A Beginner’s Guide to Decentralized Finance (DeFi) Part 2: Stablecoins

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Money

To recap what we have learned in — DeFi is the blockchain/crypto-verse’s attempt to replicate the traditional global financial system in a way that democratizes access to it, disintermediates it, and renders it non-custodial in nature.

In other words, DeFi aims to perform the same functions (or more) that the extant global financial system does, without having any centralized authority or hub of power to control and regulate the ecosystem’s everyday operations.

Before they can even begin to do so, however, the DeFi ecosystem must first be able to recreate in its own image, the very foundation and cornerstone of any financial system: money.

The Problem with Money in Crypto

There are 3 main functions of money — a store of value, an unit of account, and a medium of exchange.

For the first two functions, cryptocurrencies (the blockchain/crypto-verse’s version of money) seem to work just fine. For the last one — a medium of exchange — this is where some problems inadvertently creep in.

As of the time of writing, the global crypto market capitalization is at $1.42T USD.

This is a very decent number indeed, considering the state of the market just a year or two ago.

Here’s the problem though: the total stock market value stands at a whopping $95T USD, almost a 100x of the crypto market capitalization.

In fact, just Apple’s market capitalization alone ($2.4T USD at the time of writing) already far outstrips the entire crypto market capitalization. Just let that sink in for a little bit.

The moral of the story here is that the crypto-verse is still very much in a nascent stage, and is absolutely tiny compared to the stock and/or legacy markets.

Because of this relatively small market capitalization, the value of cryptocurrencies, or money, in the crypto-verse, is extremely volatile. This holds true even for the ‘larger’ coins like Bitcoin or Litecoin, all of which have seen great fluctuations in prices just this year (or even month) alone.

To understand why this is the case, imagine a scenario. You throw a rock into a pond, whilst your friend Alice throws a similar rock into the ocean. Which rock is going to have more of an impact where it lands?

Similar to the pond, which is much smaller than the ocean, the cryptocurrency market capitalization will be affected much more with any given action or movement (buy and sell orders), as compared to the currencies of the traditional financial markets (the ocean).

This represents a major issue, since we cannot enjoy the benefits of cryptocurrencies without the extreme value volatility that accompanies it.

Imagine how hard it is to use Bitcoin, or any other cryptocurrencies for that matter, for day-to-day financial transactions and/or trading purposes when one day they are worth X, and the next day they could be worth half of that.

This is exactly where stablecoins come in.

Stablecoins

In order for us to reap the benefits of a decentralized currency whilst enjoying some form of value stability, stablecoins are of utmost importance to the DeFi ecosystem.

In its simplest terms, a stablecoin is essentially a cryptocurrency that has its value pegged to a real-world (fiat) currency. This ensures that it will not be as volatile, and fluctuate as much, as the archetypical cryptocurrency.

For example, the first stablecoin to be listed on exchanges in 2014, Tether (trading under the ticker USDT), has an alleged 1–1 peg with the US dollar. This means that every 1 USDT axiomatically represents 1 USD in value.

You must have realised that I used the term ‘alleged’ for a reason; that is something we will explore in future articles, but which is beyond the scope of this one.

How do Stablecoins Work?

The most important thing to guarantee when it comes to stablecoins, is the fact that the coin is actually worth what it is pegged to.

For example, if the market doesn’t believe that one USDT is really worth one dollar, people will immediately dump all of their USDT and the price is likely to crash.

In order to maintain this trust, Tether has to back its coins with some sort of asset. This collateral is to ensure that the coins (USDT) are actually worth the pegged amount.

There are 2 main assets that most companies utilise as collaterals to maintain their stablecoins’ pegs to fiat currency, and to give them actual value:

  1. Fiat
  2. Crypto

There is also a third, non-collateralised form of stablecoins that has gained in popularity in recent times: algorithmic stablecoins.

Fiat-backed Stablecoins

The most popular kind of stablecoin is that which is directly backed by fiat currency with a direct 1:1 ratio. In other words, fiat-backed stablecoins are coins that are directly collateralized by fiat currencies — usually the one that they are pegged to.

In this case, an issuer (usually a centralized entity) will hold a certain amount of fiat currency in their reserve, and issue an amount of coins that is proportional to said fiat reserve.

To evince, an issuer (like Tether) may hold 1 million dollars worth of USD in its reserve, and disburse one million coins (USDT) worth a dollar each into the market, thereby retaining a strict 1:1 value ratio between USD and USDT.

