Cryptodollars 101
Summary
Stablecoins, also referred to as cryptodollars, are a class of cryptoassets designed to maintain a constant price.
The stability in price is achieved by pegging their value to another asset. The most common method is to peg the stablecoin 1:1 to the US Dollar.
Unlike most cryptoassets which volatility makes them a poor medium of exchange, stablecoins provide a solution for those looking to use cryptoassets but want to avoid volatility.
There are two types of stablecoins: Collateralized and Algorithmic based.
Estimated time: 3 minutes
What are “Stablecoins” & Cryptodollars?
Cryptoassets have a number of benefits, most notably they are fully decentralized and enable the transfer of value without the need for third party intermediaries. However, most cryptoassets suffer from a high degree of fluctuations in their market price. This short-term volatility makes bitcoin and many other cryptoassets difficult to use as a medium of exchange. As a result, stablecoins were created to maintain a constant price and bridge the gap between fiat currencies and cryptocurrencies.
Cryptodollars are assets that are designed not to fluctuate in market price. In most cases, each stablecoin is equivalent to $1. We refer to stablecoins as cryptodollars to better align this concept with the vernacular used within the traditional investment community.
Cryptodollars have a number of the same advantages of other cryptoassets such as being open, global, and accessible to anyone on the internet without the need of a bank account. Like money markets or CDs, cryptodollars can be used as a liquid placeholder for assets awaiting attractive opportunities to be deployed in the market. Fast processing and low transaction fees make cryptodollars a good choice for sending money across borders without having to pay exchange fees. As a result, they can securely be sent anywhere in the world, including to places where the U.S. dollar may be hard to obtain or where the local currency is unstable.
What kinds of Cryptodollars are there?
Cryptodollars maintain their price stability using one of two methods. The first is collateralizing the stablecoin with another asset.
Fiat Collateralized – A Fiat Collateralized cryptodollar is backed by a real-world currency, like the United States dollar. USD is deposited into a bank, after which a cryptodollar is issued with a 1:1 ratio against those dollars in the bank. When a person wants to convert their cryptodollar back to USD, that cryptodollar is destroyed and real-world USD is issued to that user. It is 100% price stable, since for every cryptodollar there is one USD in the bank reserve. One drawback of this is the centralization of these cryptodollars, as they need a trusted custodian and an auditor. Examples of fiat collateralized cryptodollars include USDT and USDC.
Asset Collateralized – Asset collateralized cryptodollars function the same way fiat collateralized do, except the underlying reserve asset is a commodity rather than a fiat currency. The most common underlying asset is gold and other precious metals. However, there are stablecoins backed by oil, real estate, and baskets of various commodities. Holders of asset collateralized cryptodollars can redeem them at the conversion rate and take possession of real-world assets. The advantage of asset backed stablecoins is that they are much less likely to see their value inflated. One of the largest asset collateralized stablecoin is Paxos in which each PAXG token is redeemable for 1 troy ounce of gold held in custody by Paxos and its partners.
Crypto Collateralized – Crypto Collateralized cryptodollars work just like the Fiat Collateralized cryptodollar, but instead they are backed by a different cryptoasset or a basket of cryptoassets. The biggest difference between the two is that the crypto collateralized cryptodollar is over collateralized due to the volatility of the underlying cryptoasset. That means for every one cryptodollar, there is more than one dollar of the cryptoasset in reserve. The more volatile the backing cryptoasset is, the higher that ratio is. Because the underlying asset is also decentralized, crypto collateralized stablecoins are decentralized and transparent in a way that fiat collateralized stablecoins can never be. However, the drawback is crypto collateralized stablecoins may not be as stable as the fiat collateralized since the price of the backing is volatile. The most prominent example of crypto collateralized stablecoins is MakerDAO’s DAI which is pegged against the US dollar and uses a basket of cryptoassets as a reserve.
The second method is to use algorithms to manage the supply and demand in real time in order to maintain a constant peg. These algorithmic based cryptodollars are not collateralized and function similar to a central bank printing banknotes to maintain valuations of the fiat currency. Rather than a central entity making the decisions, a smart contract on a decentralized platform running in an autonomous manner controls whether coins are created or burned (aka destroyed). Should a stablecoin drop below the target price of $1, the algorithm will automatically burn a tranche of coins to introduce more scarcity, pushing up the price of the stablecoin. This type of stablecoin protocol is difficult to get right and has been tried and has failed several times over recent years. Two of the few working examples using this model to date is UST (created by Luna) and UXD.
The adoption of cryptodollars has exploded since the start of 2020. There is no denying cryptodollars have found clear product-market fit in acting as a base asset in crypto trading pairs and are increasingly being used for cross-border payments, remittances, e-commerce, and more. In time, it’s possible cryptodollars could become global, digital cash.
