the crypto ecosystem, more stablecoins have entered the market to compete with USDT. What is the use case of stablecoins anyway in the crypto market and how are they different from USDT? In this article we will discuss some of the stablecoin options in the present market.

We will discuss the 4 main categories of stablecoins and make an overview of basic properties of the following coins:

  • USD Tether (USDT)
  • TrueUSD (TUSD)
  • Paxos Standard Token (PAX)
  • Gemini Dollar (GUSD)
  • USD Coin (USDC) by Circle
  • DigiX token (DGX), gold backed
  • DAI token (DAI) by MakerDAO
  • Nomin token (nUSD) by Havven
  • Steem Dollar (SBD)
  • Basis Coin

Please note that this article has been written and published October 2018: all described market data and adoption statuses are relevant for that period and/or until the latest update.

Why do we need stable coins anyway?

Ideally we don’t! Stablecoins are usually designed to peg its value to USD, which is an inflationary, fractional reserve banking created, fiat currency which belongs to the traditional financial system. Cryptocurrencies are supposed to challenge that concept by being non-inflationary, trustless global currencies that don’t depend on the “reliability” of governments for its value. Citizens of many countries have discovered painfully that reliability of their governments to control a currency is not something that always works out well (think Venezuela, Zimbabwe, Greece).

In the future, the grand vision is for cryptocurrencies to take over fiat currency and for price stability to be more common. In that scenario, there won’t be a need for stablecoins that represent fiat anymore.

However, since cryptocurrencies are still in an infant stage of technology and adoption, they also are still extremely volatile. That creates some problems for people who need to store value, traders/investors who need to hedge against volatility, and many crypto exchanges that do not have fiat trading pairs.

The use cases for stablecoins therefore are:

  • Hedge (protect against market crashes) against volatility of cryptocurrencies
  • Transact with cryptocurrencies but without price fluctuations during the transaction time
  • Being able to convert cryptocurrencies easily into fiat (USD) value on the majority of crypto exchanges that don’t support real fiat currency deposits/withdrawals
  • More altcoin trading available against fiat pegged trading pairs directly instead of having to make the extra hop from altcoin to bitcoin to fiat value and vice versa.
  • Being able to transfer fiat value quickly between exchanges within hours instead of days (compared to USD).

What categories of stablecoins exist nowadays?

Roughly we have 4 major categories in which we can divide stablecoins:

  1. Fiat collateralized stablecoins: These have in some way fiat currencies (USD) stored that back the value of each issued coin, usually in a 1:1 ratio, which means that the value of the token will be closely traded against the value of the fiat currency. Mostly USD is the collateral, although there are versions for other fiat currencies as well, although with much less volume.
  2. Commodity collateralized stablecoins: These stablecoins have other “physical” assets stored that back the coin and should therefore peg its value against that asset. One popular example for such a physical asset is gold.
  3. Crypto collateralized stablecoins: These stablecoins use cryptocurrencies in one way or the other to create collateral to back its value. These usually involve a more complex system that aims to result in a peg to USD value on a 1:1 basis.
  4. Algorithmic supply stablecoins: These stable coins aren’t collateralized at all, but use a “central bank” algorithm that increases or decreases the circulating supply based on changes in demand for the coin and thus trying to stabilize the coin’s price.

There are a total of around 30 stable coins active in the crypto ecosystem currently. We will discuss some of those per category.

Fiat collateralized stablecoins

USD Tether (USDT)

USDT is by far the most adopted, longest existing stablecoin with by far the highest liquidity (which means you can trade this coin’s trading pairs with the highest guarantee of order execution and without affecting the price too much with larger orders). It is also the most controversial one. Although each USDT token is supposed to be backed by 1 USD that is supposed to be stored in a bank account somewhere, there is much uncertainty within the crypto communities if that is really the case and there is a lot of suspicion that the Tether company is really doing fractional reserve banking when they issue new tokens (which they have been doing in enormous waves since 2017). If that is the case, there would be no 1:1 backing and that could endanger the value of USDT if this indeed turns out to be true. The problem is that there are virtually no official, reliable audits performed to prove that circulating supply of USDT is and always has been indeed equal to the amount of USD stored in reserve.

