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Feb 05, 2021

An Introduction to Stablecoins for Banks and Fintechs

By: Barry Finkelstein

Stablecoins have grown substantially in popularity, driven by demand for a price-stable asset in the fast-growing crypto capital markets. Algorand’s innovative design has attracted many market-leading stablecoins that are leveraging the platform’s ability to power secure, scalable, and efficient frictionless exchange of value. In addition to broader adoption of the network, the growth of stablecoins on Algorand is empowering a new economic reality that is FutureFi and is breaking the model of how value has been historically exchanged. 

In this guide, you will learn what stablecoins are, how they provide price-stability, and why leading stablecoins choose to operate on Algorand. 

What Are Stablecoins?

Stablecoins are digital currencies designed to maintain a stable value, typically linked to a fiat currency like the U.S. dollar. 

For example, the Centre Consortium’s USD Coin (USDC) - which operates on Algorand - is fully backed 1:1 by dollar reserve assets held in U.S. financial institutions, thus acting as a digital version of the dollar that “lives” on the internet. 

Stablecoins marry the reliability, trust, and price-stability of fiat currency with the accessibility, security, and speed of cryptocurrencies. 

Unlike cryptocurrencies such as Bitcoin, Litecoin, and Ether, which are subject to significant price fluctuations, stablecoins - as the name suggests - provide price-stability. 

Stablecoins come with many  benefits inherent in digital currencies on blockchain. They are open, accessible, inclusive, auditable, secure, and global. Anyone with an internet connection and a crypto wallet can securely store, send and receive stablecoins.  

As with other digital currencies, stablecoin transactions are irreversible and do not require a financial intermediary such as a bank or financial institution to process the funds, thus reducing counterparty risk. 

The Rise of Stablecoins: The Need for a Price-Stable Digital Currency

While Bitcoin and similar cryptoassets have attracted significant interest from investors in recent years, their price volatility has made these digital currencies less attractive from a transactional point of view. As a result, stablecoins have experienced growing demand since they emerged. 

Crypto traders were among the first to adopt stablecoins as trading capital and a settlement instrument. Today, however, the demand for price-stable digital currencies is increasingly coming from the payments space, as internet businesses, blockchain companies, and individuals are looking for simpler ways to process global payments. 

Currently, stablecoin demand comes primarily from the following four market segments:

  • Individuals looking to buy or sell goods online: eCommerce participants prefer a stable currency that enables them to predictably forecast the ultimate cost of or proceeds from a transaction. The rapid price changes often associated with traditional cryptocurrencies can make it difficult to gain the desired confidence in a transaction’s ultimate cost. 
  • Cryptoasset traders and investors: Participants in the crypto capital markets use stablecoins as a pricing currency, a settlement instrument, and trading capital. Investors can avoid the expense and hassle of converting their trade proceeds back into fiat currency whenever they make a trade or at the end of the trading day. 
  • Payments and remittances: Individuals and businesses sending cross-border remittances or payments often prefer the rapid transaction speed and low costs associated with digital currencies. However, making such transactions with volatile cryptocurrencies brings with it the risk of reduced transaction amounts if the digital currency being used declines in value. Stablecoins enable participants to avoid this risk and make transactions with confidence that their recipient will receive the amount of funds they intended to send.
  • Decentralized finance (DeFi) applications: Stablecoins enable a variety of DeFi applications similar to traditional financial applications. This includes earning interest on stablecoin holdings in a manner similar to a traditional savings account but using decentralized blockchain-powered protocols instead.

The State of the Stablecoin Market 

The stablecoin market has seen rapid growth since the first such coin debuted in 2014. While growth was slow initially, it has since ramped up to a blistering pace. From 2.5 billion USD in market capitalization in January 2019, the global stablecoin market capitalization rose to over 5 billion USD by January of 2020. From there, the market has grown quickly, with total market capitalization reaching just over 35 billion USD by January of 2021.

Source: Stablecoin Index by Messari

A number of factors have been cited for the sector’s rapid growth, including:

  • The growing variety of use cases for a price-stable digital currency: While initially used mainly as a stable source of value for crypto traders, stablecoins are increasingly being used for applications such as eCommerce, payments, and remittances, and in the DeFi sector in conjunction with apps that offer products similar to those offered by the traditional financial industry. 
  • The financial crisis caused by the Covid-19 pandemic: The pandemic led to a global leap towards digital-first. eCommerce businesses - one of the main benefactors of this trend - are looking for new and improved ways to accept and make digital payments. Stablecoins - as internet-native money - are an ideal fit and have, thus, witnessed increased adoption by internet-based businesses.
  • A dash for dollars amidst global currency volatility: In countries where the local currency is prone to devaluation, holding digital assets in a U.S. dollar-linked coin can serve the objective of capital preservation.

Types of Stablecoins 

Stablecoins can be placed in the following four categories:

  • Fiat-collateralized
  • Commodity-collateralized
  • Crypto-collateralized
  • Non-collateralized

Fiat-collateralized

Fiat-collateralized stablecoins are digital currencies backed by fiat currency holdings that operate on public blockchain networks. 

