What it is a Stablecoin & why do we need them?

Learn Crypto Blog Learn Crypto Blog
Learn Crypto Jan 20 · 6 min read
  • What is a Stablecoin?
  • Why trading fuels Stablecoin demand
  • Stablecoins, commerce & the unbanked
  • Fiat fights back through CBDCs

Stablecoins are designed to work as ‘stable’ digital versions of existing currencies - like the US Dollar - or assets like gold. But why do we need Stablecoins given they simply replicate existing forms of money or stores of value?

Stablecoins replicate a lot of the characteristics of existing money. Take USDT, aka Tether. Its name gives a pretty obvious clue that it is a clone of the US Dollar (USD) and it is designed to maintain a value equal to the US Dollar. So one Tether should always be equivalent to one US Dollar.

Though Tether has obvious similarities to its analogue cousin, it also functions without a lot of the restrictions associated with moving US Dollars around the world. In that way Tether, and Stablecoins in general, are probably best described as hybrid money. 

Unlike the US Dollar, but in common with most cryptocurrencies, Tether can be moved instantly across any borders, but is designed to maintain value with the Green Back, a characteristic lacking from pretty much all pure crypto, like Bitcoin, that have no connection to existing money and derive their value from completely new decentralised models.

Stability and speed are two characteristics that are particularly useful for commerce and trading, so Stablecoins emerged to facilitate the growth of those functions within the world of crypto.

Stablecoins & crypto trading

No matter how much Bitcoiners talk about growing adoption, there is no escaping the fact that its biggest current use case, along with most cryptocurrencies, is speculation. 

Speculation - buying/selling to try and make a profit - is popular because of the huge volatility across crypto assets. In fact volatility is what professional traders seek out. 

Unlike hodlers, who are prepared to weather both the ups and downs of the market, and hold their crypto no matter what, professional traders take a structured approach to risk. 

They want a safe haven for their capital when it isn’t actively being utilised in a trade. But equally, whenever an opportunity arises, they want to be able to execute a trade at a moment’s notice, as markets move at light speed.

We have a whole section explaining the fundamentals of cryptocurrency trading, but the TLDR for why demand for Stablecoins comes from traders can be understood from looking at basic mechanics of a trade - the Currency Pair.

As its name suggests a currency pair shows the value of one currency in relation to another. It consists of a Base and a Quote. Here’s an example:

USD/EUR = 0.8600

With this currency pair USD (US Dollar) is the base and EUR (Euro) is the quote. It shows how many Euros you would receive - at that quote - for one dollar.

Given that traders - and most of the world - work with a major fiat currency as their base, it is essential that this option is available for them when trading cryptocurrencies.

Stablecoins provide this function. The benefit of existing money - acting as the stable base - but the speed and flexibility of crypto. 

In the early days of crypto if you wanted to sell your Bitcoin into a stable currency, that meant moving funds back to your bank account which was slow and expensive. Equally, if you wanted to move your fiat onto an exchange a bank transfer might take days, and cost a lot in fees.

Though this so-called on ramp process has improved, especially with card payments, you still need to provide proof of identity and wait for verification; even then, there are limits to how much you can deposit. These restrictions on flexibility are another key downside of fiat that Stablecoins are designed to mitigate.

Yes, you’ll need to make the initial move from fiat, but once a trader has converted a significant amount to a Stablecoin, it can remain there to be used as desired, providing a level of protection against the volatility of pure cryptocurrencies. 

Stablecoins, commerce & the unbanked

Just as many day traders have a pragmatic view of crypto, trying to exploit its volatility, rather than caring about long term adoption, there are other user groups with similar needs.

The US Dollar is the world’s reserve currency so a huge proportion of business transactions are denominated in the USD, yet as already mentioned, there are restrictions on its movement across borders, and associated transfer fees. Many businesses and consumers that want access to the stability of the USD, but cannot navigate the restrictions, are turning to Stablecoins. This includes the so-called unbanked - an estimated 2 billion people without accessing to banking.

Credit cards and eWallets like Paypal, Apple Pay and Google Pay drive online retail, but don’t treat all businesses and locations alike. Those services or countries that are deemed higher risk will be charged more to use the service or not offered the opportunity at all.  

For anyone who falls into this gap, cryptocurrency provides a much more flexible alternative, but the price volatility aspect makes them unviable, even Bitcoin, the most established crypto can move 10% within a matter of hours. Stablecoins offer a via alternative.

Those businesses or consumers that can’t or won’t use fiat money, but don’t want the volatility of pure crypto are naturally drawn to Stablecoins.

So are Stablecoins the future of money?

Given Stablecoins function as a hybrid money - faster and more flexible, but without volatility - surely they are the future, and not Bitcoin, Ethereum or so other crypto? The answer to this depends on where a Stablecoin’s stability comes from.

We’ve got an entire article on the general approaches that Stablecoins take to achieve their ‘peg’ - their connection to an existing asset - but the truth is that given they lack the decentralisation of cryptocurrencies, no-one is actually sure.

Tether is the dominant Stablecoin, with a circulating supply approaching $70billion, but is yet to provide conclusive evidence that the entire amount is backed one-to-one with real dollars. The implication of that is far-reaching, not least because it undermines their fundamental value proposition - stability.

Tether is not alone in drawing criticism and questions. What is the long term value of Stablecoins if they simply inherit and amplify the problems of the fiat currencies they are designed to mimic? Unlimited in supply, centrally controlled and opaque in their function.

Not all Stablecoins are backed by fiat money, some are backed by fixed assets like gold, and others like DAI, have attempted to generate stability within a decentralised model, but face different challenges. Other approaches may emerge, but right now Stablecoins are largely a halfway house, a compromise between fiat and crypto that is far from optimal, but for which there is short term demand from users with a very pragmatic focus.  

Fiat fights back through CBDCs

Central Banks - the issuers of dollar, euros and yen - aren’t just sitting back and watching the huge surge in synthetic versions of their traditional money. They see Stablecoins as competition and are fighting back, by improving on the problems that push people away from their old school money, and creating what are clumsily called Central Bank Digital Currencies - CBDCs for short.

The People’s Bank of China have been experimenting for years with a digital Yuan, in fact most major governments are looking at rolling out digital money. CBDCs are intended to fix some of the inherent issues that have led to Stablecoins - speeding up transfers, driving down fees and being interoperable with other digital currencies. 

But on the flip side, CBDCs will give governments unprecedented access to our spending habits and even the potential ability to confiscate money at will. They are the antithesis of the decentralised vision that cryptocurrencies promise.

So if you start from the assumption that existing money is broken, then the longterm solution lies in an entirely new model - the decentralised vision of something like Bitcoin.

The attraction of Stablecoins is that they sit somewhere in between these views. They inherit the elements of existing money that some users value - stability - and improve on some of the problems - friction and cost of transfer.  But because Stablecoins are close relatives of fiat money, their value lies in their short term utility, rather than their promise as a new form of money, because they also inherit fundamental problems that may eventually undermine their use case.