Using USDT therefore requires A LOT of trust in an effectively anonymous offshore company (Tether), with an unknown amount of USD stored in unknown and unaudited bank account. This in sheer contrast to the trust-less nature of cryptocurrencies that we are trying to achieve.

Although officially it should be possible to redeem real USD by turning in USDT to the Tether company, in reality this is a process that most people can’t perform. The only other realistic way for the average crypto investor to convert USDT into USD is on Kraken Exchange, however trading volume isn’t very high and would not be able to support a giant exit if a “bank run” would occur for USDT.

USDT is dominantly transacted on the Omni protocol, which is a protocol layer on the Bitcoin blockchain, which means that the USDT ledger has the same security properties as Bitcoin. A disadvantage of this solution is that there are no viable wallet options to privately store your (Omni) USDT, there are only web wallets from Omni and Tether or just exchange wallets (all of which are not very safe).

USDT is also issued in a smaller amount on Ethereum as ERC20 token. But this token is hardly supported by exchanges and virtually no trading takes place in it. You should be aware though that the ERC20 token version is completely separated from the Omni Protocol version and are not interoperable. Sending the USDT ERC20 token to an Omni address will result in loss of funds and vice versa. The advantage of the ERC20 version of USDT obviously is that there are much more wallet options available to store your coins privately.

Biggest advantages of USDT are its high liquidity and convenience:

  • Supported by the vast majority of crypto exchanges
  • By far the highest volume and circulating supply
  • Has the highest amount of trading pairs across the crypto market.
  • Most crypto users are used to dealing with USDT
  • It has the longest track record of of all stablecoins

Currently the market capitalization of USDT is around $2.8 billion and trading volume over $2 billion on a daily basis. For more in-depth details about USDT, please refer to our article about USD Tether.

True USD (TUSD)

TUSD is a direct competitor to USDT, because it is essentially the same concept, but the company behind TUSD (TrueToken) tries to improve the trust issue by providing more transparency. It is in existence since early 2018 and has indeed seen more adoption by exchanges (it has now listed trading pairs on several of the more influential exchanges such as Bittrex and Binance) and an increase in circulating supply since its launch.

TUSD is an ERC20 token only released on the Ethereum blockchain and therefore has the same convenience as any other ERC20 token in terms of wallets and transactions.

The process is as follows: there is a purchase and redeem process that you can go through with the TrustToken company. You will need to go through KYC/AML process and the minimum transaction amount is $10,000. The system TUSD uses and a main difference with USDT, is that if you purchase TUSD through the TrustToken platform (1:1 against USD), the USD you paid are going to escrow and trust accounts. The TUSD tokens will then be issued and sent to the purchaser’s Ethereum wallet address as a sort of payment receipts or IOUs. If you wish to redeem the same process will take place vice versa: you send the TUSD tokens to the TrustToken wallet address, from where the tokens will be burned and you will get USD paid out (if the transaction is at least $10k and you have a completed KYC/AML).

An incentive to use the purchase and redeem process on TrustToken’s platform instead of just buying and selling on exchanges is that trading on exchanges usually leads to small price differences between TUSD and USD, while on the platform you will always get a 1:1 ratio for the tokens. The platform therefore provides an arbitrage opportunity, which helps stabilizing the price on all trading platforms as well.

Another huge benefit is that since their launch they have an audit of funds held in escrow every 2 weeks by an official auditor. This is 100% more transparent than Tether’s approach.

At the time of writing this post TUSD has now a circulating supply of around 117 million tokens (roughly $117 million) and a daily trading volume that exceeds $10 million, so liquidity is developing. Interestingly enough 60% of that trading volume comes from the trading pair TUSD/USDT on Binance, which means most of TUSD trading/arbitraging is between TrueUSD and USD Tether.