Users can then freely trade these USDT coins as they would, other tokens or coins in the crypto-verse. The holders should also be able to redeem them for their direct equivalent in USD at any point in time, because as aforementioned, the Tether fiat reserve is supposed to contain the same amount of value (in USD) relative to the value of USDT coins given out.

On top of USDT, there are also other commonly-used fiat-backed stablecoins like BUSD, BGBP, TUSD, GUSD, and USDC.

Cons

This model, though popular, evidently goes against one of the core tenets of the DeFi ecosystem — decentralization. It is also custodial in nature, and requires the trusting of a central entity, the issuer of coins. If an issuer is not transparent with its reserve, there is nothing much an end-user like me and you can do.

For example, Tether has long suffered severe criticism and audit requests from skeptics who do not believe that the company has enough collateral to back the USDT in circulation in a 1:1 ratio.

Further, with centralization, there exists a singular point of failure that goes against everything DeFi — or blockchain for that matter — was conceived of for.

Crypto-backed Stablecoins

Crypo-backed stablecoins are almost exactly like their fiat-backed counterparts.

One main difference, however, is that instead of fiat currency, cryptocurrencies are utilised as collateral and held in reserve to back their corresponding stablecoins.

The other main difference is a game-changer, and also the reason why more and more people are shifting to crypto-backed stablecoins in recent times; instead of having a central entity (that requires trusting, and may not be transparent) as an issuer, crypto-backed stablecoins are able to leverage on the digital nature of cryptocurrencies to let smart contracts (more trustless and transparent) handle the issuance of coins.

In order to get your hands on crypto-backed stablecoins, the process is a little different from that of fiat-backed ones. Instead of interacting with a centralized organisation, you are now interacting with pieces of code.

Users have to send and lock up their cryptocurrencies into smart contracts, which will then issue the corresponding number of stablecoins back to them. Later, to get their collateral back, users only have to send these issued stablecoins back into the same smart contract (along with any interest accrued).

This form of collateral is more transparent, and much easier to audit, since a company’s balance can always be viewed on the blockchain.

Cons

On the other hand, these crypto collaterals will also be much more volatile in nature as compared to fiat collaterals.

Therefore, and in many cases, companies issuing crypto-backed stablecoins will hold 150%, or even more, of the collateral needed. This is to buffer against potential large swings in cryptocurrency prices.

This requirement may pose some serious problems for end-users, who may face liquidation if the price of their collateral drops too much (beyond the 150% threshold).

Algorithmic Stablecoins

Instead of having fiat or crypto as collaterals to back them up and maintain the peg, some stablecoins also do so by manipulating the coin supply.

This constitutes an algorithmic peg, and stablecoins that utilise such a system are called algorithmic stablecoins. To be clear, algorithmic stablecoins do not hold any assets, fiat or crypto, as collaterals.

For any given algorithmic stablecoin, the issuing company will write an immutable set of rules into a smart contract. This smart contract will then increase or decrease the amount of said stablecoin in circulation, depending on the coin’s price in relation to the fiat currency it is pegged to.

Let’s take a look at the following scenario to give you a better idea of how algorithmic stablecoins work.

Imagine we have a stablecoin that is pegged to the US dollar through an algorithmic peg. Assuming a lot of people were to start buying the coin, its price will rise and the peg will be broken.

To prevent this from happening, new coins are issued. This increase in supply will alleviate the price pressure created by the increased demand, and will maintain the coin’s value.

If, on the other hand, many people start selling the coin, coins will be removed from the overall supply in order to hold the price peg to the US dollar.

To reiterate, algorithmic stablecoins do not hold any assets as collateral. The smart contract that manages the coin acts as a central bank, and will manipulate the price back to the peg

by changing the coin supply on the market.

Cons

However, many have argued that algorithmic pegging only makes sense in theory; it may not really work that well in real life, since manipulating the money supply isn’t a definitive guarantee that the peg will hold.

I mean, not a single project has managed to successfully develop an algorithmic stablecoin till date.

Additionally, in the case of a black swan event, algorithmic stablecoins may suffer from exceptionally volatile market moves if they do not have some kind of pool of collateral to handle these situations.

In fact, even if they do, they may still get brought into the ground. Case in point, Iron Finance (link:)

What are Stablecoins Used for?

Stablecoins have a number of use-cases. The main ones include, but are not limited to:

  1. Risk-off strategies
  2. Everyday transactions
  3. Lending and Borrowing
  4. Moving money between exchanges

Risk-off Strategies

Using stablecoins, traders can trade volatile cryptocurrencies for stable cryptocurrencies

when they want to take a more risk-off strategy.

