ELI5 What’s a stablecoin?

ELI5 What’s a stablecoin?

Since the beginning of cryptocurrency history, most crypto assets have been known to experience enormous oscillations against the US Dollar (or some other legacy currency).

This has scared many people away from cryptocurrencies.

When bonds or FED rates oscillate half a percent, there’s enormous repercussions in the worldwide markets.

Bitcoin, on the other hand, can oscillate 20 to 30% within hours and it’s considered business as usual.

Stablecoins

Cryptocurrency developers and investors decided it was time to use well known financial concepts to develop more stable cryptos.

The rationale is if we want the cryptocurrency space to grow, then some level of stability must be presented to more conservative investors.

Enter stablecoins : cryptocurrency that is backed by some asset class which does not oscillate as much as cryptocurrencies usually do.

Some examples of stablecoins include Tether(USDT), TrueUSD (TUSD), USD Tether (USDT), Paxos Standard (PAX), Centre, Gemini Dollar (GUSD) among several others.

Hedging

So, how does one maintain relative stability for an equity? Aren’t equities naturally unstable? Don’t Apple, GE, Google and other large corporative stocks oscillate a lot as well?

Yes, they do.

But there are techniques that hedge the price oscillation against some other asset that usually oscillates in the opposite direction.

Take, for instance, put vs call options. If you buy the same amount of puts and calls for the same asset, for the same period, then you’ll end up with the same value invested in both. Why? Because if one of them goes up 100%, the other will go down 50% or so. The result is a stable price, even using one of the riskiest derivatives: options.

As you can see, it’s possible to generate stability even using unstable assets.

Currency Reserves

Right now most stablecoins do not use any form of hedging. Instead, they use currency reserves for stability.

It’s the same idea behind countries that build large currency reserves.

Why does China’s currency compete with the US Dollar? Because China holds trillions in US Dollar reserves. If something bad happens, they have tons of greenbacks to honor their commitments. In the meantime, the mere knowledge that they possess the reserves guarantees their international prestige.

Most stablecoins listed above are based on currency reserves.

Tether is one such stablecoin. Binance and the folks behind Tether guarantee they have 1 US Dollar for each Tether (we believe their USD reserves are held in Bitcoin or some other “cash equivalent”). The USD reserves behind Tether guarantee its stability. The only way for Tether market cap to grow is to mint more USDT.

Similar ideas hold for USDT, TUSD, GUSD and PAX.

How are Stablecoins Different From Each Other?

You may be wondering why there are several stablecoins? Why not just stick with Tether, as has been the case for years?

The answer is risk management and compliance.

PAX, for instance, is regulated in New York. It’d be very audacious to establish a financial instrument in NY and attempt to defraud investors. Bernie Maddoff knows the consequences of this.

Tether, on the other hand, is hosted offshore and its USD reserves have been questioned many times. We can’t really be sure that Tether does indeed hold the reserves they claim to hold.

The main difference between stablecoins is, therefore, transparency and how well regulated they are.

Conclusion

We hope this short introduction to stablecoins has helped you grasp the concept a little better. In the coming years investors may look forward to seeing more complex financial instruments be used together with blockchain applications in order to create crypto assets with special traits. Stablecoins are just one such application and the possibilities are endless.



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