What are stable coins?

Due to the often extreme price volatility of cryptocurrency, there is a huge demand for a form of stable crypto-asset. That’s why ‘stable coins’ have been developed. As their name suggests, stable coins are cryptocurrencies that are designed with a common aim in mind: to provide a stable store of value.

The breadth of stable coins can be quite bewildering for investors. Here we set out in simple language what distinguishes the main types of stable coin from each other, in terms of what they’re for and how they work.

The three broad categories of stable coin are: fiat-backed tethers; asset-backed coins; and coins that adjust the amount or liquidity of the coin supply.

Tethers

The class of stable coins that most crypto users will be familiar with are the fiat currency-backed tethers, the best known of which is the US dollar tether (USDT). 

These stable coins aim to provide a one-to-one peg to maintain parity of the value of the cryptocurrency against a specific fiat currency. The purpose of tethers is to provide an efficient, low transaction cost, means of preserving the fiat value of crypto wealth, without having to continuously rebalance holdings between crypto and actual fiat currency.

To achieve that end tethers are backed, to varying degrees, by fiat currency. Credibility and stability for these coins depends largely on how fully backed the tether is by the currency to which it is pegged. Each USDT, for example, is fully backed by one actual US dollar (although due to lack of transparency there is some scepticism about whether this is in fact the case).

Some other tethers, especially those that are not fully backed, have been prone to sometimes large deviations from their fiat pegs, as changes in demand force sharp realignments in value. 

It should also be remembered, however, that even if a tether is fully backed, an investor has no contractual right to the underlying currency that backs it. There is no ‘convertibility’. Nevertheless, for USDT at least, this pseudo backing has so far been sufficient to maintain appropriate parity with the dollar.

Inevitably, however, these coins require a considerable degree of central administration, and are quite far removed from the community based, decentralizing ideals of Satoshi’s white paper. Moreover, any centralized cryptocurrency is vulnerable to attack or state sanctions, just like any other centralized system or institution. 

Asset-backed stable coins

Another class of stable coin tries to achieve stability in a slightly more decentralized way, by pegging not to fiat, but to other types of asset instead. As with tethers, credibility rests primarily on the degree to which the coin is backed by the reference asset.

These can be either traditional assets, such as equities or commodities, or other crypto-assets. The peg can be based on single instruments or a portfolio. The intention is to produce a less volatile asset for investment purposes, but not to maintain parity with a given fiat currency.

In the case of coins backed by a portfolio of assets, some of the idiosyncratic risks of the various underlying instruments are diversified away. The overall degree of stability depends on how much of that idiosyncratic risk is eliminated. But even if all of the idiosyncratic risks is diversified away, there remains a market risk. This relates to changes value due to shocks that affect the prices of all of the assets in the portfolio in a correlated way.

In addition, there are major scaling problems with this approach, due to the liquidity demands from inflows and outflows to the collateral pool. In order to accommodate flows into and out of the stable coin, the collateral used to back it must be highly liquid, so that assets can be readily bought and sold without affecting their price. If flows out of the coin cause the price of the underlying to fall, the entire market capitalization of the cryptocurrency should decline to reflect that.

That liquidity requirement is at present not met for a crypto-asset backed coin, making such stable coins extremely vulnerable to runs. In a rush to sell, investors may find themselves unable to exit, because the underlying is illiquid. Fire sales of either the collateral or the coin or both would be the likely result. Even those coins backed by relatively liquid, traditional assets, are still vulnerable to losses arising from negative feedback loops like this.

While the aim of reducing reliance on fiat as a safe store of value is laudable, there is still a large degree of centralization in the administration of such coins. Again, this renders them vulnerable to attack.

This class of stable coin is perhaps better thought of as a form of collateralized portfolio investment vehicle, which reduces, but does not eliminate, volatility. They are also exposed to liquidity constraints in the event of runs and are at risk of potentially very sharp swings in value under stressed conditions - that is, precisely when investors need stability.

Supply adjusters

The third major class of stable coin represents an altogether new form of asset. It aims to utilise the unique ability of crypto to vary its own supply or the liquidity of coins in response to changes in demand, thereby helping to keep supply and demand in balance and so lessen variability in the price.

By exploiting the ability to influence the availability of coins to achieve price stability, these projects offer a much more fully decentralized alternative to asset-backed stable coins, and are far removed from the tethers, which arguably are little more than glorified fiat. They also offer the possibility of eliminating at least some market risk, by introducing pricing dynamics which dampen the impact of market-wide shocks.

The governance structures and precise mechanisms used to adjust directly the amount or liquidity of coins in supply vary between projects, with many innovative approaches being pursued. Some coins seek simply to affect price dynamics to make adjustments smoother. Others peg more explicitly to particular reference assets.

One of these supply adjusting stable coins is the decentralized dynamic peg soon to be implemented by BitBay (BAY). The details are to be released over the coming months, but from what snippets the team has let drop, BitBay will permit only gradual appreciation in value in response to increased demand. And in the event of selling pressure, a portion of the staked coin supply will be frozen.

The aim is to eliminate short-term movements arising from speculative activity and noise, and so provide a more reliable store of value and medium of exchange for buyers and sellers of goods and services on the BitBay decentralized marketplace. The intention is not to try to stand against major market moves altogether. It’s a pragmatic, use-case driven approach. We at BitBay can’t wait for the dynamic peg to go live in the autumn.

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