All you need to know about Stablecoins

Have you ever wondered why on earth would the world need stablecoins when we have got PayPal or Venmo or GooglePay? Me too. So I looked into it and I have some interesting findings which I believe is of interest to you as well. In this post, let's discuss about stablecoins. I hope you you learn a thing or two about it as well.

A banking transaction

Andrei Jikh has done a fantastic video explaining this and I recommend you to watch it. When you pay with your debit card for your coffee at Starbucks, there is a three step process that is happening in the backend:

1. Execution: This is where the seller states the price they are willing to sell the commodity or asset in this case a cup of coffee and the buyer agrees to transfer money from their account to the sellers. Using the sellers banking system, in this case scanning a bar code or swiping the buyers card on the transfer machine, the transaction is said to have 'executed'

2. Clearing: When both parties agree to to this bank transaction which is initiated in the previous step, at first it needs to be recorded in a ledger, in this case the bank's own LEDGER to which the buyer has no access to. If the buyer and seller uses different banks, say JP Morgan and Citi bank, both the banks will record this transaction in their own ledgers.

3. Settlement: Once the transaction is cleared from the banking side, where the seller's bank confirms the buyer's bank account had the money and they had the decided amount transferred to the seller's account, the seller (Starbucks) gives the asset (cup of coffee) to the buyer (you).

Everyone is happy. Buyers get their coffee and Sellers get their money. So what's the problem or is there any problem?

Elephant in the room - The Bank

The problem with this type of transaction is the bank itself. For this transaction to happen, the banks play a huge role as they facilitate the transactions between sellers and buyers. This gives them a lot of power. Well, if they are all trustworthy it wouldn't be a problem but they are not. There are various instances where banks themselves were involved in shady activities in the financial world. A single google search will fetch many results to prove this point. There are instances where banks are directly involved in money laundering activities, fake account creation, market manipulation, gambling with money and any risky activities that one can think of. Financial crisis of 2008 tops this list.

That's not all. Banks have veto power over any transactions. For whatever reasons, if a bank doesn't want a transaction to happen, they can instantly stop it. That shouldn't be the case right, I mean, it's the users money which they have trusted the bank and put it there. In my opinion, the users should have complete control over their money and no third party can meddle with it. Also banks know every single financial activities that you do. It's in their ledgers. They can sell this data to potential buyers who can target ads specifically to a user based on their buying trend.

Another side effect of having banks holding the money is that we cannot do transactions on holidays. I am not talking about sending a dollar or two to sellers or friends but transactions involving big amounts. It can only be done during banking hours. Yes this is true in this modern age still following traditional practices. Also you need to shell out a good amount as transaction fee to facilitate this transaction. In fact, this is the main reason why cryptocurrency was appealing to many in the beginning, especially the crypto whales, where any amount of transactions can be carried out to anyone in the whole world in an instant.

A possible solution - Stable coin

So what is a stable coin and how can it solve the current issues with the banking problems? Let's talk about it. I recommend watching this brilliant video by a YouTube channel called 99BitCoins as they have clearly explained everything in details.

By definition, A stable coin is a digital currency that is designed to reduce volatility of the coin price compared to highly volatile cryptocurrencies like Bitcoin or Ethereum.

You may ask - what's the problem with cryptocurrencies being 'volatile'? Well, by traditional means, money should serve three purpose - store of value (it should hold it's value to the near future), medium of exchange (it can be exchanged for assets) and unit of account (it can used to price different commodities, like $1 for a cup of coffee). Our fiat currencies can be used to serve as a medium of exchange and unit of account but it cannot be used to store value because fiat currencies are inflationary in nature, i.e. it's value depreciates over time. Cryptocurrencies on the other hand, are at the moment used as a store of value as most of the crypto assets value increase over time. That also means that it cannot be used to exchange commodities or price different assets as it's value keeps fluctuating in either ways.

Stablecoins are pitched as a solution to this volatility. They are made 'stable' in two ways - one way is to peg the coin to a “stable” collateral asset like the U.S. dollar (USDT or Tether) or gold (DGX) or crypto assets (Elastic BTC) and another way is to use algorithms to manipulate supply based on demand to stabilize the value like Ampleforth (AMPL).

What can we possibly do with stablecoins?

A stablecoin offers the convenience of the cryptocurrencies and the stability of the fiat currencies. Best of both the worlds. Most of the stable coins are utility tokens which means they can be used to create smart contracts as well which is another added benefit.

