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What is a Stablecoin?

Stablecoins: What is a Stablecoin?

By MathTiger | MathTiger-Crypto | 25 Jun 2021


This article is part of a series analyzing stablecoins pegged to the United States Dollar (USD).  Are all stablecoins equally stable?  In the coming weeks, I plan to analyze and rank each of the main stablecoins in the crypto ecosystem, in terms of stability.  Before I start that process, I thought it would be helpful to discuss what a stablecoin is, and what purpose it serves.

1. Disclaimer.


Before I go into the details of how stablecoins works, please note that I am an educator by profession, not a financial advisor.  The purpose of this article is to provide you with information, not financial advice, so you can learn about stablecoins.  Please supplement this article with your own research - DYOR.  Also note, that depending on when you read this article, some of the information may be out of date.

All images in this article are either from the Wikimedia Commons, of my own creation, or can be found in the links at the end of this article.

2. What is a Stablecoin?


A stablecoin is a token that is strongly correlated (or "pegged") to some type of outside asset.  It could be a fiat currency (US Dollars, Euros, etc.).  It could be a different fixed asset (gold, etc.).  In theory, the price of a stablecoin should match the price of the asset it is pegged to.  For example, the US Dollar Coin (USDC) is a stablecoin that is pegged to the US Dollar.  The value of one USDC should therefore equal the value of one US Dollar.

USD Coin (USDC) - CryptoMarketsWiki

The way that a stablecoin (optimally) does this, is to physically hold that asset, in a 1-to-1 ratio to the number of coins available.  For example, Coinbase (who helped create and fund the USDC), should hold 1 dollar in reserve for every 1 USDC in circulation.  If there were 1 million USDCs being traded, then Coinbase should have 1 million US Dollars on hand to back them, which users could trade their USDCs in for whenever they wish.  If Coinbase mints another 1 million USDCs, then they have to go out and acquire another 1 million dollars to back them up. 

A. What is an Algorithmic Stablecoin?

I plan to study algorithmic stablecoins in much more detail in the future, but I'll provide a short definition, in case you have heard the term.  An algorithmic stablecoins attempts to peg an outside asset (eg. the US Dollar), without holding that asset in a 1-to-1 ratio.  Depending on the algorithmic stablecoin, they use market forces, partial collateralization, and mathematical algorithms to attempt to meet this goal.

In my opinion, these should likely be called "Algorithmic Coins", and not "Algorithmic Stablecoins".  There have been some famous examples of algorithmic coins which have attempted to peg an outside asset, but failed, and lost all of their value.  That is outside of the scope of this article, but I plan to revisit it in a future article.  (I will link here when that happens)

3. Why do Stablecoins Exist?


As a relatively new asset class, cryptcurrency has a lot of volatility.  The value of assets in the space can fluctuate wildly over small periods of time.

BTC/BUSD Jan 23, 2021

Here is the fluctuation in price of Bitcoin (BTC) in one day.  If you made a purchase with your BTC at around 11:00 (AM) on June 22nd, it would be worth roughly $28808 USDs.  If you made that same purchase a day later, and at the same time, it would be worth roughly $34950 USD's; an increase in over 20% of its purchasing power!  While this was a particularly volatile day for BTC, it is not unusual for it to fluctuate in value by 5% over the course of a day.

On a long timeline, BTC is trending up, and increasing in value against the USD.  On a small timeline, there can be a lot of fluctuation in the price, which can make it undesirable to use for currency transactions in periods of volatility.

A. Are There More Stable Alternatives to Bitcoin?

So if Bitcoin has these large fluctuations, perhaps it would be better to invest in a coin or token that was less volatile.  However, most of these assets are highly correlated to the price of bitcoin. (Please note - these correlations change over time, this is just one data point)

BTC Price Correlation

What do these numbers mean?

Correlation is ranked on a scale between -1 and +1.

  • When the correlation is greater than zero, the two assets are positively correlated.  This means when one asset goes up (or down) in value, the other asset will also go up (or down) in value.
  • When the correlation is less than zero, the two assets are negatively correlated.  This means when one asset goes up in value, the other asset will go down in value.
  • The closer the correlation is to +1 (or -1), the stronger the link.  For example, based on this chart, Ethereum (ETH) has a 0.73 correlation with BTC, while Monero (XMR) has a 0.54 correlation with BTC.  So when Bitcoin increases in value, we expect both of these assets to increase in value.  However, ETH (0.73 correlation) will more closely follow the percentage gains of BTC than XMR (0.54 correlation) will.
  • When two assets have a correlation of 0, they are independent.  This means that a change in price of one asset, is unrelated to the change in price of the other.  (it does not mean they will always act in opposite ways - that is a negative correlation)

Correlation Coefficient

Looking at the chart, there is one asset that is independent of cryptocurrency - gold!  So if you wanted to hold an asset that does not fluctuate with cryptocurrency, you could hold onto gold.  However, most of our daily transactions are not done in gold.  Thankfully, another asset that is not strongly correlated with BTC is the US Dollar!

