Have you ever wondered why on earth would the world need stablecoins when we have got PayPal or Venmo or GooglePay? Me too. So I looked into it, read about it and I have some interesting knowledge which I believe is useful to you as well. In this post, let's discuss about stablecoins.
Journey of a banking transaction
Before jumping into the stablecoin discussion, we need to know about banking transactions and how are they processed.
Andrei Jikh has done a fantastic video explaining this and I recommend you to watch it. When you pay with your debit card for your coffee at a Starbucks for example, there is a three step process that is happening in the backend to process your transaction:
1. Execution: This is where the seller states the price that they are willing to sell the commodity or asset (in this case a cup of coffee) and the buyer agrees to transfer money from their account to the seller's account so that they can get the coffee. Using the seller's banking system (in this case scanning a bar code or swiping the buyer's credit or debit card on the transfer machine) when the buyer pays, the transaction is said to have began it's 'execution'
2. Clearing: When both parties agree to this transaction which was initiated in the previous step, at first it needs to be recorded in a ledger stating the execution of the transaction between the parties, in this case the bank's own ledger (to which the buyer has no access to for whatever reasons). If the buyer and seller uses different banks, say JP Morgan and Citi bank, both the banks will record this transaction in their own ledgers.
3. Settlement: Once the transaction is cleared from the bank's side, where the seller's bank confirms that the buyer's bank account had the money and they had the amount transferred to the seller's account, the seller (Starbucks) gives the asset (cup of coffee) to the buyer (you). Actually what happens in the background is the seller's bank balance will increase by the amount the buyer has transferred and the buyer's bank balance will be reduced by this same amount.
Everyone is happy. Buyers get their coffee and Sellers get their money. So what's the problem or is there any problem?
Elephant in the room - The Bank
The problem with this transaction lies with none other than the bank itself. For this transaction to happen, the banks play a central and deciding role as they facilitate the transactions between sellers and buyers. This gives them a lot of power. Well, if they are all trustworthy it wouldn't be a problem but in reality, they are not. They only work for their own (the bank itself and it's share holders) profit. There are various instances where banks themselves were involved in shady activities in the financial world. A single google search will fetch many results to prove this point. There are instances where banks were directly involved in money laundering activities, fake account creation, market manipulation, gambling with users money and any risky activities that one can think of. Financial crisis of 2008 sits at the top of such list.
That's not all. Banks have veto power over any transactions. For whatever reasons, if a bank doesn't want a transaction to happen, they can instantly stop it without giving any reason to the user. That shouldn't be the case. It's the users money which they have trusted the bank and put it the account which the bank has provided. In my opinion, the users should have complete control over their money and no third party should be meddling with it. Also banks know every single financial activities that it's users do. It's in their ledgers. They can sell this data to potential buyers who can target ads specifically to a user based on that user's buying trend.
Another side effect of having banks holding the money is that we cannot do transactions on holidays. Now I am not talking about sending a dollar or two to sellers or friends but transactions involving huge amounts, nationally or internationally. It can only be done during banking hours. Yes, this is true in this modern age; we are still following traditional practices. Also you need to shell out a good amount as transaction fee which is based on the transaction amount itself to facilitate. In fact, this is the main reason why cryptocurrency was appealing to many in the beginning, especially to the crypto whales, where any amount of transactions can be carried out to anyone in the whole world in an instant.
A possible solution - Stable coin
So what is a stable coin and how can it solve the current issues with the banking system? I recommend watching this brilliant video by a YouTube channel called 99BitCoins as they have clearly explained everything in details. Anyways, let's continue.
By definition, A stable coin is a digital currency that is designed to reduce volatility of the coin price compared to highly volatile cryptocurrencies like Bitcoin or Ethereum.
You may ask - what's the problem with cryptocurrencies being 'volatile'? Well, by traditional means, money should serve three purpose - store of value (it should uphold it's value to the future), medium of exchange (it can be exchanged for assets & commodities) and unit of account (it can used to price different commodities, like $1 for a cup of coffee). Our fiat currencies can be used to serve as a medium of exchange and unit of account but it cannot be used to store value because fiat currencies are inflationary in nature, i.e. it's value depreciates over time. Cryptocurrencies on the other hand, can used as a store of value as most of the crypto assets value increase over time. But it cannot be used to exchange commodities or price different assets as it's value keeps fluctuating; it may go way up or come crashing down losing all of it's value.
Stablecoins are pitched as a solution to this volatility. They are made 'stable' in two ways - one way is to peg the coin to a “stable” collateral asset like the U.S. dollar (Eg: USDT or Tether) or gold (Eg: DGX) or crypto assets (Eg: Elastic BTC) and another way is to use algorithms to manipulate supply based on demand to stabilize the value like Ampleforth (AMPL).