To recap quickly the most prominent benefits of TUSD compared with USDT:

  • TrustToken does not hold the USD reserves themselves (contrary to Tether), but in escrow accounts, which reduces the counterparty risk and one of the main concerns compared to Tether.
  • TUSD supply and stored USD reserves are indeed audited and published frequently, opposed to Tether that has not published any official audit for years except for an unofficial “screenshot” by a law firm.

Paxos Standard Token (PAX)

PAX is one of the most recently launched stablecoins, released by the company Paxos Trust, which is the company behind the OTC (Over The Counter) exchange itBit. In September 2018, they were approved by the New York Department of Financial Services and therefore claims to be the first regulated stablecoin. The PAX token is also a 1:1 USD backed token which can be purchased and redeemed directly on the Paxos website, but can also be traded OTC on itBit.

Paxos needs to comply with several regulations such as the Bank Secrecy Act and AML. Paxos will have monthly audits of their third party USD reserves. There are about 10 trading pairs currently against PAX on three exchanges, including Binance. Despite being young, it has already a total supply of 13 million tokens and a trading volume of $22 million. Also here the trading pairs against USDT are the most popular: 92% of PAX token trading is in the PAX/USDT pairs. Not many other (alt)coins are listed against PAX with reasonable trading volume (liquidity) yet, but that has obviously to do with its short existence.

Gemini Dollar (GUSD)

This is the invention of the Winklevoss brothers’ Gemini Exchange, which is been approved roughly at the same time and under the same conditions regulations as PAX by New York Department of Financial Services. The USD reserve will be held by a US-based bank and fall under FDIC protections. They will also perform monthly audits on the USD reserves against the circulating supply. GUSD is also a 1:1 backed by USD stablecoin and issued on the Ethereum blockchain as ERC20 token. The limitation here is also that it has been released so recently (September/October 2018) that there isn’t so much liquidity and supply yet – 1.2 million circulating supply and only less than $100,000 trading volume.

It is interesting that according to Coinmarketcap.com there are no GUSD trading pairs on Gemini exchange itself, although people can convert it for USD on the Gemini platform and transact with it on the Ethereum blockchain. Most of the trading with GUSD trading pairs takes place on Bibox exchange and it also has trading pairs on HitBTC.

USD Coin (USDC) by Circle

We can easily say that September 2018 is the month of new USD stablecoins, because Poloniex’ parent company Circle also listed their regulated stable coin USDC during this time. It’s almost repetitive: USDC is also issued as an ERC20 token on the Ethereum blockchain! USDC has a New York Bitlicense and is registered as a Money Transmitting Service.

Users can purchase and redeem tokens on a very similar to other stablecoins as described in Circle’s application. There is no information yet available on Coinmarketcap, but trading pairs in BTC, ETH and USDT are trading on Poloniex and it is Circle’s intention to add more trading pairs and get listings on more exchanges (like OKCoin, Digifinex, and KuCoin).

An interesting difference between the other USD backed stablecoins is that, besides Circle, it should become possible for other entities to issue USDC as well in the future. The process would have to go through the so-called CENTRE Consortium and the company would need to comply with the same regulations obviously. This idea could potentially enhance some form of decentralization and decreasing the single-point-of-failure risk that most stable coins have to deal with.

Metal Collateralized Stablecoins

DigiX Gold Token (DGX)

DGX is an ERC20 token that is backed at a 1 token = 1 gram of gold ratio. Which means that price stability is not achieved by a peg to USD but to gold, which does expose it to the slightly more volatile gold price. There is a complex eco-system designed to ensure the gold backing and enhance the trust of investors. Basically the gold is stored in a Singapore-located vault and has quarterly audits by an established auditor on the amount of gold stored in the vault. Besides that there is a smart contract process involved in the creation and redemption of DGX tokens that is called Proof of Assets which should provide a decentralized way to audit the process on the blockchain.

