A Comprehensive Guide to Stablecoins

Bitcoin has shaken the world since its launch. Its enigmatic creator, Satoshi Nakamoto, intended this disruptive and game-changing technology to be a new form of cash. However, what’s stopping this “peer-to-peer electronic cash system” from becoming mainstream is its price volatility.

The value of all cryptocurrencies in the world has now topped $1.04 trillion, with Its total market capitalisation now higher than many countries’ GDPs.

You’d struggle to buy groceries with Bitcoin though. If you’re in business, your suppliers will want payment in fiat currencies, not Ethereum or Dogecoin. Given all of the inherent benefits of cryptocurrencies, why is this the case?

In this article, we find out why crypto hasn’t gone “mainstream” yet and how stablecoins may be the solution people want.

Stablecoins: The solution to the volatility problem

When we get paid, we want a high degree of certainty that the money we’ve earned will be worth the same amount tomorrow or next month.

Price volatility is what holds cryptocurrencies back, as prices can swing back and forth regularly. This is not the only reason why there’s reluctance to switch to crypto, but it’s a key contributor of reluctance towards crypto investment.

Stablecoins address these major consumer and business worries head-on, with the ultimate goal of stablecoins is to become the most reliable digital form of fiat-free cash.

A stablecoin is a cryptocurrency whose value remains stable over time as it is pegged to the value of the underlying currency e.g $1 dollar or £1 pound. This stability means that consumers, businesses and investors can have confidence in their worth. It also means they could use them as everyday means of exchange.

Other changes need to happen before people become as accustomed to crypto as they are about fiat currency.

Other important issues include:

• Lack of bank support: Banks are heavily regulated and are wary of cryptocurrencies, with few allowing crypto-related transactions.
  
• Medium of exchange: Without a stable value, transactions become harder. That’s because both parties must agree on what the value of the crypto is, making the transaction more barter-like.
  
• Unit of Account (UoI): For cryptocurrencies to be useful for price, their value must remain stable. Price inconsistencies arise when the value fluctuates.

Why stablecoins are the future of cryptocurrencies

Stablecoins are an attempt to address these shortcomings and make crypto appeal to the public.

The aim is for stablecoins to satisfy the commonly agreed requirements of what sound money is. 

That is, they must be a store of value (SoV), a medium of exchange (MoE), a unit of account (UoA), and fungible. They must be easily moved and divisible as well.

The stablecoin solution

Unlike Bitcoin and Ethereum, stablecoins can achieve these requirements because of their lack of price volatility.

So, if you trade 1 BTC for a stablecoin, for example, its value will be the same even if the price of Bitcoin drops. You can also convert your stablecoins back to BTC anytime.

This predictability makes stablecoins suitable for investing in options, derivatives, and prediction markets. It is also a better currency of choice if you invest over an extended timeframe.

The pros and cons of each type of stablecoin

There are five main different types of stablecoin:

• Fiat-collateralised stablecoins: These are stablecoins which derive their value from fiat currencies. The main currency underpinning the value of fiat-backed stablecoins is usually the dollar.
  

• Crypto-collateralised stablecoins: These stablecoins use other cryptocurrencies such as Bitcoin as collateral.
  
• Non-collateralised stablecoins: These stablecoins maintain their value through smart contracts and other mechanisms. However, there’s no collateral backing them.
  
• Algorithmic stablecoins: These stablecoins are similar to non-collateralised stablecoins but rely on seigniorage and algorithms that help balance the circulating supply and price.
  
• Commodity-backed stablecoins: These are stablecoins backed by gold, silver, or another precious metal. An example of a gold-backed cryptocurrency is Kinesis gold (KAU).

Let’s look at the advantages and disadvantages of each.

Fiat-collateralised stablecoins

Fiat-collateralised stablecoins share a lot in common with paper money (fiat money) like the dollar or pound. They are not backed by gold reserves in a central bank and are instead backed one-for-one by U.S. dollars.

A central entity is responsible for the collateral that supports a particular stablecoin. They also manage the cryptocurrency’s reserves. They issue a token representing the amount of money they hold.

They have a ratio of 1:1 against the fiat currency they have a peg to. This makes fiat-collateralised stablecoins the easiest and most straightforward to create and operate.

The central entity needs to make sure that the valuation of its collateral keeps up with the value of the coins issued. To this end, they need to carry out frequent valuations of their own collateral and allow outside auditors to verify their valuations.

An example of a stablecoin using this type of architecture is Tether.

