Stablecoins are asset-backed cryptocurrencies. By linking their value to a more stable asset, stablecoins aim to avoid fluctuating as much or as often as traditional cryptocurrencies like Bitcoin.
The most popular stablecoins — Tether and USD Coin — are both pegged to the US Dollar at 1:1. This means that 1 Tether Coin and 1 USD Coin are both worth $1. Alternatively, some stablecoins are tied to a commodity like gold or silver.
In either case, a ‘reserve’ of the asset that backs the cryptocurrency has to be deposited with a traditional bank in an amount proportionate to the number of tokens in circulation. So if a stablecoin is pegged 1:1 to the US Dollar and there are 10,000 coins in circulation, the reserve must be $10,000.
This reserve acts as collateral. So, in theory, you could exchange one unit of a stablecoin for one unit of the asset that backs it.
Less commonly, stablecoins are backed by one or more other cryptocurrencies or by an algorithm.
Here, the process happens entirely on-chain.
Let’s say you want to buy stablecoin that is backed by Ether. To get the stablecoin, you’d tie a predetermined amount of Ether to a smart contract. This would then release the stablecoin.
Many crypto-backed stablecoins are over-collateralized. The excess collateral acts as a buffer in case the cryptocurrency that backs the stablecoin falls in value.
By contrast, algorithmic stablecoins aren’t collateralized. Instead, they simply track another asset. When the asset goes down in value, the algorithm decreases the number of coins in circulation. Conversely, when the asset’s value goes up, the number of coins in circulation increases.
- BitUSD, the first stablecoin ever created, was launched in 2014 by former Ethereum Foundation CEO Charles Hoskinson and father-son duo Stan Larimer and Daniel Larimer. But the idea dates back to 2012, when JR Willett came up with the idea for Mastercoin, an open source protocol that aimed to remedy Bitcoin’s volatility and illiquidity.
- Mastercoin, which was rebranded as Omni in 2015, was one of the first platforms to allow ICOs and ITOs. Tether, the biggest stablecoin by market cap, is built on the Omni protocol.
- While stablecoins are theoretically less volatile than traditional cryptocurrencies, counterparty risk is a serious problem. Many issuers aren’t transparent about where they hold their reserves. And Tether has refused to allow a full audit.
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Despite its popularity, Tether is hugely controversial. According to this study, at the height of the 2017 cryptocurrency boom it manipulated the price of Bitcoin and other cryptocurrencies. Several multimillion dollar class-action lawsuits have been filed against Tether and cryptocurrency exchange Bitfinex on the basis of these findings.
Speaking of manipulating prices, the Mastercoin white paper — which author JK Willets ambitiously called “The Second Bitcoin White Paper” — was remarkably prescient about the risk of market abuse.
Unfortunately, it falls short of suggesting mechanisms to prevent this. The white paper’s Appendix A, aptly headlined “Horrible, Awful, Very Bad Things” simply notes that:
“…it should be clear by now that MasterCoins can be used for some very bad things. Anyone working on an implementation of the MasterCoin protocol should be very careful to warn users to not break the law of their country of residence. It is up to the user to know the laws of their country…“
The Metaco view
“It’s neither helpful nor desirable to see cryptocurrencies and traditional currencies as being in competition with — and trying to eradicate — each other. The market will be much more resilient if the two co-exist and complement each other. In this respect, stablecoins are very much a bridge to the future…”