Introduction to stablecoins
The price of cryptocurrencies fluctuates greatly. Scepticism toward cryptocurrencies and blockchain technology, in general, has increased due to the volatility associated with trading in crypto assets. Even though cryptocurrencies may provide a lot of benefits like higher returns, transparency, and decentralized authority but their volatility raises doubt about their purchasing power over time. Therefore to counteract the volatility of the digital market, there exist stable coins that provide equal volatility and returns as physical assets.
Wikipedia says “Stablecoins are cryptocurrencies where the price is designed to be pegged to a cryptocurrency, fiat money, or to exchange-traded commodities (such as precious metals or industrial metals”. Similarly, Coindesk also describes stable coins as a type of cryptocurrency whose value is pegged to another asset class, such as a fiat currency or gold, to stabilize its price. In other words, stablecoins are the poker chips of the digital world.
To explain further, a stablecoin’s value is always equal to the asset it is pegged to. For example, USD Coin (USDC) is pegged to the US dollar. This means 1 USDC is equal to $1. The smart contract behind the stablecoin maintains its’ value always equal to the value of the pegged asset.
Advantages of stablecoins
Holding a stablecoin and transacting with it is more beneficial than a fiat currency. A stablecoin is more open, global and accessible to anyone having internet. The advantages are-
- Lower volatility than Bitcoin and altcoins
- the higher speed of transaction
- lower transaction cost
- cheap remittance
- higher interests than the traditional currency
How does a stablecoin work?
A stablecoin works by two methods. The first method involves the actual backing by the physical asset. The second method has an algorithm that controls the value the of stablecoin and keeps it equal to the value of the pegged asset. Let us discuss both of them.
Suppose a company wishes to launch a stablecoin having its’ value pegged to the US dollar. The company will deposit an amount in a financial institution (say, a bank) for which they want to launch a coin, say $100 million. The company will then launch $100 million coins with each coin having a value of $1. The transactions of the coins will be replicated on the actual money deposited in the bank. For example, if the token owner cashouts a coin, then $1 will be taken out of the deposit. Example- Tether (USD₮).
This method has many versions, the collateral can be fiat currency, precious minerals like gold, other cryptocurrencies etc.
This method uses an algorithm to control the value of the stablecoin. The algorithm makes changes on the chain as per the transactions of the coins. This method needs no collateral and the algorithm controls the demand and supply to regulate the price. Example- TerraUSD (UST).
Central Bank Digital Currency
The US Federal Reserve defines CBDC as a digital form of central bank money that is widely available to the general public. In other words, a CBDC shall be a decentralized version of the country’s currency. It is a blockchain-based token pegged to the country’s fiat currency. A CBDC aims to provide better privacy, transparency, accessibility, transferability and financial security.
There are two types of CBDCs- wholesale and retail. Further retail is also of two types- token-based retail CBDC and account-based retail CBDC. I am saving the discussion on all these types of CBDC for some other day.
Many countries have adopted CBDC. Investopedia reports as of May 2022, 9 countries are running their pilot projects for CBDCs and 80 countries have their CBDC projects underway.
The US Fed printed a paper titled “Money and Payments: The U.S. Dollar in the Age of Digital Transformation” which marks the first step toward CBDC.It says that the Fed is exploring the benefits of CBDC and how it can help transform and integrate with the existing payments system.
On similar lines, the Bank of England and Bank of Canada are also exploring the possibility of CBDC. The Reserve Bank of India announced its’ CBDC, digital rupee to launch by end of 2023. Sweden’s Riksbank is also developing e-krona.