A stablecoin is a cryptocurrency that is designed to have stable price characteristics. The ultimate goal of stablecoins is to be a stable digital form of fiat-free cash with the potential to solve the problem of cryptocurrency volatility. In order to achieve this, stablecoins have to satisfy the requirements of sound money. That is, they must be a store of value (SoV), a medium of exchange (MoE), or a unit of account (UoA), and they must be easily moveable and divisible as well.
Store of Value (SoV)
This refers to a form of wealth with a future-proof maintained current value without any depreciation. Examples of SoVs are gold, silver, and other precious metals.
Medium of Exchange (MoE)
For stablecoins to be a medium of exchange, they have to facilitate the sale of goods without using a barter system.
Unit of Account (UoA)
A cryptocurrency must provide a unit of measurement that allows its value to be defined and compared, and all cryptocurrencies can be used as an UoA. For example, the cost of a car could be 10,000 units of a stablecoin.
Different Stablecoin Models
Stablecoins are a new class of cryptocurrencies that offer steady valuations and price stability. They are designed to retain their purchasing power with little to no impact from inflation. In order to maintain steady valuations, stablecoins are tied to price stable assets like gold or the U.S. dollar. Different methods are used to achieve price stability depending on different stablecoins. For now, there are four broad categories of stablecoins, but there are other stablecoin proposals in the process, which may be introduced in the future.
Fiat Collateralized
This type of stable coin (e.g. Tether) uses a particular standard fiat currency value as collateral. A central entity is responsible for the collateral and will issue a token representing the money being held. The ratio of the number of crypto-coins issued is also 1:1 against the fiat currency it is pegged to, as it represents the most straightforward method of stablecoin creation and operation.
Crypto-Collateralized Stablecoins
Crypto-collateralized stablecoins (e.g. MakerDAO) depend on the cryptocurrency value they use as collateral to maintain a stable target price against certain assets. In essence, these types of stablecoins work in a similar way to their fiat counterparts. The only difference is that the collateral is not considered as an asset in the real-world, but rather in another cryptocurrency.
Non-Collateralized Stablecoins
Non-collateralized stablecoins (e.g. Basecoin) are cryptocurrencies with stable prices and are not backed by collateral. Their implementation involves a system or an algorithm that contracts and expands the coin supply depending on its value. This approach is based on the Quantity Theory of Money, which implies that there is a direct relationship between the quantity of money in an economy and the level of prices of goods and/or services sold. This means that the coin supply will depend directly on stablecoins’ prices. For example, if a coin’s value is above $1, the supply will increase. On the other hand, if the value drops to less than $1, the supply will decrease.
Commodity-Backed Stablecoins
Holders of commodity-backed stablecoins essentially have a tangible asset with a real value — something most cryptocurrencies do not have. The most common commodity to be collateralized is gold (e.g. Kinesis gold-backed Stablecoins), but others are backed by oil, real estate, and baskets of various precious metals. In the case of commodity-collateralized stablecoins, anyone in the world could conceivably invest in precious metals like gold, or even real estate in Switzerland. These kinds of assets have generally only been reserved for the wealthy, but stablecoins open up new possibilities of investments to average individuals globally.
Stablecoins backed by commodities are much less likely to be inflated than fiat backed stablecoins because it is more diffult to mine gold or silver than it is to create money out of thin air. The main characteristics of backed stablecoins are:
- Their value is fixed to one or more commodities and redeemable (more or less) based on demand,
- The amount of commodity used to back the stablecoin has to reflect the circulating supply of that particular stablecoin.
Holders of commodity-backed stablecoins can redeem their value at the defined conversion rate to take possession of real assets. The cost of maintaining the stability of the stablecoin is the cost of storing and protecting the commodity that is being backed.