For example, if I’m invested in Bitcoin and I don’t want to risk the price of Bitcoin falling too much against the US dollar, I can just exchange my Bitcoins for USDT and retain my dollar value.

Once I want to “get back into the game” and hold Bitcoins once again, I can just exchange my USDT back to BTC.

This method is extremely popular with crypto-only exchanges that don’t supply their users with the option to exchange Bitcoin for fiat currencies due to regulatory and/or other limitations.

Everyday Transactions

If anyone wanted to utilise a cryptocurrency to complete his/her everyday transactions, stablecoins would be the much wiser choice as compared to other coins.

For example, if you wanted to buy a cup of coffee at your local cafe, it would be pretty unwise to pay for it in Bitcoins. What if the value suddenly shot up after you’ve made the purchase? You’d make quite a big loss then. Similarly, what if the value suddenly plummets after the transaction? That will not benefit the merchant (who received the Bitcoins as payment) at all.

Stablecoins thus afford a more stable form of cryptocurrency when it comes to non-big ticket everyday payments and transactions.

Not only will the merchant and purchaser benefit from the lower fees of cryptocurrency transactions, they will also get to enjoy the value stability of fiat currencies.

Decentralized Lending and Borrowing

Lending and Borrowing are a huge part of any financial system, the DeFi ecosystem included.

It is pretty apparent why stablecoins play an integral role when it comes to these activities, for it makes sense that one should only be able to borrow a relatively stable currency.

If it were not the case, many issues like high slippage, loss of value etc. are likely to arise.

Moving Money between Exchanges

Another great advantage of stablecoins is that you can move funds between exchanges relatively quickly, since crypto transactions (stablecoins are still essentially ‘crypto’) are faster and cheaper than fiat transactions due to their disintermediated nature.

The option for such a fast settlement and movement of value between exchanges makes arbitraging more convenient, and closes the price gaps that you usually see between Bitcoin exchanges.

In essence, stablecoins allow for a healthy functioning (and growth) of the entire DeFi ecosystem, for it unlocks access to many services that will otherwise be impossible to provide.

What are Some of the More Popular Stablecoins?

Of course, with so many stablecoin options out there, it would be prudent for me to tell you about the ones that are more commonly used, and concomitantly, possibly more reliable than the others.

First, USDT or USD Tether, which I’ve already mentioned quite a bit in this article,

is a fiat collateralized stablecoin that is pegged to the US dollar.

The coin was created by the company Tether, and has remained relatively stable since its introduction in 2015.

Next, TUSD — not to be confused with USDT — stands for TrueUSD, and is a relatively new fiat collateralized stablecoin that attempts to address the criticism directed at Tether and their un-transparent practices when it concerns their fiat reserve.

For TUSD, US Dollars (the collateral) are held in the bank accounts of multiple trust companies. These bank accounts are published every day and are subject to monthly audits.

Additionally, GUSD, also known as Gemini USD, is a fiat collateralized stablecoin issued by the popular crypto exchange Gemini, which was established by the Winklevoss brothers.

According to Gemini, GUSD is the first regulated stablecoin in the world.

Further, USDC, which stands for USD Coin, is a fiat collateralized stablecoin issued by Circle and Coinbase that also (like TUSD) privileges transparency and accountability in their handling of the reserve (collateral) funds.

Finally, DAI is a very popular stablecoin created by MakerDAO that is crypto collateralized. Many argue that it was DAI and MakerDAO that ushered in the yield farming craze, and I personally would be hard-pressed to disagree with that.

Final Thoughts

Despite its numerous downsides and risks, it is undeniable that stablecoins are still a critical — if not foundational — component of the DeFi ecosystem.

Their value stability allows them to be used reliably not only as mediums of exchange, but also as a great tool for traders and investors to leverage on when it comes to their various activities within the space.

Indeed, stablecoins are — to me — a key element that could potentially propel the entire DeFi space to new heights via its ability to serve in use cases where volatile alternatives are not ideal.

I would definitely love to see more unique use-cases surrounding stablecoins pop up within this space in time to come.

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A full-time educator, but even fuller-time Cryptocurrency and Blockchain nerd — Certified Blockchain Practitioner — Certified Bitcoin Professional

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Derek Lim

Derek Lim

A full-time educator, but even fuller-time Cryptocurrency and Blockchain nerd — Certified Blockchain Practitioner — Certified Bitcoin Professional

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