Stablecoins

Stablecoin is one of the digital assets developed to have a value very close to currency or underlying assets.

Stablecoin was created with the original purpose of being a financial instrument that can be held to avoid volatility in the cryptocurrency market. Investing in stablecoin allows investors to protect their capital and profit when severe corrections occur. Additionally, there are more ways to use this asset for business use cases, such as payment, remittance, on-ramp and off-ramp, etc.

The reason why stablecoin is very popular and widely used comes from two features: fast transactions and cost-effectiveness compared to traditional bank transactions. However, there are some major challenges for stablecoin adoption, such as financial policy risks, anti-money laundering policy (AML/CFT), consumer protection, etc.

Currently, stablecoin can be divided into three categories based on its backed assets:

Fiat-backed stablecoin

This is a centralized third-party stablecoin backed by fiat currency, short-term treasury bond, or multiple fiat currencies. Most stablecoins are backed by a 1-to-1 ratio in USD, which means that 1 unit of stablecoin can be exchanged for 1 USD.

The underlying currency assets reserved in the bank account can be redeemed anytime through the distributors. The reserved amount of currency assets should equal the total amount of stablecoin supply in the system. In theory, if the stablecoin was redeemed for its underlying fiat currency, the stablecoin supply should be decreased immediately. However, in practice, such a process will be performed in a batch. In high demand, we barely see the supply decreasing because the supply and demand will offset each other.

Fiat-backed stablecoin will effectively stabilize its value if the stablecoin issuers can reassure the investors that they have reserved currency in their bank account, which can be withdrawn anytime as requested. To build more confidence, stablecoin issuers have some external audits to check whether their reserved currency amount is equal to the circulating supply or not.

Asset-backed stablecoin

This stablecoin can be issued with a centralized or decentralized protocol backed by different types of assets that are not fiat currencies, such as commodities, bonds, digital assets, etc. This type of stablecoin will soft-peg to its underlying asset value.

Stablecoin with decentralized protocol can be performed by users depositing their digital assets with the smart contract as collateral. Then, the users can borrow stablecoins. This kind of stablecoin is said to be a tokenized debt. However, if digital assets value decreases below the minimum collateralization ratio, the asset deposited as collateral might get liquidated.

Pegged value of stablecoin can be achieved through arbitrage activity and monetary policy, such as interest rate. When the value of stablecoin tends to decrease, the system can increase the interest rate to influent the borrowers to repay their tokenized debt. On the other hand, when the value of stablecoin tends to increase, the system can decrease the interest rate to influent the borrowers to take more loans and then sell them in the secondary market.

Compared to fiat-backed stablecoin, this type of stablecoin relies more on a decentralized protocol (in the case of using decentralized protocol), but it will be difficult to scale up. However, if the system can function normally as it is supposed to, this type of stablecoin can stabilize its value continuously.

Non-collateralized stablecoin

Stablecoins have a flexible supply, and their pegged value is under the control of algorithms. Therefore, stablecoins do not need any backed asset, but it creates incentives for investors to stabilize the value.

The mechanism to create stability utilizes dual-token design and secondary market. When the stablecoin value increases, the system will mint more stablecoins for bidding with share tokens. In contrast, when the stablecoin value decreases, the system will mint more share tokens for bidding with stablecoin.

Due to its characteristics of requiring no collateral asset and depending primarily on decentralized process, more efforts have been trying to create this type of stablecoin. However, many stablecoins cannot be used practically and still fail due to their complicated design. Moreover, this type of stablecoin has also been the subject of debate over its potential for being securities.