What Is Stablecoin?

Stablecoin is a cryptocurrency with a fixed exchange rate or with certain means of resisting exchange rate fluctuations. In most cases, stablecoins are pegged to real-life assets like fiat currencies, precious metals, or asset baskets. Others emulate certain monetary policies practiced by central banks in a decentralized fashion.

Stablecoins make a good means of exchange, an accounting unit, and a store of value. They enable one to get paid in cryptocurrency without fearing its price would go down. Stablecoins may become an alternative to fiat currencies for unstable economies with high inflation rates and currency restrictions. Lastly, they may find their use in cryptocurrency loans and derivatives.

There are three categories of stablecoins in terms of their backing:

• fiat-backed, such as Tether or TrueUSD;
• backed with digital currencies or a cryptocurrencies basket, such as BitUSD in BitShares;
• unbacked, such as seigniorage shares.

Economically speaking, stablecoins of this kind are promissory notes. Each stablecoin corresponds to a fiat unit stored by a third party. When a user wants their USD back, the issuer liquidates the corresponding amount of the user’s stablecoins and sends them the corresponding amount in fiat. DigixDAO works in a similar fashion but uses gold instead of fiat.

Pros: easy to understand, stable, and resistant to hacks as the collateral is not on the blockchain.

Cons: require one to trust a third party; have to be audited to check whether the collateral corresponds to the number of coins in circulation; take a while to be transferred to fiat; are highly regulated.

Such coins are usually backed by crypto-assets to a proportion greater than 1:1. As cryptocurrencies are highly volatile, such requirements for the collateral minimize the insolvency risks for the stablecoin’s issuer.

Pros: no need to trust a third party; higher decentralization; prompt regulation of supply and demand; liquidity higher than that of fiat-backed stablecoins; high transparency; no need for an audit.

Cons: the exchange rate is not really stable compared to the fiat-backed coins; if the exchange rate drops, they will be automatically redeemed; the need to rely on another cryptocurrency; higher complexity compared to fiat-backed coins.

Seigniorage Shares is a concept of cryptocurrencies pegged to fiat without any collateral in other assets. In fact, it’s the decentralized version of a central bank policy. For instance, the issuer may algorithmically alter the supply of their stablecoins to maintain the price at the desired level.

If the price goes up, the smart contract issues additional coins to sell them until the price drops to the designed value. If the price goes down, the smart contract buys the stablecoins until the price is right again. If it doesn’t work, the issuer may produce seigniorage shares that entitle stablecoin holders to future revenues from seigniorage. The stability of such a system directly correlates with the demand for such stablecoins. If users stop trusting those coins, the system will fail.

Pros: no need for collateral; higher decentralization due to the lack of pegging to fiat or crypto assets.

Cons: complex monetary mechanism; the need for steady demand; high susceptibility to market events; difficult evaluation of their viability.

The article was amended to correct minor errors.