The creation process involves an extra step in the token minting process, which is proof of registration of the physical gold bar that is purchased through the DigiX Global Company. The registration creates a “Digital Asset Card” on the Ethereum blockchain that contains specific data like a timestamp, gold bar serial number, chain of custody signatures. This Digital Asset Card is stored in an Ethereum wallet and fed to the DGX smart contract which then mints the corresponding amount of tokens that are validated by the Digital Asset Card as “Proof of Assets”. If anyone wants to redeem the DGX tokens for physical gold (which is possible in certain countries), you can first redeem your tokens for a Digital Asset Card, and then use that to redeem the gold.

Another element of the DGX ecosystem is a second token that is the DigixDAO (DGD) token which gives the token holder governance rights in the decentralized organization which aims to build an ecosystem around DGX token. Token holders can vote on proposals for that purpose. By actively voting and engaging, DGD token holders are awarded with DGX tokens that are earned by transaction fees (from creating and redeeming tokens). For creating or redeeming DGX tokens you need to convert at least 100 DGX tokens from or to 100 gram of gold.

Of course this eco-system and the value of the token rely a lot on the existence of the DigiX company to provide the service (just like all other asset collateralized stable coins). Additional risk is obviously that you are not protected against a gold bear market when that occurs. Other obstacles are the low trading volume of around $75,000 on a daily basis, which is a very low liquidity. More than 95% of trading in DGX takes place on Cryptono and Kyber Network.

Crypto collateralized

DAI by MakerDAO

The stablecoin DAI in combination with its governance token MakerDAO (MKR) are both Ethereum based tokens and provide an extremely complex solution for price stability. However, in contrast to the fiat/asset backed stable coins, it offers a far more decentralized solution where there isn’t a single point of risk involved. Furthermore, DAI is collateralized with cryptocurrencies instead of fiat currencies, but its price stability mechanism is supposed to keep a 1:1 ratio with the US dollar. Because the system is so complex, it is beyond the scope of this post to dive into the technical details, so I will try to summarize the process:

  • MKR token holders govern and vote on issues of keeping the financial system healthy and the DAI price stable: maximum amount of Debt that can be created per “Debt Position” (Debt ceiling), Collateral-to-debt ratio, Stability fee (comparable with interest rate)
  • Fees in MKR earned in the DAI creation process are burned, which decreases supply which should increase the MKR price over time.
  • HOWEVER, bad governance by MKR token holders on things beyond “central bank” tasks, which results in the price moving too far away from the peg, leads to the automatic creation + market selling of more MKR tokens which dilutes the circulating supply (economically punishing MKR holders for bad governance).
  • Users can generate new DAI by creating a CDP (Collateralized Debt Position) which means locking in a certain value of Ether in a smart contract.
  • User can only redeem the Ether back if the Debt is paid in full in DAI + an additional fee (stability fee) in MKR token
  • There is also a Target Rate Feedback Mechanism that can be activated under severe market circumstances that will automate the price stability mechanism. This is a “central bank” algorithm that should increase or decrease the DAI supply and simultaneously decrease and increase demand for DAI whenever the DAI market price moves away from its targeted peg.

DAI and MakerDAO is an interesting experiment with a crypto collateralized stablecoin that uses a decentralized solution of smart contracts and governance to maintain price stability (currently against USD) without having to rely on USD centralized collateral.

DAI is on the market since Jan 2018 (the early stage of the bear market) and has therefore at least proven to be actually stable against USD despite being collateralized with cryptocurrency which saw a 70%+ crash during its first months of existence, which seems its first proof of viability. Even though there were a few very short lived price spikes up and down, its price has not been lower than $0.889 and not higher than $1.07, but the normal price range has been similar as that of USDT, which is quite stable indeed. Market cap (and circulating supply) is around $60 million, with a trading volume of $5 million, with more than 80% of its trading in BTC/DAI and ETH/DAI trading pairs on HitBTC. It trades on 12 exchanges in trading pairs against around 15 different cryptocurrencies.

