As we’ve seen Bitcoin’s price go from a fraction of a cent to over $65,000, people have lost sight of the fact that Bitcoin was originally designed to be a digital currency.

The title of the original Bitcoin Whitepaper: “Bitcoin: A Peer-to-Peer Electronic Cash System”

But Bitcoin’s hard supply cap and, by extension, hyper-deflationary nature, have made it a decent speculative asset (with price increasing as more and more people buy into Bitcoin) but a terrible currency. That’s where stablecoins come in.

Stablecoins are the future of crypto

There’s a reason people around the world like to transact in USD, EUR, and other fairly stable fiat currencies. Stable currencies allow for the execution of long-term financial obligations where everyone involved can rest easy knowing that the currency they’re trading with is going to maintain a relatively similar value over the course of their agreement with each other.

And if you think about it, almost every significant transaction in your life is a long-term transaction: from your day job to your taxes to your rent and utilities to your car payment to any form of insurance, etc, etc, etc. This means that Bitcoin is poorly suited, from an economics perspective, for the vast majority of transactions in our lives, and that we need some sort of stable currency to transact with on the blockchain if we ever want to move more of our financial lives over to it.

The future is stablecoins.

What are stablecoins? Well, in a nutshell, they are tokenized representations of a fiat currency (usually USD) kept on the blockchain. Stablecoins allow us to transact on the blockchain in a currency that is both stable and familiar to use, opening up the real potential of DeFi and other applications to live alongside our existing financial lives, and speeding up the adoption of crypto among the masses (which is our actual goal).

What we can do with USD on the blockchain

Having our USD directly on the blockchain opens up so many new opportunities which should be divided into things we can do today and things we’ll be able to do in the future.

Today

1. Move in and out of crypto investments without needing a fiat exchange: I can buy and sell crypto assets directly on the blockchain without needing to send my assets to an exchange to do so.
2. If I want to reduce my crypto asset exposure but still keep funds on the blockchain — due to some market volatility or because I’m anticipating a life-event that I want to have funds available for — I can simply sell some assets into a stablecoin.
3. Savings and lending protocols on the blockchain. Having USD natively available on the blockchain opens up the possibility for savings protocols that will algorithmically lend out saver’s deposits, basically a bank run by algorithms that anyone can participate/invest in. These sorts of protocols are widely available today in the DeFi world and often offer interest rates orders of magnitude better than what you’d get from a bank.

Tomorrow

Having USD on the blockchain opens up the possibility of moving a greater number of transactions, particularly spending transactions, to the blockchain. Instead of buying a sandwich with your credit card, you could buy it with your crypto wallet. Instead of paying rent with a bank transfer or check, you could pay it with your crypto wallet. You get the idea.

Me when I can buy things with my crypto wallet.

The more of these transactions that move to the blockchain, the more money people will be putting on the blockchain. And with more money comes both asset appreciation for the underlying crypto assets that power this technology and the option to have more of our funds on the blockchain where we have more control and opportunities for money management than in the traditional finance world.

But before we get too wrapped up in the future, let’s break-down exactly what kinds of stablecoins exist today and how they work.

The three types of stablecoins

There are three broad categories of stablecoins, differentiated by how they keep their 1:1 peg to USD. It’s important to understand the broad strokes so you can decide how you want to store your stable money on the blockchain.

Fiat-collateralized Stablecoins

These stablecoins maintain their peg by maintaining a reserve of fiat assets to back their stablecoin issuance. Examples include USD Coin ($USDC), Binance USD ($BUSD), Paxos Dollar ($USDP), and of course, the infamous Tether ($USDT).

Fiat-collateralized stablecoins allow individuals to redeem their stablecoins for an equivalent amount of fiat currency from the issuer’s reserves or give the issuer dollars in exchange for newly minted stablecoins. This makes it very easy to maintain its 1:1 peg with its fiat equivalent in the market, and as long as the reserves are large enough and sufficiently liquid.

The major disadvantage here is that we have to rely on multiple third parties for trust that the company which issues the stablecoin actually holds sufficient reserves at all times. This means costly and frequent third-party reserve audits to maintain trust in the token’s backed value, and means that these crypto assets are still ultimately dependent on the traditional financial system to work.

However, if the stablecoin issuer engages in shady operations and plays games with the reserves, then obviously this could cause a bank run and hurt everyone left holding a bag of those stablecoins. Thusfar, this has never happened, but it is worth noting that Tether ($USDT) — the largest stablecoin issuer by market cap — is currently alleged to have mis-represented their reserves and minted a lot of Tether stablecoins when they weren’t actually able to receive bank transfers. These allegations are not proven, and Tether recently had to settle with the NY Attorney General over some of these allegations (but did not admit wrong-doing). You can read more about it if you like, but for this reason, I personally choose not to hold any $USDT if possible.

