Six Things You Should Know About Stablecoins

The only thing that’s predictable about the cryptocurrency market is its unpredictability. The volatility may be exhilarating or terrifying for speculators, but for cryptocurrency to become a mainstream form of exchange, observers say, it will have to become more stable.

“Imagine you’re paid a salary of one bitcoin (BTC) per month,” writes Nader Al-Naji, founder of the basis cryptocurrency, whose parent company garnered more than $130 million in funding in April. “If the price of bitcoin drops, you might not be able to make rent. If it rises, your employer won’t be able to afford your salary. It’s simply not a reliable means of payment.”

Enter “stablecoins,” cryptocurrencies designed to hold a constant value against a stable asset, such as a fiat currency. These currencies’ backers argue that would eliminate volatility while retaining the benefits of cryptocurrency, including global reach and a decentralized store of value.

If stablecoins do go mainstream, we may at long last be able to use cryptos to buy a cup of coffee.

“Now you can pay a salary, take out a loan, or buy coffee with a cryptocurrency, enabling a new economy of cryptocurrency financial applications,” say the founders of TrustToken, which launched the trueUSD stablecoin in March and anticipates launching stablecoins tied to the euro and bonds.

Interested? Then here are six things to know about stablecoins:

1. Models and Mechanisms Vary

Essentially, there are three basic models of stablecoins, each of which works in different ways.

Fiat-backed stablecoins, such as tether (USDT) and trueUSD, are essentially pegged to a fiat currency and the (at least implicit) idea that there’s some amount of that currency tucked away in a bank somewhere that could be exchanged for a predictable amount of the crytpocurrency. As such, audits and other assurances of collateral are critical.

Crypto-collateralized stablecoins, such as dai, are backed by another, more volatile cryptocurrency (In dai’s case, it’s ether (ETH). Even so, they maintain a stable value against fiat currencies through complex mechanisms that involve overcollateralizing the more volatile cryptocurrency and changing incentives when their value shifts. (This video provides an explanation of how this works in dai.)

Non-collateralized stablecoins loosely mimic central banks by controlling the supply of the currency to keep their value stable. Basis, for example, uses the destructibility of tokens on the blockchain to maintain value by “destroying” coins exchanged for bonds when oversupply pushes the value too low and cashing those bonds in when too few coins in circulation push the value above the peg, calling the process “an algorithmic central bank.”