What are stablecoins? Stablecoin classification & price balancing mechanism
What are stablecoins? Why are stablecoins important in crypto? How many types of Stablecoins are there? Learn all about stablecoins here!
Cryptocurrencies are known for their huge volatility in the short and long term.
Although DeFi promises to take Crypto to another level from cryptocurrency to crypto assets in a new economy, most of them are often looked down upon for looking like speculative assets due to their highly volatile prices.
Stablecoins promise to be a potential piece to connect the crypto space with the traditional financial market through its “stable” nature.
However, when it comes to Stablecoins, most of you think of Tether (USDT) and think that Stablecoin is a cryptocurrency that is converted to 1:1 value by the US Dollar.
But that’s not true! There are many different types of stablecoins in the Crypto market, and USDT is just one of dozens of stablecoins currently on the market.
In this article, idolmeta.net will provide you with information including:
- What are stablecoins?
- How many types of Stablecoins are there? How does the price balance mechanism of Stablecoins work?
- Are Stablecoins Trending?
What are stablecoins?
A stablecoin is a cryptocurrency designed with the aim of minimizing the impact of price volatility by fixing it to a more stable asset such as fiat money, commodities (gold) , silver…), or maybe another cryptocurrency.
Stablecoins take advantage of the characteristics of blockchain and peer-to-peer value transfer, while users are not subject to high volatility as from other cryptocurrencies.
What problems do stablecoins solve in Crypto?
Stablecoins were born to solve the biggest problem in the current Crypto market, which is volatility.
- For traders or investors, they can transfer assets to stablecoins to avoid the volatility of cryptocurrencies without necessarily changing to Fiat.
- For shops, it is difficult for any company to accept payment in 1 type of Crypto with a fluctuation of 20-30% in value in a short time. This, in turn, has made the widespread adoption of cryptocurrencies so much more difficult.
Thus, it can be seen that Stablecoins are important as a bridge between the electronic market and the traditional financial market.
Converting from Fiat to crypto is much easier with the advent of Stablecoins.
As Erik Voorhees, CEO of Shapeshift, observed:
“Stablecoins are important in the same way that a bridge is important. You may not care much about the bridge, but without it, the beautiful land beyond is much harder to get to”.
How to solve problems in the Crypto market of Stablecoins
Why are stablecoins important to crypto?
Most of us are not comfortable with loss, which is exaggerated when crypto is highly volatile and highly speculative.
Token prices can drop several dozen percent within a week, for many people, this is very difficult to accept.
For example, you win a few trades and decide to take profits in BTC, about 1 week later, you lock BTC out in VND and find that the amount of VND you put in and out has no difference. How do you feel?
Stablecoins separate the high risk/high return characteristic of cryptos from the frequent volatility of crypto assets, the “stable” characteristic, which makes Stablecoins a more suitable cryptocurrency for storing and as a medium of exchange of value.
Depending on the comparison criteria, they can classify stablecoins in different ways. The criteria I choose to classify stablecoins in this article is “collateral ratio” (also known as “backed”).
The reason for choosing the collateral ratio classification is that collateral plays an important role in supporting stablecoin prices in the peg, by creating a return on reserve assets.
As such, Stablecoins will include:
- Full-reserve Stablecoin.
- Partial-reserve Stablecoin.
- Over-collateralized Stablecoin.
- Non-reserve Stablecoin.
These stablecoins on the market are USDC or USDT, they use the US dollar or equivalent highly liquid assets as a reserve.
1 USDC minted on-chain will have 1 US dollar or equivalent asset in reserve.
This type of stablecoin on the market is also known as Custodial or Centralized Stablecoin, because they require users to trust custodian, not smart contracts on-chain.
Despite the concerns surrounding centralization, currently, USDC and USDT are the two most used stablecoins in DeFi.
Find out more details about USDT and the controversy surrounding the largest stablecoin in the market with the article: What is Tether (USDT)?
A typical stablecoin for this is Frax finance’s FRAX, with each minted FRAX coin on the market only a fraction of its value is held in USDC.
Volatility and remaining reserves will be absorbed by FXS (Frax Shares, project governance token).
After a period of activity, Frax’s pattern proved to work quite well as the price of FRAX remained hovering around its $1 peg level.
DAI is the most representative stablecoin of its kind on the market. Basically, for every DAI minted in the market, there will be $1.5-1.6 worth of assets collateralized in the Maker Vault.
If the value of the collateral falls below the minimum threshold (typically 150%), the Vault will be liquidated, reducing the supply to bring the DAI price back to the peg price.
Over-collateralized is a pretty good approach in the context of Crypto being a relatively low-liquidity market, this approach makes it possible for DAI to always be Backed by an amount of assets worth more than the total of DAI Minted.
The limitation of this approach is that it is difficult to scale.
Typical examples of this type are algorithmic Stablecoins, such as Basis Cash.
In which, the system’s stablecoin, BAC, is issued without a reserve of collateral. Instead, value is fully preserved by algorithms that shrink and expand supply when the BAC price is above and below the peg.
