The true key to unlocking the great potential of blockchain will come with the widespread adoption of Stablecoins.”
— Rune Christensen, Founder of MakerDAO

As the world succumbs to the coronavirus pandemic, many governments around the world are rushing to not only find a cure for COVID-19, but concrete plans that could save their people and the economy. The world’s largest economy - the United States, has introduced a $2.2 trillion stimulus package in the hope of rescuing the failing economy and its people. However, the US government needs to devise a fail-safe method that could deliver the emergency financial aid to its population, while preventing people from congregating at a bank or another physical location to collect the aid at the same time.

Shortly after, a draft was proposed to distribute these funds in the form of a “digital dollar”. If successfully implemented, the U.S. central bank digital currency could possibly be underlied by blockchain technology. A digital dollar would allow its citizens to have immediate access to their funds, instead of spending the time to visit a bank for the cheques and risking being infected. In order to ensure that the value remains pegged to the USD, experts may suggest issuing stablecoins, which could emulate the price of USD at all times.

For those who are familiar with cryptocurrency trading, stablecoins could be viewed as a temporary shelter in the midst of major price fluctuations. As the name suggests, this unique form of cryptocurrency is of a stable value when compared to popular cryptocurrencies like Bitcoin (BTC), Ethereum (ETH) or Ripple (XRP). Stablecoins are backed by real-world assets, with values often pegged to the asset values as well.

For instance, some stablecoins are known to be backed by a cryptocurrency collateral. One example is DAI, a stablecoin created and issued by the MakerDAO Foundation in 2015. DAI is a cryptocurrency-backed stablecoin with its USD peg being maintained via over-collateralization with a more volatile cryptocurrency known as ETH. However, within the cryptocurrency trading community, an older fiat-backed stablecoin called Tether (USDT) is preferred, which has since become the USD-pegged stablecoin with the highest market capitalization in the cryptocurrency market.

Since, cryptocurrencies have yet to reach mainstream adoption, new traders from traditional stock markets are intrigued with the prospect of profiting off the notoriously wild volatility seen in cryptocurrency assets. Because of the existence of stablecoins, investors have therefore gained the trust and confidence in cryptocurrency trading as they could make use of these non-volatile, asset-backed cryptocurrencies to minimize their volatility.

The definition of Tether’s stablecoin

As mentioned earlier, the largest of these fiat-backed Stablecoins is Tether (USDT). The stablecoin was issued by one of the top cryptocurrency exchanges known as BitFinex. Since its creation in 2012, it had suffered a series of notorious transparency and regulatory issues, but this stablecoin managed to consistently dominate the global stablecoin market with a whopping 75% market share.

The value of USDT is based on the value of the backing currency held by a trusted third-party entity (usually a bank). In this setting, the trust in the custodian of the backing asset is crucial for the stability of the price of USDT. For every one issuance of USDT, an equivalent amount of US$1 must be deposited to the corresponding bank account. The 1:1 correspondence between Stablecoins and the collateral deposit ensures the peg stability. Another interesting point to note is that the cost of maintaining the stability of the stablecoin is equivalent to the cost of maintaining the backing reserve and the cost of legal compliance, maintaining licenses, auditors and the business infrastructure required by the regulator.

The demand for Stablecoins

One of the main obstacles that most cryptocurrencies have to overcome is the price volatility. In the context of commerce today, major price swings do not appeal to merchants as much as traders. For example, dealing with a daily value fluctuation of 15% or more would prove detrimental to the merchant. Unfortunately, the only way forward to a mass adoption would be for merchants and other businesses to start accepting cryptocurrencies, in order to facilitate liquidity in the real world. Therefore, with stablecoins, they will be introduced to the new asset class with a higher inclination towards acceptance of cryptocurrencies. Coupled with a stablecoin conversion, a merchant will be more confident in the value of their received fees, even if they are dealing with a more volatility cryptocurrency such as Bitcoin.

Stablecoins have also proven to be the perfect solution for cryptocurrency exchanges, as they require a way for their traders to protect themselves from cryptocurrency volatility without converting back into fiat currencies, which often involve a complicated and time-consuming process. Another requirement that most cryptocurrency exchanges have to fulfill would be a fiat on-ramp, which allows a convenient way to exchange fiat into cryptocurrency. When a large institutional customer enters the cryptocurrency market, they usually deposit their fiat into the exchange’s designated bank account and receive corresponding stablecoin value and use it for trading on an exchange.

It is only until recently that most exchanges chose USDT as the primary stablecoin for these purposes. In 2018, US financial authorities and regulators have attempted to oust USDT due to the failure of Tether’s company to comply with various regulatory requirements. As a result, various US-based cryptocurrency exchanges have issued their own regulated stablecoins. Numerous leading cryptocurrency exchanges operating in the United States such as CoinBase, Gemini and Binance have released more compliant-friendly stablecoins such as USDC, GUSD and BUSD respectively, catering to their respective markets. However, large non-US based exchanges such as Binance and BitFinex are still mostly accepting the largely unregulated USDT, along with the newer regulated stablecoins as mentioned above.

In spite of compliance issues as explained earlier, actions taken by leading cryptocurrency exchanges have further reinforced the fact that, due to great demands, the stablecoin is a force to be reckoned with and will likely remain as an important cryptocurrency in the foreseeable future. The stability of a stablecoin serves as an invaluable tool for traders hedging their deposits.

The Trader’s mechanism for hedging

Hedging, or hedge, is a strategy commonly used in the traditional investment market to protect the trader’s position by reducing the risk of adverse price movements in an investment asset. Other methods include balancing an investment portfolio with a fair mix of low-risk and high-risk investments.

While cryptocurrencies are considered a new form of asset class, the general outline of a cryptocurrency exchange does not differ much from the traditional market, except in the approach of hedging. Seasoned cryptocurrency traders typically use stablecoins as a hedge against BTC and other cryptocurrencies. Many cryptocurrency day traders convert their cryptocurrencies (e.g. BTC) for stablecoins such as USDT whenever there is a rumor or news that may negatively affect the cryptocurrency price, in order to protect their cryptocurrency holdings value. Such scenarios could happen regularly every month, and it is evident from the average monthly volume that USDT has the second highest trading volume, after BTC, making it the most popular stablecoin in the market that is used by traders to hedge their positions.

USDT enables short-term cryptocurrency traders to not only reduce investment risks, but also the painstaking process of converting back to fiat currencies, which could create a lot of inconveniences to traders. Stablecoins like USDT streamline the entire trading process by having a tokenized option or preserving the value in USD instead.

An element for a dynamic crypto landscape

While stablecoins cannot be compared with other cryptocurrencies that have functions other than price speculation and trading, they essentially complete the entire cryptocurrency investing experience. Without stablecoins, it could prove to be more difficult to push for mass adoption of cryptocurrencies. Stable cryptocurrency acts as a gateway for investors and merchants who are unfamiliar with the digital currency, to greatly facilitate the onboarding process into understanding cryptocurrencies, thereby gaining the trust and confidence of new investors to seamlessly navigate between the traditional financial market and cryptocurrency market.

Meanwhile, popular unregulated stablecoins such as USDT are likely to suffer more scrutiny due to the transparency and regulatory issues as the population of cryptocurrency investors grows. Eventually, a new generation of stablecoins may attempt to solve the issue via different routes, like full regulatory compliance in the case of xEuro, or fully migrating to the blockchain world, like MakerDAO’s DAI stablecoin.