Why Stablecoin?

If you follow the concept of the technology acceptance curve according to Geoffrey A. Moore from his book “Crossing the Chasm”, blockchain products had overcome the chasm between the early adopters and the early majority by the time the first Spot Bitcoin Exchange-Traded Products (ETPs) started trading in January 2024 at the latest. However, anyone who takes a closer look at the world of crypto will realize that Wall Street has only opened the door to a universe whose vastness can only be guessed at based on the use cases that already exist.

Bitcoin and what’s next?

The majority of crypto offerings in the “New World” are still based on proven business models of traditional finance (TradFi). Anyone wishing to purchase their first Satoshis (smallest unit of Bitcoin) usually does so via a central crypto exchange. After FTX, one of the largest trading platforms, collapsed in 2022 and even the industry leader Binance faltered in 2023, people prefer to rely on regulated providers or well-known brands that, as in the case of Coinbase, are usually too big to fail due to their business relationships with financial giants. And if El Salvador has been using Bitcoin as a legal tender since 2021 and central banks around the world are now working on introducing Central Bank Digital Currencys (CBDC), even though the current fiat money is already largely used in electronic form, the crypto world probably offers more than just speculation in highly volatile coins. So what would be the next step?

Tower of strength

In order not to be put off by buzzword bingo with DeFi, DEXes, DAOs and DApps, but also not to fall into FOMO about entering the crypto world too late, it is worth taking a look at a product that opens up the seamless transfer of fiat values into the crypto space and various possible uses there due to its price stability — Stablecoins. A Stablecoin is a special cryptocurrency that is designed to ensure price stability, as opposed to the pronounced price fluctuations that usually occur with cryptocurrencies. The value of a Stablecoin is typically pegged to a stable asset such as a fiat currency or a commodity reserve. According to CoinMarketCap, one of the best-known and most frequently visited websites in the cryptocurrency sector, over 160 of the almost 9,000 cryptos listed are Stablecoins and Tether (Code: USDT) is the third largest overall after Bitcoin (BTC) and Ethereum (ETH). This is a coin that, as the name suggests, is pegged to the US-Dollar and is intended to replicate it in the crypto world. But how do Stablecoins work and what are their use cases?

Stabilization methods

In addition to transparency, high liquidity, fast transactions and, in some cases, decentralization, Stablecoins are characterized by their stability in line with the nomenclature. Four main mechanisms are used to achieve this:

1. Fiat-backed Stablecoins:

These Stablecoins are backed by traditional currencies in a reserve system that maintains a 1:1 ratio between Stablecoins issued and fiat currencies held. The stability is guaranteed by ensuring sufficient holdings in reserve to enable the return or redemption of issued Stablecoins at any time (e. g. USDT, EURS or VCHF).

2. Crypto-backed Stablecoins:

These Stablecoins use a cryptographic approach to achieve price stability. A smart contract protocol is used to monitor the supply and demand of the Stablecoin and react accordingly. This is typically done by backing the Stablecoin with a basket of cryptocurrencies or crypto-assets, dynamically adjusting the ratio between Stablecoins issued and crypto-assets held to ensure price stability (e. g. DAI, VAI or USDX).

3. Algorithm-supported Stablecoins:

These Stablecoins use algorithmic mechanisms to achieve price stability. A complex algorithm continuously monitors and analyzes the supply and demand of the Stablecoin and automatically adjusts the supply to ensure price stability.

• The Rebase mechanism does this either by issuing new coins or burning existing coins (e.g. AMPL, BASE)

• With the Seigniorage mechanism, several tokens are usually required — the Stablecoin, an equity token and a bond token. If the supply needs to be increased, the equity token holder receives a corresponding share of the new Stablecoins. The other way round, the Stablecoin is exchanged for the bond token, which can later be exchanged for Stablecoins again (e. g. BAS, FEI).

• In the fractional mechanism, the value of the Stablecoin is only partially hedged by a basket of mostly crypto assets and the rest is regulated by an algorithm. If demand is high, new coins are issued; if the supply needs to be reduced, coins are converted into the assets that serve as collateral (e.g. FRAX).

4. Commodity-backed Stablecoins:

These Stablecoins are backed by physical commodities such as precious metals or other commodities. The value of the Stablecoin is backed by the value of the underlying commodity or a combination of commodities. The price stability of the Stablecoin is ensured by securing an appropriate amount of the underlying commodity in reserve (e. g. PAXG, OIL).

However, blind faith is not recommended even with stablecoins, as the crash of the algorithm-based stablecoin TerraUSD (UST) in 2022 shows, when the coin lost over 99% of its value.

Use cases für Stablecoins

Anyone who has ever instructed a foreign bank transfer from a local bank knows that this is often associated with increased effort and/or costs. Thanks to SEPA, these hurdles have largely been removed in the Eurozone. Nevertheless, payments involving various intermediaries usually take at least one bank working day — if all goes well. Stablecoins come into play here and in the following other use cases:

1. Payments:

Stablecoins make it possible to transfer money worldwide at low cost and, depending on the protocol, within seconds, without the restrictions and fees of traditional banking systems. Nevertheless it should be noted that Stablecoins have not yet achieved widespread acceptance, also in light of the fact that the legal and regulatory environment for Stablecoins can vary depending on the country or currency area.

2. Lending & Borrowing:

Users can use Stablecoins as collateral to take out loans without traditional financial institutions — and their additional costs. The same applies to the returns for lenders by lending their Stablecoins to borrowers. However, there is also a risk that borrowers will not repay their loans, which can lead to losses for lenders if the loans are not appropriately collateralized or secured by available insurance.

3. Staking:

Stablecoins can be used to participate in liquidity pools and earn rewards in the form of additional Stablecoins or other tokens. According to Beefy Finance, a leading DeFi platform for automated yield farming, above-average returns in the double-digit range are possible here, depending on the size of the pool and the coins used — in conjunction with other cryptocurrencies, even up to triple-digit returns, although the risk of (impermanent) loss is explicitly pointed out in this context. Additionally staking also helps to ensure the security and integrity of blockchain protocols by allowing users to deposit their Stablecoins as collateral to validate transactions.

4. Store of value:

Stablecoins offer a way to store value in the crypto world without being exposed to the volatility of other cryptocurrencies. By using Stablecoins pegged to safe currencies (e.g. USD, CHF, CAD), users can protect themselves from inflation in their home currency. But as the TerraUSD example shows, stability depends on the integrity and transparency of the underlying reserve. If issuers are subject to stringent regulation and compliance, regular audits are carried out and there is a lively community whose exchanges can be tracked on the relevant social media channels, this should suggest a higher degree of seriousness.

Conclusion

If you only invest in crypto products on the capital market, you can participate in the fluctuations in value and business models, but you remain in the “old world”. The crypto universe is more than that. Not only are existing business models replicated here in an optimized way, but something really new can actually emerge in a kind of gold-rush atmosphere — with all its opportunities and risks. For many, the leap into this largely unregulated world seems too far. A bridge is needed. Stablecoins can be something like that. Why not give it a try?!