Crypto ‘stablecoins’ explained: What are they, how they work, and how they’re used

‘Stablecoins’
are hot.

REUTERS/Arnd
Wiegmann/File Photo

• ‘Stablecoins’ are the hottest thing in crypto right now, with
  over 50 projects in development.
• A ‘stablecoin’ is a cryptocurrency that’s price is pegged to
  a real-world asset like gold or the dollar.
• Here’s a guide to what they’re used for, how they work, and
  why people are excited about them.

LONDON — The latest innovation in the fast-moving world of
cryptocurrencies is the “stablecoin” — cryptocurrencies pegged to
real-world assets such as the dollar or gold.

A report from crypto
wallet provider Blockchain released this week found that “the
number of active stablecoin projects has dramatically increased
over the past 12-18 months and more than a dozen project teams
have stated they plan to launch in the coming weeks/months.”
There are now over 50 in development globally.

Here’s everything you need to know about the hottest new area of
crypto:

What is a stablecoin?

“Stablecoins” are cryptocurrencies whose prices are linked to a
real-world asset. In theory, they could be linked to anything,
but the majority are linked to currencies such as the dollar or
euro.

How do they work?

There are two main types of stablecoins: reserve-backed and
algorithmic.

Reserve-backed stablecoins function a little like paper money
used to when it was linked to the gold standard. Just as cash
used to be ultimately backed by gold reserves in a central bank,
reserve-backed stablecoins are backed one-for-one by reserves of
the currencies they are pegged to.

Issuers of
coins like USDC or
Tether “tokenize” dollars by exchanging them for a stablecoin
and depositing the dollars in a bank. Those dollars are then left
untouched until somebody redeems the stablecoin for the dollars.
It’s this confidence that the stablecoin can be redeemed that
maintains the price peg.

The second type of stablecoin is one that is not backed by any
reserves but instead controlled by an algorithm.Blockchain

Garrick Hileman, head of research at Blockchain and author of the
recent stablecoin report, told Business Insider: “They’re really
using software rules to try and match supply with demand to
maintain a peg to something like the US dollar.

“As demand for an algorithmic stablecoin increases, supply also
has to increase to make sure there’s not an appreciation in the
value of the stablecoin. At the same time, as the value
decreases, there needs to be a mechanism by which supply can be
reduced again to try and bring the price of the stablecoin back
to the peg.

“That’s really the class of stablecoins that are much more
challenging to design. They’re really unproven at this point.”

Examples of algorithmic stablecoins in development include Basis,
Terra, Carbon, and Fragments.

Why do people need stablecoins?

Cryptos have been plagued by price volatility, with swings of 5%
or even 10% in a day not unusual. This volatility has led critics
to say that cryptos are speculative investments rather than
currencies or assets.

Stablecoins are an attempt to harness the benefits of cryptos —
value can be transferred digitally — and combine them with the
stability and trust in mainstream currencies.

Hileman told BI: “For millions of individuals, tens of millions
in our view, as well as institutions, the volatility of crypto
assets that we saw last year really is keeping a number of
people’s on the sidelines of the cryptocurrency movement.

“Stablecoins can address that and enable a number of use cases
that bitcoin or ether or other more volatile cryptocurrencies are
suboptimal for — things like insurance.”

What are they used for?

The most common use case for stablecoins at the moment is as a
liquidity tool for cryptocurrency exchanges. Many exchanges have
been shut out of mainstream banking because banks are wary of
dealing with anything crypto-related for compliance reasons.

As a result, many exchanges can’t accept dollar or euro deposits.
Clients want to buy with dollars and to be able to trade out of
cryptos into dollars at times of high volatility. Stablecoins
offer an elegant solution to this problem.

However, proponents of stablecoins think the technology could
allow for more complex financial products to be built on crypto —
things like insurance, smart contract dividend payments, and
loans.

Which are the biggest stablecoins?

Tether is by far the most popular stablecoin and is used
primarily by exchanges to offer dollar-like liquidity.

“Tether (USDT) is the second most actively traded cryptocurrency
(~60% of BTC daily trading volume) and earlier this year entered
the top-10 crypto asset rankings by market value,” Blockchain
said in its report.

Hileman said: “Certainly, last year we saw Tether really
demonstrate that there was a real demand for a stablecoin. We saw
use of Tether on exchanges like Poloniex that did not have access
to US dollar deposits really take off. It helped facilitate the
rise of a number of exchanges that were either cut off or chose
not to integrate with the existing banking system.”

Who’s developing them?

Stablecoins are being developed by both new startups and existing
crypto businesses such as Circle and Gemini, the crypto exchange
run by the Winklevoss twins.

There are currently 57 stablecoins in development according to
Blockchain’s report. 23 are already live.

Recent examples include the
Winklevoss twins’ Gemini coin, Paxos Standard, the
US Dollar Coin, developed by Goldman Sachs-backed Circle, and
the LBXPeg.

The
number of stablecoins in development has boomed over the last 18
months.
Blockchain

Venture capitalists are also betting big on the space.
Blockchain’s report said: “$335 million in venture funding has
been raised by all stablecoin project teams to date.” A notable
investment in the space came from Silicon Valley fund Andreessen
Horowitz,
which recently invested $15 million into stablecoin
project MakerDAO.

Why are so many appearing?

Hileman said that the success of Tether “really set off a whole
load of innovative teams to think about: how can we do this
better?”

Despite its popularity,
Tether has been beset by criticism of its auditing standards,
corporate opacity, and claims of manipulation. As a result,
many in the industry feel there is an opportunity to provide a
better solution.

The potential for stablecoins to be used in everything from
crypto insurance to lending and savings means entrepreneurs also
hope there can be room in the market for many successful
stablecoins.

What are the challenges stablecoins face?

Heilman told BI that one of the biggest challenges facing
stablecoins is scaling. For reserve-backed stablecoins to reach a
level where liquidity is deep enough to support interesting
applications of the technology, backers will have to invest
millions or even billions in each coin.

This could create “a cap on how fast the stablecoin can grow,”
Heilman said. “When you’re talking about use cases in the
trillions, having any upward limit or friction on how quickly
something can grow is potentially a huge problem.”

Heilman also believes that stablecoins looking to replace Tether
as a liquidity proxy may end up having a tougher time than some
may assume.

“Tether, for all the complaints and criticism and concerns, has
generally been pretty reliable at holding its peg to the US
dollar. It’s worked well enough,” he said. “Tether had a huge
head start. It has a network effect — it has a love of exchanges,
over 150 that have listed it, it’s a top 10 cryptocurrency.”

The Winklevoss twins are
developing their own stablecoin.
REUTERS/Stephen Lam

Another potential hurdle is regulatory scrutiny. Heilman believes
that central banks may be quicker to act on stablecoins than they
were on cryptos like bitcoin because stablecoins more closely
resemble fiat money and could have effects on monetary policy.

Not everyone believes in the promise of stablecoins either.
Bitfinex’d, a prominent crypto Twitter account that attacks what
it sees as bad practice in the space, recently said: “Essentially
the only application for them is for scam exchanges to use
it,” in relations to those outside the banking system.

Preston Byrne, a fellow of the Adam Smith Institute and the
former COO of blockchain company Monax, has also expressed
skepticism,
calling stablecoins “doomed to fail” in a lengthy blog post.

Finally, the emerging asset also faces a variety of technical
challenges. Blockchain’s report concludes: “The technology is
still nascent and it is highly unlikely that the perfect
stablecoin design exists at present; we expect further
experimentation and innovation.”