One of the biggest problems facing cryptocurrencies today is their extreme volatility. Though crypto price movements seem to have mellowed out in recent weeks, many would-be investors have undoubtedly held off on investing in the cryptocurrency industry because they are concerned that it is a bubble waiting to pop.
With this shortcoming in mind, a subcategory of cryptocurrencies has emerged called ‘stablecoins’, which are explicitly designed to minimize price volatility. These projects use various mechanisms in order to keep their tokens as close to the same fiat value at all times, regardless of market activity.
The defining feature of these coins is the mechanism used to keep token prices stable. In Part 1 of our series on stablecoins, we will be covering ‘fiat-backed’ stablecoins. These are projects that maintain a stable coin price using a system based on collateralized fiat currency. According to research by Blockchain.com, this accounts for roughly 35% of all stablecoin projects.
By the end of this guide, you will have a solid understanding of how fiat-backed stablecoins work to minimize volatility, the specific mechanisms used by some of the most popular fiat-backed stablecoins, as well as some the larger implications that fiat-backed stablecoins may have for the crypto industry.
Let’s get started!
What are Fiat-Backed Stablecoins?
Fiat-backed stablecoins are cryptocurrencies that attempt to maintain a stable token value that is pegged to the value of a specific fiat currency. These coins generally work by manipulating the token supply—either by creating or destroying tokens—in order to maintain a 1:1 ratio between the number of tokens in circulation and the amount of collateralized fiat they have in their reserves.
The easiest way to understand asset-backed stablecoin mechanisms is to see them in action. Let’s begin with the most popular stablecoin in the world today—Tether.
Examples of Fiat-Backed Stablecoins
Currently ranked as the 8th-largest cryptocurrency by market cap, Tether is the undisputed king of stablecoins. It is also an excellent example of the fundamental principles behind asset-backed stablecoins, due in part to its simplicity.
Tether is a stablecoin protocol created by Tether Limited that is based on Bitcoin’s Omni Layer protocol. The most popular Tether coin is USDT, which is pegged to the value of the U.S. dollar (USD). This means that every USDT token is worth close to $1 at all times (give or take a few fractions of a cent). Tether Limited has also produced a similar token pegged to the euro, called EURT
Tether achieves price stability through a mechanism in which users deposit a certain amount of USD into Tether Limited’s bank account and are then given an equivalent amount of USDT in exchange. When users want to cash out their USDT for USD, Tether Limited destroys the users’ old USDT in order to maintain a 1:1 ratio between the amount of USDT in circulation and the amount of USD in their reserves.
The steps in the life of a typical Tether token are illustrated in the following image from the Tether white paper:
- Users deposit fiat currency into Tether Limited’s bank account (For this example, we are assuming the fiat is USD).
- Tether Limited issues an equivalent amount of USDT and deposits it into the users’ Tether accounts.
- Users can transact with one another.
- Users looking to exchange their USDT for USD can redeposit their tokens into their Tether account.
- Tether Limited destroys the deposited tethers and gives the users an equivalent amount of USD.
As you can see, the Tether system is elegant and straightforward. Tether’s simplicity is likely part of the reason for the platform’s success compared to other stablecoin projects that operate through more complex stability mechanisms (just wait until we cover Maker in Part 2).
But despite Tether’s popularity, the coin has also experienced its fair share of controversy. The biggest point of contention with regard to Tether is whether or not the company truly has fiat reserves to back up all tethers in existence.
Tether Limited states in the platform’s white paper (and many times since then) that the company’s reserves are to undergo regular audits in order to prove to investors that Tether Limited is maintaining the correct cash reserves at all times. However, the company has been inconsistent in actually undergoing these audits.
The platform’s most recent ‘audit’ took place on June 1, 2018 and was performed by the law firm Freeh, Sporkin & Sullivan LLP (FSS). FSS claims that they were able to confirm Tether’s reserves at that point in time; however, the document also states, “The above confirmation of bank and tether balances should not be construed as the results of an audit and were not conducted in accordance with Generally Accepted Auditing Standards.” Tether’s previous ‘audits’ include similar disclaimers saying that they were not in fact audits at all.
The lack of transparency in this regard is important because the entire Tether system relies upon the premise that each USDT token is backed up by a USD. If Tether is failing to maintain their reserves, then there is no other mechanism in place keeping USDT’s value stable besides investor trading. Tether Limited, for their part, does have a “Transparency” page on their website which claims to show a current balance sheet for the tethers in circulation along with their reserves, but without regular audits, Tether Limited still requires investors to place in it a significant amount of trust that the company is holding up their end of the bargain.
Coming in at number 55 by market cap, TrueUSD is another stablecoin pegged to the U.S. dollar that uses a similar 1:1 exchange mechanism. However, TrueUSD differentiates itself from Tether in the way that it handles user funds, along with its superior transparency.