On paper, it has a market cap of roughly $82 billion and a daily volume that exceeds $14 billion. Although Tether has come in for much praise, it’s been the subject of controversy too. There have been concerns about the lack of professional and publicly available audits. That’s still the case in 2023.

However, fiat-collateralised stablecoins have their share of problems. For this type of stablecoin to be successful, users have to trust the central entity that holds the money or collateral. As we’ve seen, it’s easy for trust to become eroded in a particular crypto.

Crypto-collateralised stablecoins

Crypto-collateralised stablecoins hold other cryptocurrencies as their collateral. The aim is to keep a stable price by tying their value to other digital assets, not fiat or real-world assets.

Fiat-collateralised stablecoins are simple but centralized. Crypto-collateralised stablecoins are more decentralized, as they rely on other cryptocurrencies for backing. Many crypto enthusiasts prefer decentralized coins because of their apparent greater transparency. 

Crypto-collateralised stablecoins experience high volatility. For this reason, they need over-collateralisation which requires a large amount of capital. 

This compensates for the fluctuating prices of the cryptocurrencies held as collateral. It also means, however, that users have to have more in collateral than they do in stablecoin to maintain the currency’s stability.

In this setup, a large portion of cryptocurrencies contributes to the stablecoin’s price stability.

Using this type of stablecoin works well for daily transactions, but holding them long-term is risky. In addition, stablecoins have not been rigorously tested in real markets yet.

An example of a crypto-collateralised stablecoin is Dai, issued by MakerDAO.

Despite growing popularity, many users struggle to understand how this cryptocurrency type functions. To use crypto-collateralised stablecoins, you must deposit cryptocurrencies into a smart contract. The smart contract then issues you a specific quantity of stablecoins. 

However, the stablecoins you receive have a total value less than the cryptocurrencies you deposited.

Another issue arises when the smart contract auto-sells your cryptocurrencies if their value goes down. This means that you would lose your collateral and your loan at the same time.

Non-collateralised stablecoins

Unlike crypto-collateralised stablecoins, non-collateralised stablecoins have no collateral backing them whatsoever. They use smart contracts and algorithms to adjust the amount of coins in supply based on their value. 

This approach comes from the Quantity Theory of Money, which states a direct link between an economy’s money supply and its prices.

Therefore, the stablecoin supply correlates directly with its prices. If the coin value exceeds $1.00, the supply grows. Conversely, if the value falls below $1.00, the supply shrinks.

Such adjustments exert upward or downward pressure on the coin value as required.

Algorithmic stablecoins

Algorithmic stablecoins are another type of non-collateralised stablecoin. How they differ from non-collateralised stablecoins is that they rely on seigniorage. Seigniorage is the difference between the face value and the production cost of a currency.

If the price goes up, more coins come onto the market. If the price goes down, coins leave the market reducing the supply. 

The algorithm intends to balance supply and demand but there are risks. 

If there are flaws in the algorithm or investors lose trust and confidence, there’s a risk the coin will become unstable. There is a chance of a “bank run” on the currency if this happens.

Commodity-backed stablecoins

Commodity-backed stablecoins are the fifth major stablecoin type. 

Fiat-backed stablecoins like Tether are more common but gold-backed cryptocurrencies are catching up. These stablecoins have their value backed by commodities like precious metals, most notably gold and silver.

This is how they work. For a stablecoin backed by gold, each coin issued represents a specific amount of gold. This is normally a gram of gold or even ounces of gold.

People and investors buy these stablecoins on platforms like the Ethereum blockchain, often in the form of ERC-20 tokens. 

The backing of gold or other precious metals provides value to the coins. Investing in gold is as old as human history. Gold is a stable asset that doesn’t see the same volatility as the stock market. 

With gold-backed cryptocurrencies, you get the best of both worlds – the solid backing of a real-world asset and the flexibility of a digital one.

When you buy a gold-backed stablecoin, you’re buying a tokenised form of ownership that entitles you to a specific amount of gold. 

This gold sits in a secure vault and is audited by third parties. You can redeem your stablecoin gold for real physical gold whenever you want, depending on the provider.

Gold-backed crypto from Kinesis

If you want to invest in stablecoins backed by gold or silver, you can with Kinesis.

We brought one of the first gold stablecoins to the market with additional utility and rewards, as you can earn a yield on your gold and silver holdings with us. Kinesis gold and silver can be spent using the Kinesis Virtual Card, and also transacted with ease with Kinesis Pay.

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This publication is for informational purposes only and is not intended to be a solicitation, offering or recommendation of any security, commodity, derivative, investment management service or advisory service and is not commodity trading advice. This publication does not intend to provide investment, tax or legal advice on either a general or specific basis.