Nomin (nUSD) by Havven

Another interesting crypto collateralized stable coin ecosystem is Havven and its stable coin nUSD (Nomin token). Both are also Ethereum based ERC20 tokens. This is also a similar arbitrage system as DAI, although it has its own characteristics and functionality. Again, it is rather complex to understand all elements, but I will try to summarize it here:

  • Havven token holders are responsible for keeping the Nomin token nUSD stable against the USD. This is done by an arbitrage mechanism between locking up Havven tokens as collateral against newly issued nUSD or in reverse burning nUSD by reclaiming Havven tokens.
  • Havven tokens have to be locked in a smart contract and 20% of the USD value of those tokens will be issued as nUSD tokens that will be brought into circulation. That means there is an 80% buffer of value in Havven to back up the USD peg.
  • Users that transact with nUSD will pay a small transaction fee that is used to pay the Havven holders as reward for their price stability efforts. Havven holders that are more actively engaging in price stability efforts will receive a higher reward in nUSD.
  • One key difference with DAI is that the collateral for DAI is Ether and for nUSD it is Havven token.

nUSD is only operating since July 2018, so not much can be concluded about the success of the system under extreme market circumstances, but so far it seems to achieve its goal in maintaining price stability against USD in a decentralized manner. There is only $1 million worth of nUSD in circulation and the trading volume is around $125,000. It can only be traded on KuCoin in 3 trading pairs against USDT, BTC and ETH.

Steem Dollar (SBD)

Steem Dollar (SBD) is part of Steemit, a blockchain platform for content creators. Steemit rewards content creators for their content by paying them in cryptocurrencies that can be used in the system. STEEM tokens and SBD tokens are the two cryptocurrencies that are important for the peg of SBD against USD. Content creators are paid in both currencies, however SBD can be created or redeemed against the market value of STEEM in USD at a 1:1 ratio. Which means that $1 market price worth of STEEM can be converted for $1 USD.

The SBD system has been in place since summer 2016 and therefore has a longer track record than most of the here above discussed stablecoins. Market cap is still below $15 million however and trading volume is only around $500,000, which keeps it fairly illiquid. In the early stage the price of SBD has been as low as $0.77 but for most of the time under normal market circumstances it has been trading in a fairly stable range around $1. However in 2 instances the price has spiked irrationally: in May 2017 the price briefly reached $22 after which it quickly crashed back to its pegged value. The second instance was the irrational bull rally of late 2017 where the price went as high as almost $14 at its peak in Dec 2017 (people were paying $22 for a coin that is designed to be worth $1 – speaking of irrationality), after which it steadily declined back to its original pegged value range.

SBD because of these 2 instances, although having a longer track record, has also proven to be susceptible to price volatility under exceptional circumstances. However that has been to the upside (above $1), and so far its low has been at a 23% discount against USD and only in its infant stage.

Not collateralized (algorithmic supply)

Basecoin (Basis Protocol)

The price stability of this coin is supposed to be managed by the Basis Protocol, which is a “central bank algorithm” that increases and decreases the circulating supply of the coin based on supply and demand. “Supposed to” because this coin is not operational yet, which is why I will only touch briefly on this coin, mainly because it has raised $125 million in an SEC filed token sale (March-April 2018), with large investor backing, which seems to indicate that there is a lot of interest for this project. Basecoin, however has not been launched yet and therefore mostly exists on paper so far. Also there are some critical issues that need to be solved as well in order to be a reliable, decentralized algorithm that can maintain a stable peg under all circumstances and that includes manipulative attacks by speculators (as in the real world example of George Soros and his big short on the British Pound in the past).

The idea is that the protocol is entirely self-regulating the coin supply based on information fed by different oracles that make the protocol aware of the conditions of price, supply, and demand. By using a mechanism of three different types of tokens, the stable coin Basecoin should be held to its pegged asset. The pegged asset could be the USD, but theoretically any other asset or even a basket of assets could be implemented (such as the World Price Index).

