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Crypto Classroom Lesson #9: Stablecoin

Most cryptocurrencies are volatile as we often see a 10% move for the price of Bitcoin or Ethereum on any given day. To better facilitate practical transactions for good & services and store of USD value, several stablecoin projects were launched.

A stablecoin is a cryptocurrency that is designed to minimize price volatility by being pegged to another asset such as the U.S. dollar or gold. However, most asset-backed stablecoins are considered to be centralized as the collateral (underlying asset) is controlled and managed by the issuer of the coin (centralized body).

There are three main advantages of using stablecoins:

1. Stablecoins can be used in smart contracts; e.g. decentralized fundraising and decentralized financial products such as consumer loans.

2. Stablecoins act as a bridge for quicker and less costly international money transfers compared to fiat.

3. Various exchanges provide crypto to stablecoin pairs which allow traders to adjust their exposure.

Stablecoins can be categorized into fiat-backed and crypto-backed. The main difference is while the collateralization of fiat-backed stablecoins happens off-chain, the collateralization of crypto-backed stablecoins is done on the blockchain via smart contract, hence more transparent and decentralized.

 

Fiat-backed stablecoins

Tether (USDT)

USDT is a stablecoin claiming that each token is backed by one US Dollar. It was initially issued on Bitcoin’s blockchain using the Omni Layer Protocol and later issued on the Ethereum blockchain (a Euro version of USDT, EURT was also issued) by Tether Limited. It is the most liquid stablecoin at the time of writing.

USDT can be directly redeemed 1:1 with USD on the Tether.to platform. However, there is a fee on fiat deposits and withdrawals.

USDT has been the centre of controversy several times in the past.

– During the 2017 Bitcoin rally, Tether was accused of manipulating Bitcoin prices by ‘printing’ USDT. Large amounts of USDT created by Tether Ltd were sent to Bitfinex (an exchange with the same CEO) to drive prices higher.

– A Bloomberg report published in June 2018 suggested that the price of USDT was manipulated by wash-trading on Kraken (exchange). Analysts observed oddly specific order sizes were placed frequently (likely by trading bots) and small orders were moving the price as much as big orders.

– In October 2018, there were rumors suggesting Noble Bank, Tether’s partner, was insolvent. Many worried Tether did not have sufficient USD to back its stablecoin. This resulted in a sharp dip in USDT’s price and continued to trade at discount for more than 2 months.

At the time of writing, USDT leads all stablecoins in 24-hour trading volume at $3.9b.

 

TrueUSD (TUSD)

TUSD is an ERC20 token developed by TrustToken. Upon completing KYC, anyone can wire USD to TrustToken’s third-party partners and receive TUSD through smart contracts. To redeem TUSD, the process is simply reversed and the tokens are burned.

Status of the funds is regularly checked by a third party auditor. The latest attestation shows TrustToken has sufficient funds to cover the TUSD circulating supply.

Unlike other stablecoins, TUSD has no direct relationship with exchanges and thus has no conflict of interest.

Besides the above, other major fiat-backed stablecoins include USD Coin (USDC), Paxos Standard (PAX) and Gemini dollar (GUSD) which are all ERC20 tokens. GUSD and PAX are regulated by the NYDFS (New York State Department of Financial Services).

 

Crypto-backed stablecoins

DAI

Created by MakerDAO, Dai stablecoin is an ERC20 token that is pegged to the USD. The Dai system is decentralized as there is no centralized body backing its value. Thus, there is no need for a trust to escrow funds. Users can borrow Dai using ETH as collateral through smart contracts (collateralized debt position). To retrieve the ETH, one simply needs to return the borrowed Dai.

Dai’s decentralized system is designed to maintain the value of Dai to 1 USD.

– If the price of Dai falls below 1 USD, CDP owners are incentivized to purchase Dai and close their CDP position (pay off the loan in Dai) at a discount. The increase in demand will drive the price of Dai back to 1 USD.
– If the price of Dai is above 1 USD, there are incentives for ETH owners to create CDP and sell the Dai on the market.

More details on Dai’s mechanism will be discussed a later blog-post.

In conclusion, stablecoins can be seen as a digital version of fiat currency. They provide the below benefits:

– Quick and low-cost transactions
– Utilizing dApps and smart contracts
– Protecting holders of the volatile price movements in the crypto market.

Most stablecoins are centralized and require trust in the issuing body. When this trust is broken we have seen huge price swings and failure to maintain a peg (e.g. Nubits and BitUSD).

 

Written by Peter Chan
Trader @Genesis Block
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