Unpacking Stablecoins

You probably know the 2 largest cryptocurrencies by market value. Do you know what’s the 3rd largest? 🤔

#Bitcoin and #Etherium reserve the title for being #1 and #2, while Tether (USDT) has jumped up the ranks to pick up the #3 spot. Tether is a stablecoin developed by Bitfinex and has a current market cap of $82.5bn. 👀

Given their growing importance, let’s unravel stablecoins.

What are Stablecoins?

Stablecoins are cryptocurrencies that have a stable value, as opposed to the volatile nature of Bitcoin, Etherium, Solana etc. For instance, a USDT (which is a dollar-denominated stablecoin) has a fixed market value of $1.

How do Stablecoins maintain a fixed value?

Not every stablecoin is created equal. There are 4 types of stablecoins, based on how they maintain their value vs fiat currencies:

1. Fiat backed: equal reserves of the currency
2. Cryptocurrency backed: equal or more reserves of >=1 cryptocurrencies
3. Commodity backed: equal reserves of some commodity
4. Algorithmic: by controlling the supply of coins (burning/minting)

Fiat backed stablecoins are the most popular, however, other types of stablecoins are quickly gaining traction. 📈

Why do we need stablecoins?

We have fiat currencies and other coins, so why the hell is this digital coin (which is similar to fiat) needed?

Stablecoins are valuable because:

• they allow crypto holders to stay invested in the crypto-economy, instead of cashing in/out of the ecosystem

they allow stable value exchange and can be used for payments, remittances, loans

• they are trustless and hence don’t need KYC

Now let’s briefly understand how cryptocurrency backed stablecoins like DAI work. 💡

What’s DAI?

DAI is the stablecoin issued by Maker. Maker is a DAO that enables lending through Collateralised Debt Positions (CDP) smart contracts, leveraging the supply-demand dynamics of Maker and DAI.

The way it works is the following (oversimplified):

• Say I want to take on debt by collateralising my ETH
• Based on the collateral-debt-ratio of ETH, MakerDAO creates a CDP, collateralizes my ETH and issues DAI to me
• Over time, a stability fee accrues on my loan (like interest), which can only be paid in Maker tokens
• If I want my ETH back, I need to pay back the debt in DAI and the stability fee in Maker (once maker tokens are paid back, they are burned)
• In the meantime, if the collateral breaches the liquidity ratio, then my collateral and debt can be auctioned off to recover debt and maintain DAI’s target price

Effectively, MakerDAO manages the supply of DAI in a way that 1 DAI = $1. If the DAI price drops <$1, then CDPs become expensive and investors are incentivised to buy DAI. While if the DAI price >$1, then CDPs become cheaper and the investors are incentivised to sell their holdings.

Once Maker/DAI grow in adoption, we could potentially get rid of loan intermediaries (underwriters, credit bureaus, brokers) to make lending great again. Intriguing isn’t it! 👏

#blockchain #crypto #defi