On a very high level the system could work like this:

  • Basecoin: this is the stable coin in the system that is initially algorithmically pegged to USD at a 1:1 ratio.
  • Base bonds: these are tokens that are auctioned by the blockchain when the supply needs to be decreased. Buyers will pay with Basecoins that will be locked out of circulation and the “bonds” will have an expiry date and a compensation, which the protocol determines in order to make it more, or less, attractive to buy the bonds.
  • Base shares: these operate when the protocol wants the supply to be increased. These “shares” will have a fixed supply and will pay out “dividends” in Basecoins to the share token holders whenever the supply needs to be increased and thus functions as a mechanism to distribute newly created Basecoins.

There doesn’t seem to be a clear indication when the Basis Protocol and Basecoin are going to be launched and even when that happens it will be a very experimental phase at first to see if the premise of the protocol actually works and maintains its value under real world market circumstances.

Final Thoughts

With the recent launch of several regulated and/or audited USD-pegged AND 1:1 backed cryptocurrencies, the competition with USDT is increasing substantially and they could take over a large portion of Tether’s dominant market share. When more users trade for any of the other stablecoins and exchanges start to phase out USDT in favor of the other stablecoins, the systemic risk that USDT now imposes on the cryptomarkets would then also shrink substantially. Until then, USDT is still by far the most adopted, convenient and liquid stablecoin in the market.

One of its main criticisms could also be one of its advantages: BECAUSE nobody really knows where Tether stores its USD reserve and is an offshore company, it would be harder for the US government to track and shut down the company’s operations and as a consequence seize all Tether’s assets. Its secrecy may very well be its virtue as well, as opposed to some other USD backed stablecoins that are US based companies and that are fully compliant and transparent with regards to their funds. These regulated, transparent stablecoins are much easier for the US government to locate and seize their assets at will.

Centralized and asset collateralized stablecoins have a single point of risk/failure: the company that is supposed to provide the service of storing and increasing/decreasing the supply. If that company stops to operate (properly), the stablecoin’s value will lose its peg and value proposition. So this requires an enormous amount of trust in the issuing company, while the point of cryptocurrency is to achieve a trustless monetary system.

USD pegged stablecoins have the advantage that a user can hedge their crypto investments against market crashes, use for trading in/out the cryptomarket easily, and to avoid price volatility with payments. Long term they are by definition exposed to the same inflationary and central bank money printing as the real USD and on that point defeat one of the key purposes of cryptocurrency: being a mathematically guaranteed and deflationary currency.

The ideal scenario that cryptocurrency enthusiasts are building towards is a monetary system where cryptocurrencies are used as medium of exchange, unit of account, and store of value. When global mass adoption occurs, the expectation is that better price stability will occur, which then makes stablecoins obsolete. Until then, properly and reliably functioning stablecoins may function as a bridge to that scenario.

Decentralized, crypto-collateralized, USD-pegged stable coins have the advantage that they don’t have the single point of risk that their centralized counterparts have in form of the supporting company. They are however still in a very infant, experimental stage and therefore may not be able to function properly under all market situations and/or when they are under a manipulative attack. However when they do have a longer track record under all circumstances, they could form a very viable alternative to the centralized and/or commodity/fiat asset collateralized competitors.

To be really useful in the cryptomarket, a stablecoin should have many trading pairs on many exchanges and have a high liquidity. This means that only a small number of stablecoins could actually be able to ultimately have a dominant enough position to be really useful and attractive for investors.

Disclaimer:

This article was written to the best of our knowledge with the information available to us. We do not guarantee that every bit of information is completely accurate or up-to-date. Please use this information as a complement to your own research. Nothing we write in any of our articles is intended as investment advice nor as an endorsement to buy/sell/hold anything. Cryptocurrency investments are inherently risky so you should never invest more than you can afford to lose.

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