That guy on Twitter talking about Tether and its reserves.

I think these kinds of stablecoins are fine, though I do not choose to hold any (mostly because Terra’s algorithmic coin ($UST) has a lot more utility but that will come in tomorrow’s article).

Crypto-collateralized Stablecoins

These kinds of stablecoins are very similar to fiat-collateralized coins, except the collateral held in reserve to back these stablecoins are other crypto assets instead of fiat money. The most prominent example is Maker Dai ($DAI).

Unlike fiat-collateralized stablecoins, the collateral for coins like $DAI is held on-chain and thus is publicly viewable, eschewing the need for costly third-party reserve audits on a regular basis. And something like $DAI is also governed by smart contracts which make sure that the reserves are always kept liquid enough to cover all the outstanding $DAI in circulation.

That probably sounds pretty nice, but there are some very significant draw-backs to coins like $DAI. $DAI and other crypto-collateralized stablecoins require a lot of collateral to generate (much more than fiat collateral), and generally that means locking up assets like $ETH to mint new $DAI (for instance). This presents a scalability problem in that minting more $DAI is held back by the amount of collateral necessary to do so.

It also exposes a different risk: if the underlying debt positions that generated these coins in the first place experiencing mass liquidations in a crypto market crash, that could potentially de-peg these kinds of stablecoins and hinder people’s ability to clear their debt positions before getting liquidated. This asset class is fascinating but I don’t have the space to expound further right now. I am considering writing a longer dedicated article on the subject of $DAI and other crypto-collateralized stablecoins in the future. Let me know in the comments if this is something you’d be interested in.

I haven’t done enough research on these kinds of stablecoins in order to confidently recommend or not recommend them. It is something I will be learning more about, but for now, I can’t advise either way.

Algorithmic Stablecoins

The final — and in my opinion most interesting — class of stablecoins. These coins maintain their 1:1 peg with the equivalent fiat currency through smart algorithms (as the name would suggest).

Me trying to explain algorithmic stablecoins.

Algorithmic stablecoins are a relatively new development in the decentralized-finance world, but they show a lot of promise. Of particular interest for me is the Terra blockchain and its world of stablecoins, all backed by smart monetary policy and their native backing coin: $LUNA.

Algorithmic stablecoins don’t rely on an accumulation of reserves which makes them nearly infinitely scalable. We can mint more and more of these stablecoins over time as their demand increases with their governance protocols ensuring they keep a stable value.

These kinds of stablecoins also don’t need to interact at all with the traditional finance system, saving lots of money on audits and reserve management.

I’ll save Terra-specific discussion for next week’s article: “Crypto’s new dollar.” But this is where I personally keep all my stablecoin reserves (and most of my entire crypto portfolio).

The big con with an algorithmic stablecoin is in the name: failure of the underlying algorithms to maintain the peg. If the stablecoin loses its peg, people may want to exit it as fast as possible, further sending it down the drain.

This situation did happen somewhat recently to a project called Iron Finance. You can read about the situation if you like. Bank runs like this are possible with algorithmic stablecoins, so you need to be very careful when evaluating a stablecoin as a place to park your funds. Also worth noting that Iron Finance has since developed a new protocol, basically a v2.0, that seems far more stable and trustworthy, for what it’s worth. Regardless, I personally trust Terra’s algorithmic stablecoins, after doing a lot of due diligence about the project, but I encourage you to do your own research as well.

Powering the next phase of the global financial system

As I mentioned at the beginning of this article, I believe that stablecoins are the key to unlocking the potential of blockchain technology for all. Being able to transact on the blockchain in a familiar and stable currency like USD will open up the possibility to create a real consumer economy on the blockchain (I wrote an article about this very topic which is very underrated). Unlocking the possibility for people to not just invest on the blockchain but actually hold custody and spend their money will drive massive growth in crypto adoption, and stablecoins will be at the center of this drive.

Tomorrow’s article is a follow-up to this one specifically about the Terra blockchain I mentioned earlier and their ecosystem of stablecoins and why I believe $LUNA (the native coin of Terra) is one of the best investments in crypto today.

As I am not a registered fiduciary agent, none of my advice is legally binding in any way, and choosing to follow or not follow it is a responsibility that lies squarely on your shoulders. Crypto is a volatile market, and a significant crash in values is a normal event in this space, just as a significant increase in values is. Treat the market as an irrational actor (which is what it is), buy the proverbial dip when possible, take some profits along the way, and enjoy the ride.