This model assumes that parties are actively involved in maintaining the price of BAC in order to earn relevant incentives.
Example of how Basis Cash works.
Basis cash has 3 Tokens: BAC, BAS, BAB:
BAC is a Stablecoin – it is pegged for 1$ and has a daily stabilization mechanism.
When BAC trades above 1$:
BAS Holder can Stake BAS => Earn Inflation (Earn BAC) according to the formula:
(Your BAS/Circulating Supply BAS) * Total Supply BAC * (TWAP BAC Price – 1)
BAS Holder earns BAC Free, so according to the model theory, they will sell to the market to make a profit => Selling pressure pushes BAC price down to 1$.
When BAC trades below $1:
- Holder BAC can use BAC to buy BAB at the rate BAB = (BAC Price)^2.
- BAB does not expire and can be exchanged when the price of BAC is greater than 1$.
- For example, when a user is holding 10 BAC and the price of each BAC is $0.8, then the user can use 10 BAC to buy 15,625 BAB.
- Let’s say, 3 days after BAC price increase to 1$, then user can exchange 15.625 BAB = 15.625 BAC and sell BAC on DEX and earn almost 50% profit from his 10 BAC.
According to this pattern, buying pressure pushes the price of BAC to $1.
Stablecoins Price Stabilization Mechanism
All stablecoins require one or several mechanisms to correct the price when it deviates from the peg, by looking at the plausibility and feasibility of these mechanisms we can consider the idea of whether the project is feasible or not.
Some of the most notable stablecoin price adjustment mechanisms on the market today are:
- Redeem & Expand.
- Leveraged Loans.
Note, a project may use one or more of the ways below in combination to keep stablecoin prices around the peg level.
Redeem & expand
For Stablecoins like USDT or USDC when the price leaves the peg, the system has a balance mechanism as follows:
- If USDC is trading for less than $1, USDC holders should exchange USDC for the underlying collateral, thus buying a dollar for less than a dollar.
- If USDC is trading above $1, holders should collateralize the dollar to minted USDC and sell it on the market for the difference.
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- Model Seignorage (3 tokens) of Basis cash.
- Model Rebate (2 tokens) of Ampleforth.
- Frax Finance’s fractional model (2 tokens).
- Terra’s Model (2 tokens).
In particular, Terra’s model is considered the most successful, based on the scale and application of Terra’s stablecoin.
Terra’s stablecoin UST is minted by burning LUNA (Terra’s native token), with this model UST volatility is absorbed by LUNA:
- When UST price < Peg ⇒ Protocol sells LUNA to buy back Stablecoin.
- When UST price > Peg ⇒ Mint add USDT.
Leveraged Loans is a fairly complex price balancing system, the famous stablecoin using this model is MakerDAO (DAI).
In it, users lock up collateral, such as Ethereum and other tokens, in collateralized debt positions (CDPs). They can then borrow DAI from the system.
Users can then unlock their collateral by paying back the borrowed DAI, plus a stability fee that accrues over time.
If the value of the collateral in the CDP falls below 1.5 times the value of the borrowed DAI, the debt position is automatically liquidated and the collateral is used to redeem the DAI.
Additionally, if the value of the collateral loses value rapidly and falls below the value of the borrowed DAI, the MKR token is minted to cover the shortfall.
Stablecoin Investing: Will Stablecoins Become Trending?
Before talking about the Stablecoin trend, let’s reiterate a bit about the formation and development of the Stablecoin ecosystem from 2013 until now.
As you can see in the chart below, Stablecoins really exploded in 2018 with more than 36 consecutive Stablecoin projects hitting the market, accounting for more than 54% of the total current Stablecoins.
Besides, Stablecoins will continue to thrive with the participation of big players such as JPM Coin of J.P. Morgan bank, Libra of Facebook.
I will summarize some of the main points of the article as follows:
The most important feature of Stablecoins is that it separates the high risk/high return characteristic of cryptos from the frequent volatility of crypto assets, making Stablecoins a more suitable cryptocurrency for storing and as a medium of exchange of value.
According to the collateral ratio criterion, we have 4 types of stablecoins with different characteristics:
- Full-reserve stablecoins: USDC and USDT are the two most used stablecoins in DeFi.
- Partial-reserve stablecoins: For every FRAZ coin minted in the market, only a fraction of its value is stored in USDC.
- Over-collateralized stablecoins: DAI can always be backed by an amount of assets with a value greater than the total amount of DAI minted, however, the limitation of this type of stablecoin is that it is difficult to scale.
- Non-reserve stablecoins: Algorithmic Stablecoins have stability based on an elastic supply and demand mechanism using an algorithm called Rebase.
Top 3 price balance models on the market right now: Redeem & expand, Algorithmic, Leveraged Loans.
Above is the basic information for those who are new to joining and learning about Stablecoins.
idolmeta.net now has a more in-depth analysis article on Stablecoins inside each ecosystem, through characteristics, classification, development stage and data analysis, thereby projecting the future and find stablecoin investment opportunities.