At the moment though, stablecoins are used mainly in crypto exchanges where users can buy cryptocurrencies in exchange for stablecoins and also the users can transfer the coins between different exchanges which is a way to circumvent regulation and high fee payment as you do not need a bank account to hold stablecoins; just about any digital wallet would do. Crypto exchanges also offer attractive incentives like earn interest for lending the stablecoins which is usually higher than a regular FD or RD interest rates. Moreover, people have sent, both nationally and internationally, as much as a million dollars worth of USDC with transfer fees of less than a dollar without involving a bank. Satoshi Nakamoto would be proud.

Limitations of stablecoins

There are limitations to both asset pegged and algorithmically pegged stablecoins.

In the case of asset pegged stablecoins:

• Though there is high degree of stability, the underlying collateral asset cannot be used for any other activities; it will sit idle forever
• There is a risk of embezzlement of the company which issues the stablecoin itself. Users place their trust on these companies which may or may not be worthy.
• The stablecoin company is required to show proof of solvency, i.e. they need to prove they hold enough reserves to be pegged to the stablecoin. For example many exchanges has been using tether as their stablecoin but tether is in hot water recently for conducting shading business practices. 
• Some doesn't consider stablecoins as cryptocurrencies because well they are essentially centralized with a company or trust that maintains the peg
• Crypto pegged stablecoins can be audited easily but the underlying asset itself is volatile which means lower degree of stability
• Many criticize that it would be impossible to maintain the peg in the long term as the demand grows
• All stablecoins have a looming threat over their head for they are doomed to fail due to issues in maintaining them
• CHF (Swiss Frank to the USD), CNY (Chinese Yuan to USD), etc are some of the earlier failed stablecoins

On the other hand, we have the algorithmically pegged stablecoins. They've got problems too:

• Though no assets are required for this coins, many question the nature of this stablecoin solution
• There is no guarantee for the pegged coins as they are not backed by anything but the smart contract
• It runs purely on the trust that people place on the smart contract
• Regulatory authorities doesn't like the idea of non asset backed stablecoin. For example Basis - an algorithmic stablecoin got shut down by regulatory authorities

Nevertheless, people use stablecoins to carry out various financial operations by accepting these limitations.

How do stablecoins make money?

Interesting question.

Well, some stablecoins charge a nominal fee to use their coin for transactions. If it is widely adopted, then that itself can generate a lot of money. But for the most part, stablecoins are issues as a marketing channel to raise awareness to their services to the general public. Many exchanges own stablecoins like coinbase, binance, circle, gemini, etc which can be used to buy crypto assets and servicing from those exchanges. It is an economy of scale, i.e. the more people use a stablecoin the more valuable it is. Many banks and corporations are also looking forward to release stablecoins of their own which means stablecoin business could be huge. It's all about becoming the most dominant player in the stablecoin market.

The game of caching up

As discussed before, many banks now are catching up with the blockchain technology. At the time of writing this blog, 85% of the central banks in the world are now investing in digital versions of their currency. Why? Well, in simple words, cryptocurrencies are an existential threat to the banking system. The core idea behind the cryptocurrency technology which was put forward by Satoshi Nakamoto (whomever it is) was to decentralize the banking process such that there will be no central authority involved in the financial transactions. So what are they going to do about it?

They can do one thing - release a stablecoin as the digital currency, make it the only legal tender for crypto transaction and by that way, they can still retain some control in the crypto world and still be in the game. Not just the banks, major corporations are on this race too. For example: Facebook's Diem, China's Digital Yuan, Russia's Digital Rubble, etc are a few. The main of such stablecoins is to become the new world currency like how everything is compared with the dollar.

Examples of stablecoins

Let's see some examples for stablecoins:

• Tether (USDT) - Fiat Collateralized. Started by the company Tether in 2015. Involved in controversies.
• True USD (TUSD) - Fiat Collateralized. Addressed the issues of Tether. Relatively new.
• Gemini USD (GUSD) - Fiat Collateralized. Claims to be the regulated stablecoin. Issued by the Winklewoss Brothers backed crypto exchange Gemini.
• USD Coin (USDC) - Fiat Collateralized. Issued by crypto exchanges COINBASE and Circle.
• Dai (DAI) - Crypto Collateralized. Issued by Maker Dao