What can we possibly do with stablecoins?
A stablecoin offers the convenience of the cryptocurrencies and the stability of the fiat currencies. It is pitched as to offer the best of both the worlds. Most of the stable coins are utility tokens which means they can be used to create smart contracts as well which is another added benefit.
At the moment though, stablecoins are mostly used in crypto exchanges where users can buy cryptocurrencies in exchange for stablecoins and also can transfer the coins between different exchanges which is a way to circumvent regulation and high fee payment as you do not need a bank account to hold stablecoins; just about any supporting digital wallet would do. Crypto exchanges also offer attractive incentives like earn interest by lending the stablecoins which is usually offered at a higher rate than a regular FD or RD interest rates. Moreover, people have sent, both nationally and internationally, as much as a million dollars worth of USDC with transfer fees of less than a dollar without involving a bank. Satoshi Nakamoto would be proud.
Limitations of stablecoins
That being said, there are limitations to both asset pegged and algorithmically pegged stablecoins.
In the case of asset pegged stablecoins:
- The underlying collateral asset cannot be used for any other activities; it will have to sit idle forever as it is pegged to the stablecoin
- There is a risk of embezzlement of the company which issues the stablecoin itself. Users place their trust on these companies which may or may not be worthy of that trust.
- The stablecoin company is required to show proof of solvency, i.e. they need to prove they hold enough reserves to be pegged to the stablecoin. For example many exchanges has been using tether as their stablecoin but tether is in hot water recently for solvency disclosure issues.
- Some doesn't consider stablecoins as cryptocurrencies because well, they are essentially centralized with a company or trust that maintains the peg
- Crypto pegged stablecoins can be audited easily but the underlying asset itself is volatile which means lower degree of stability
- Many criticize that it would be impossible to maintain the peg in the long term as the demand grows
- All stablecoins have a looming threat over their head that they are doomed to fail due to issues in maintaining them
- CHF (Swiss Frank to the USD), CNY (Chinese Yuan to USD), etc are some of the earlier failed stablecoins
On the other hand, we have the algorithmically pegged stablecoins. They've got problems too:
- Though no assets are required for this coins, many question this very nature of the solution
- There is no guarantee for the pegged coins as they are not backed by anything but a smart contract which algorithmically manipulate the supply to keep the peg stable
- It runs purely on the trust that people place on the smart contract
- Regulatory authorities doesn't like the idea of non asset backed stablecoin. For example Basis - an algorithmic stablecoin got shut down due to regulatory uncertainties.
Nevertheless, people and exchanges use various stablecoins to carry out various financial operations by accepting these limitations.
How do stablecoins make money?
Well, some stablecoins charge a nominal fee to use their coin for transactions. If it is widely adopted, then that itself can generate a lot of money. But for the most part, stablecoins are issued as a marketing channel to raise awareness to that company's crypto services to the general public. Many exchanges own stablecoins like coinbase, binance, circle, gemini, etc which can be used to buy crypto assets and servicing from those exchanges. It is a pure economy of scale, i.e. the more people use a stablecoin the more valuable it is. Many banks and corporations are also looking forward to release stablecoins of their own, which means stablecoin business could be huge. It's all about becoming the most dominant player in the stablecoin market which at the moment is quite under explored.
Banks are caching up
As discussed before, many banks now are catching up with the blockchain technology and cryptocurrencies. At the time of writing this blog, it is known that 85% of the central banks in the world are now investing in digital versions of their currency. Why? Well, in simple words, cryptocurrencies are an existential threat to the banking system. The core idea behind the cryptocurrency technology which was put forward by Satoshi Nakamoto (whomever it is) was to decentralize the banking process such that there will be no central authority involved in the financial transactions. So what are they going to do about it?
They can do one thing - release a stablecoin as the digital currency, make it the only legal tender for crypto transaction and by that way, they can still retain some control in the crypto world and still be in the game. Not just the banks, major corporations are on this race too. For example: Facebook's Diem, China's Digital Yuan, Russia's Digital Rubble, etc are a few. The main of such stablecoins is to become the new world currency like how everything is compared with the dollar.
Examples of stablecoins
Let's see some examples for stablecoins:
- Tether (USDT) - Fiat Collateralized. Started by the company Tether in 2015. Involved in controversies.
- True USD (TUSD) - Fiat Collateralized. Addressed the issues of Tether. Relatively new.
- Gemini USD (GUSD) - Fiat Collateralized. Claims to be the regulated stablecoin. Issued by the Winklewoss Brothers backed crypto exchange Gemini.
- USD Coin (USDC) - Fiat Collateralized. Issued by crypto exchanges Coinbase and Circle.
- Dai (DAI) - Crypto Collateralized. Issued by Maker Dao
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