By Slobodan Sudaric, partner in the Protocol Economics team at cLabs, working on Celo
Around the world, inflation and costly, slow transactions have been the norm in traditional financial systems for decades. That is, until the emergence of cryptocurrencies. When Bitcoin and its successors entered the scene, they created a new, faster, and cheaper alternative to traditional payment systems by removing the need for third-party intermediaries. Some cryptocurrencies’ fixed supply of tokens even offered an answer to the inflation that plagues fiat currencies.
As is the case with most inventions, however, where one problem was solved, another took its place. While cryptocurrencies were faster and cheaper to exchange than their fiat predecessors, their price action was also more volatile. How reliable is a currency if its value can triple or halve in a matter of hours?
Yet every problem has a solution, and so came stablecoins.
Stablecoins first emerged on the cryptocurrency scene in 2014, designed to protect users from the volatility of cryptocurrencies like Bitcoin and Ethereum by tracking the value of an underlying asset. Their stability allows them to function as a more reliable medium of exchange and a store of value.
Stablecoins are typically backed by a reserve of an asset or a basket of assets. For fiat-backed stablecoins, the stablecoin issuer typically holds a value of the fiat currency in cash or other high-liquidity assets equivalent to the number of coins issued to track it. Users can redeem one stablecoin for one unit of currency at any time, but they must trust that the issuer won’t mismanage or misreport its reserves. Popular fiat-backed stablecoins include Bitfinex’ Tether or Circle’s USD Coin that both track the value of the US dollar.
For crypto-backed stablecoins, on the other hand, the reserve holds its assets on a public blockchain, making it fully verifiable and removing the need for stablecoin holders to trust the issuer. Users redeem stablecoins by interacting with a smart contract that programmatically exchanges stablecoins for reserve assets at the user’s request. Examples include the US dollar-tracking Dai coin on the Ethereum blockchain or the cUSD and cEUR coins on the Celo blockchain.
Stablecoins initially struggled to gain traction due to a lack of transparency, long transaction times, high costs, and limited access relative to other cryptocurrencies. However, as developers overcame these obstacles, stablecoins began to experience wider adoption, exceeding a circulating total supply of 100 billion USD in 2021. This adoption was driven in particular by use cases in transactions and decentralized finance (DeFi).
As with other cryptocurrencies, transactions involving stablecoins benefit from the decentralized nature of blockchain technology, cutting out intermediaries like banks and payment providers. This provides for a fast and cheap alternative to traditional transaction channels.
Transactions using stablecoins can cost as little as a fraction of a penny, regardless of value, and are typically processed in a matter of seconds. In comparison, most traditional payment providers charge a flat fee plus an additional 1.5% to 3% for each transaction.
Another advantage of blockchain technology is it reduces counterparty risk by eliminating the intermediary. The sender and receiver transact directly with each other rather than through a third party, removing a potential point of failure, an additional step in the transaction, and with it an additional cost.
Stablecoins also offer users an affordable way to send money across borders. To put this in context, sending $200 in stablecoins can cost less than one cent, compared with a global average charge of $12 according to the World Bank, rising to more than $30 in some countries.
Thanks to projects such as Kotani Pay, users can send and receive money and apply for loans even from the most basic mobile devices owned by roughly 60% of the African market.
Stablecoins allow for targeted, fast, and cost-efficient distribution of humanitarian and environmental aid. In June 2020, a nonprofit called the Grameen Foundation launched a project to send emergency cash relief to female entrepreneurs in the Philippines. Delivering aid, however, was a challenge given the measures to combat the global Covid pandemic, so the foundation used Celo stablecoins to send nearly $160,000 worth of financial aid to more than 730 beneficiaries. The recipients spent the money through a custom microsite selling groceries and daily necessities.
The world is gradually shifting towards a gig economy, especially in developing countries that generally have large, informal labor markets. Meanwhile, improved connectivity has created microwork opportunities, giving people a chance to either earn a full-time living or top up their salary with side jobs. However, microwork payments are typically small, making low-fee solutions that use stablecoins a suitable option for compensation.
Decentralized finance (DeFi)
Stablecoins give users access to a new generation of financial products, traditionally only available through banks, from their mobile phones. These products, which typically fall within the decentralized finance (DeFi) ecosystem, are particularly important in countries with underdeveloped financial infrastructures which makes it difficult to open a bank account or apply for credit or lending facilities.
By converting local currency into stablecoins, users can protect their income and savings from the risk of hyperinflation which rapidly erodes the value of fiat currencies.
Hyperinflation remains a concern for millions of people, with inflation rates in some countries exceeding hundreds or even thousands of percentage points in 2020. Take Zimbabwe, for example. Prices may be rising by an estimated 100% this year, and that’s an improvement on the 550% rise in 2020. Elsewhere, Argentina is facing more than a decade of double-digit inflation with rates currently between 40% and 50%.
In countries with low inflation, such as the EU and the US, stablecoins can help to avoid savings and income erosion. The European Central Bank’s deposit rates are negative at present, and commercial banks pass these costs to customers, either as negative rates or increased fees. However, Euros held as stablecoins aren’t exposed to these rates, or, for that matter, the foreign exchange risk of converting Euros into other fiat currencies.
On platforms like Aave or Moola Market, users can earn on stablecoins they lend out, or borrow stablecoins if they don’t want to sell their holdings. Rates for loans depend on demand for a coin – they rise when demand grows and fall when it shrinks. Borrowers can provide another crypto asset as collateral to continue holding onto that asset, but they face liquidation risk if the value of the collateral drops, leaving the outstanding portion of the loan uncollateralized.
In traditional markets, assets are traded via order books on centralized exchanges that determine clearing prices according to supply and demand. Decentralized exchanges (DEXs) such as SushiSwap or Ubeswap remove the need for an intermediary. Instead, users trade directly against liquidity pools, a collection of coins held in a smart contract on the blockchain. DEXs employ an algorithm to adjust the price of an asset based on flows in and out of the pools but they can only execute trades if the pool has sufficient liquidity. This is why they offer incentive payments to liquidity providers. There are risks though, especially when the coins provided to the pools are volatile in price. Volatility may lead to impermanent loss, where losses can be recouped if prices swing in the opposite direction.
The use-cases for stablecoins are many. Compared with traditional financial systems, they enable faster and cheaper transactions and can offer a hedge against inflation. They have inspired a suite of new financial tools made to help users give, earn, save, lend, and exchange their assets. Stablecoins have offered an entryway into financial systems for millions of previously unbanked people across the globe in just the first decade after their invention, placing them among the most important financial tools to watch in the coming decades.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.