Fiat currency-backed stablecoins typically provide audits to verify that every coin issued is backed 1:1 by the fiat currency its price is pegged to. These coins involve a degree of centralization as a trusted custodian must hold the currency backing the stablecoin. They also typically offer the greatest price stability, given their fiat currency backing. 

Examples of fiat-collateralized stablecoins include Tether (USDT) and USD Coin (USDC)

Commodity-collateralized

Another take on stablecoin design is to back a digital currency with a commodity thought to act as a store of value – a precious metal such as gold. 

While commodities are not necessarily the most price-stable assets, they have many years, in some cases centuries, of price performance investors can study to gain insight into price patterns. As a result, market participants who understand the factors behind the price movements of a particular commodity might be comfortable using a stablecoin based on that commodity. 

An example of a commodity-backed stablecoin would be MELD Gold (MCAU).

Crypto-collateralized 

Some stablecoins are designed to provide stability without recourse to traditional currencies outside of the world of cryptoassets. These coins are linked to other digital currencies rather than to fiat currencies. This keeps all aspects of the stablecoin on a blockchain

Given that cryptoassets (aside from stablecoins) tend to be volatile, the question arises, how can a stablecoin backed by a digital currency promote stability? The solution used to solve this dilemma is known as the over-collateralization protocol, which involves collateralizing the stablecoin by making a deposit that is larger than the value of the linked cryptocurrency in order to absorb the volatility. 

For example, if you deposit 400 USD of cryptocurrencies in a smart contract to back 200 USD stablecoins, this 2x ratio serves in most cases to prevent the volatility of the cryptocurrency backing the stablecoin from affecting its value. If its value were to drop 25%, the 400 would become 300, which would still be more than enough to retain a 1 dollar value for the 200 stablecoins it collateralized (300 > 200). 

This brings up the question, why would you deposit 400 USD worth of cryptocurrencies to secure 200 USD of stablecoins?

There are two main reasons to do so:

  • Interest can be paid to the issuer, as some DeFi platforms currently do
  • Additional stablecoins can be created via financial leverage, benefiting the issuer 

With these crypto-collateralized stablecoins, if the price of the collateral drops below the value of the stablecoins it supports, the stablecoin is subject to liquidation. Because of this risk of liquidation and the greater volatility of the underlying collateral, these types of stablecoins have not achieved the same popularity level as other stablecoins. 

Non-collateralized

Given that fiat currency is ultimately not backed by anything other than the full faith and credit of the government issuing it, a move to release similar crypto tokens has led to the creation of non-collateralized stablecoins.

The idea behind this type of stablecoin is to utilize a smart contract to issue digital currency in the same way a central bank might issue fiat currency. The goal of the contract would be to maintain a stable value for the currency. For instance, the smart contract could be tasked with maintaining a 1:1 relationship with the USD by controlling the quantity of the digital currency. 

While this type of pegging a currency to another has been done by various central banks to control the value of their currency, it is not yet clear exactly how this would be accomplished in the crypto world. Thus, non-collateralized stablecoins, aside from a couple of failed attempts, remain mostly theoretical at this point. While such a stablecoin would likely be highly decentralized and uncorrelated with other cryptoassets, the complexity involved in setting one up and the potential failure points make it a challenging project to launch. 

Stablecoins on Algorand

The Algorand blockchain provides near-instant transaction settlement at de minimus cost, measured in pennies. As more and more stablecoins are moving towards a multi-chain framework, the speed and cost structure of operating on Algorand allows for this functionality to be realized.

For example, the two market-leading stablecoins - Tether USD and USD Coin - have moved onto the Algorand blockchain to provide cheaper and faster stablecoins transactions. 

Tether USD (USDT)

Tether is a market-leading stablecoin issuer that launched the largest stablecoin by market capitalization, Tether USD, in 2014. Since then, USDT has managed to maintain its first-mover advantage to establish itself as the leading stablecoins for cryptoasset traders and investors. 

USD Coin (USDC)

USDC is a fully-reserved U.S. dollar-backed stablecoin, launched by industry pioneer Coinbase and Circle. Each USDC is backed 1:1 by U.S. dollar reserves held in regulated U.S. financial institutions and is subject to monthly attestation by a leading global auditing firm to provide utmost transparency for its holders.    

Other stablecoins operating on Algorand include QCAD, Monerium, Transfero’s BRZ, and Meld Gold.

Why Leading Stablecoins Choose Algorand

As the leading scalable, secure, and fully decentralized blockchain network, Algorand has emerged as a go-to chain for the world’s leading stablecoins. 

Stablecoins operating on Algorand benefit from:

  • Low transaction costs
  • Near-instant settlement
  • Transaction finality
  • Robust core security
  • Simplified user protocols
  • Easy token issuance or swapping for developers or enterprises
  • Universal interoperability of all assets issued on Algorand

Algorand’s ability to rapidly process high-volume transactions at a low cost makes it a go-to strategic partner for the multi-chain transfer frameworks that benefit stablecoins. 

The chain’s stablecoin-friendly features and the debut of several leading stablecoins on the platform has established a foundation for the addition of further innovative stablecoin projects in the future. 

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