While Tether requires users to trust that the company has the appropriate fiat reserves in order to back up each tether token, TrueUSD relies upon a legal framework using escrow smart contracts and licensed trust companies to handle all exchanges between actual USD and TrueUSD tokens. This means that the TrueUSD developers never actually touch deposited user funds.
The following graphic from the TrueUSD website illustrates the process:
First, users send a wire transfer to one of TrueUSD’s partnered trust companies. The trust company then signals the TrueUSD smart contract to release TrueUSD coins to the users’ crypto wallets.
The process for cashing out TrueUSD tokens is essentially the same sequence in reverse. Users deposit their TrueUSD coins into the TrueUSD smart contract from a registered Ethereum address. TrueUSD then signals the trust company, who then sends users their funds.
In an effort to further boost user confidence, TrueUSD also partakes in regular audits. Unlike Tether, however, TrueUSD has been much better about staying on a regular attestation schedule. TrueUSD’s attestations have also been performed by a licensed accounting firm called Cohen & Company, rather than a law firm.
The primary stability mechanisms used here are more or less the same as those used in Tether. The circulating supply of TrueUSD is carefully controlled such that it is in a 1:1 ratio with the amount of fiat USD users have deposited. The primary differences between the two platforms are the degree to which the developers handle users’ funds and the companies’ financial transparency.
Up and Coming Stablecoins: The Gemini Dollar, USDC Coin, and Paxos
While Tether and TrueUSD are by far the biggest players in the fiat-backed stablecoin market, there has been a recent surge in similar dollar-backed stablecoin projects. In fact, 3 highly-publicized stablecoins launched in September, 2018: the Gemini dollar, the USD Coin, and the Paxos Standard.
Interestingly, these projects share many fundamental features: they are all built upon the Ethereum blockchain and adhere to the ERC-20 token standard; they are all regulated under New York’s BitLicense; and they are all affiliated with a major cryptocurrency exchange.
Each of the three coins also uses a stability mechanism that is essentially the same as the mechanism used in Tether: Users interested in acquiring any of the above coins deposit USD into an online account and are given newly created tokens in exchange. When it comes time to cash out the tokens, users re-deposit the coins back into their account, the tokens are destroyed, and users are given USD.
Given all of these similarities, you might be wondering what the differences are between these projects. In short, the primary differentiating factors between these coins are the cryptocurrency exchanges with which they are affiliated and on which they are available for trading.
The Gemini dollar (GUSD) was created by the Winklevoss twins’ Gemini exchange. USD Coin, also called USDC, was created by Boston-based cryptocurrency firm Circle, which owns the Poloniex crypto-to-crypto exchange. Finally, the Paxos Standard (PAX) was created by Paxos and is affiliated with the itBit exchange.
Now that we have a clear picture of the fiat-backed stablecoin market, let’s take a look at stablecoin use cases and their role in the broader cryptocurrency industry.
The Role of Fiat-Backed Stablecoins in the Cryptocurrency Industry
Because fiat-backed stablecoins are designed to have stable prices, they are not attractive speculative investments compared to other cryptocurrencies. No one should be investing in any of the above projects and expecting a significant return on investment.
Instead, fiat-backed stablecoins are primarily used as a convenient way to exchange (what are essentially) fiat currencies while reaping the benefits of traditional cryptos. These benefits include: faster transaction times compared to ACH wire transfers, decentralization, blockchain-based security, anonymity, and internationality.
Fiat-backed stablecoins are particularly valuable for use in decentralized applications (dapps). This is a major factor in why the Gemini Dollar, USDC, and Paxos are all built on Ethereum. By adhering to the ERC-20 token standard, each of the above projects is immediately compatible with every Ethereum wallet and Ethereum-based dapp. ERC-20 stablecoins allow dapp developers to accept payments for their services without having to open themselves up to the volatility of ether and other cryptos.
Finally, fiat-backed stablecoins are useful to individual and institutional investors for essentially the same reason they are useful to dapp developers: they provide investors with a secure way to enter the cryptocurrency market without immediately exposing themselves to the volatility experienced by the standard gateway cryptocurrencies—Bitcoin and Ethereum. Fiat-backed stablecoins also allow investors to trade on crypto-to-crypto exchanges for altcoins without having to first purchase a major crypto through a fiat-to-crypto exchange.
You now have a foundational understanding of what fiat-backed stablecoins are, how some of the most popular fiat-backed stablecoins work, and the role that fiat-backed stablecoins play in the larger cryptocurrency industry. In Part 2 of this series on stablecoins, we will move on to projects with alternative stability mechanisms, including cryptocurrency-backed stablecoins, market-controlled stablecoins, and algorithmic stablecoins.