4. The Problem that Stablecoins Attempt to Solve


In most places in the world, wide-scale adoption of cryptocurrency is not here yet.  So, for many expenses, we are forced to deal in our local fiat currency.

Unfortunately, exchanging crypto-currency for fiat currency is not a seamless process, for many reasons:

  • Most banks or financial institutions do not interact directly with financial cryptocurrency exchanges.
  • The fees involved with financial institutions can add to the cost of using cryptocurrency.
  • Institutions that do allow crypto-to-fiat exchanges will only support a small set of coins and tokens.
  • It is often a time-consuming process to convert to, or from, fiat.

So, there is some need of an asset which can be easily converted to from Bitcoin (or other cryptocurrencies, but I will just focus on Bitcoin for now).  This asset also needs to be independent of Bitcoin; meaning the correlation between it and Bitcoin should be as close to zero as possible.

File:US one dollar bill, obverse, series 2009.jpg ...

Stablecoins solve this problem, by representing a token which can easily be exchanged for Bitcoin, but without the volatility.  Since most of these are pegged to real-world fiat currencies, this also allows for an easy exchange of crypto into fiat currency.  If one "Crypto dollar" is equivalent to one "US Dollar", then the tokens can easily be exchanged through any supporting financial institution.  \This allows a user to exit the volatility of the cryptocurrency market, into the more stable fiat currency market.  Since it is a token, re-entering the cryptocurrency market is as easy as trading that token back in for Bitcoin.

In a perfect world, a stablecoin that is pegged to the US Dollar, should have a correlation of +1.0 with the US Dollar.

5. A Solution to a Short-Term Problem


The overall goal of Bitcoin, according to Satoshi Nakamoto, is to create "a new electronic cash system ... completely decentralized with no server or central authority." Bitcoin, simply speaking, aims to replace fiat currencies.  If it eventually succeeds at its goal, we could expect the volatility of Bitcoin to decrease as time goes on (which has been happening), until it reaches a point that it is its own stable currency.  In other words, the goal is for Bitcoin to be the stablecoin.

File:Bitcoin logo.svg - Wikimedia Commons

But, we aren't there yet, and we have to deal with the world we live in.  Stablecoins give users a tool to switch between cryptocurrencies and fiat currencies.

6. A Comparison of Stablecoins (and other articles)


These rankings are based mainly on how reputable the coin is; i.e., how certain can we be that the coin is fully collateralized?

  • I value evidence of complete collateralization above every other metric.
  • Generally speaking, if two coins are equal in every way, I will rank the coin with a larger market cap higher.
  • If a coin is more decentralized, but equal in other measures, I will rank it higher on the list - potentially above other coins with a higher market cap.

I will update this list as I review more stablecoins.  My most recent review was the BUSD on July 2, 2021.  Click the coin to see a link to my review of it.

Stablecoin Rankings:

1. Binance USD (BUSD)

 

7. Conclusion


I hope you have enjoyed this overview of what a Stablecoin is.  Over time, I will be analyzing and ranking the most active stablecoins in the cryptocurrency ecosystem.  If you would like to follow my research, be certain to bookmark this article, and check back weekly.

A. Comments

Do you have any questions on stablecoins you would like me to address?  Please leave a comment ifso.

B. Next Up!

I plan to start my research into stablecoins with the Binance USD (BUSD) stablecoin.  Look for that article next week.

C. Referral Link and Tips

If you are a Canadian user, Paytrie offers a way for you purchase Stablecoins with Canadian Dollars, for a 0.6% transaction fee.  It is the app I use to purchase Stablecoins to use on international exchanges and Dapps.  If this interests you, please use my referral code of cK$JkcV7J, or click on the link below:

Purchase Stablecoins with Canadian Dollars through Paytrie!

Also, if you enjoyed or learned something from this article, please leave me a tip.  More tips gives me more encouragement to write and research more in the future.

Take care, and I will see you all next time!

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MathTiger
MathTiger

I teach mathematics and computer science in Canada. I have a Bachelor in Computer Science, a Master or Mathematics, and am completing a Master's in Computer Science. I am highly interested in cryptocurrency at the moment!


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