What Are Stable Coins & How Do They Work? Is Libra a Stable Coin?
Stable coins are those cryptocurrencies that tend to hold the key, which bridges the gap between cryptocurrency benefits and the stable features that the fiat currencies have to offer. They offer price stability of the fiat currencies but do not take a physical form (papers and coins), such as fiat money.
Fiat Money – What Is That?
If you are confused with the word “FIAT” currency, let us explain that fiat money covers all the official currencies, which we use as a general medium of exchange – EURO, USD, GBP, YEN. They are issued and declared as “official store of value” by the governments. There are two main reasons for the stability of the fiat currencies, namely
– the reserves of the commodity behind it (gold, forex reserves, etc.), and
– the action of the main market players (central banks).
The reserves act as collateral and this is why the price has a better chance for stability than cryptocurrencies such as Bitcoin or Ether.
Note also, that fiat currencies in their material are worthless – 10 EUR banknotes do not have any intrinsic value. What does this mean?
It means that if you would like to sell the paper of 10 EUR banknotes, you could not sell it for 10 EUR, but for much less – it means that the value is not inherent to the paper. The reason, why a paper in your pocket has an actual 10 EUR value is because the government determined it is worth 10 EUR.
Fiat money is (or was) backed by something tangible that has intrinsic value (also known as the “melt” value) – gold or silver. The gold or silver standard means that you could take your paper in the bank and exchange it for the respective amount (ounce) of gold or silver. The US was taken off the gold standard by President Nixon, and since then the USD is backed by the faith of its people and the government’s debt. And it is mostly the same as every other fiat currency.
Stable coins, on the other hand, are not government-issued money (yet), take only digital form and their price is not volatile like the price of Bitcoin or Ether. So, how is this possible?
Stable Coins and Their Value
On a general note, stable coins are taken to be a new type of virtual currency that frequently have their own value pegged to yet another different asset. What you need to understand is that these coins can actually be pegged to our traditional (government-issued) money or commodities. Usually, they are pegged to:
- the US dollars, GB Pounds, Euro, or a combination/basket of the fiat currencies,
- other virtual currencies (ETH),
- gold, silver and/or other precious metals and stones,
- or even all of the above.
Following the same system, as we have seen with the fiat money, a unit of a stable coin (for example 1 Tether) would be equivalent to 1 EUR/USD/GBP.
Stable coins pegged to fiat money or commodities have been structured to handle the volatility that is usually seen in these virtual currency prices. Also, they are (or should be) collateralized. What this means is that the overall number of stable coins that are in circulation is supported by assets that are held in reserve. Simply put, if there are 5000 thousand US dollars pegged stable coins that are in circulation currently, there should be an equivalent amount of 5000 dollars waiting in a bank (if the conversion rate is 1:1).
Types Of Stable Coins
There are roughly three main types of stable coins which include:
1. Fiat-Collateralized Stable Coins
The fiat-collateralized stable coins are the virtual currencies that are pegged to a national currency such as EURO, USD, etc. The cryptocurrency and stable coin Tether is pegged to the US dollar. It is the simplest way that a stable coin can actually be developed and remain price stability. The tokens are (normally) distributed at the 1:1 ratio against the collateralized Fiat currency.
There is also a hybrid of this type, such as Libra (mostly known as the cryptocurrency of Facebook). The value of Libra Coin is pegged to a basket of different bank deposits and short-term government securities. Whether Libra really is a stable coin or not is still a question, and we will discuss it in more detail further down in this article.
Like its name already implies, the fiat currency will have to be deposited as collateral for a Fiat-collateralized stable coin to be in existence.
2. Crypto-collateralized Stable coins
Similar to how a fiat-collateralized stable coin has its fiat tender as collateral, the crypto-collateralized Stable coin has a virtual currency locked up as its collateral. The token of this type is MakerDAO (DAI) token.
In a bid to compensate for all of the volatility of the collateralized virtual currency, a security pledge is demanded by the stable coin. What this means is that the coin will at the end of the day not have a 1:1 ratio towards its collateral virtual currency but will instead, get to look more or less like a two-dollar pledge for all one-dollar stable coin being issued.
3. Non-collateralized Stable coins
These are the stable coins that utilize a seigniorage shares system. Here, seigniorage is simply the difference between the cost of printing money and the value of money.
As it stands, non-collateralized Stable coins depend on a mechanic algorithm that transforms the supply volume in a bid to maintain price. With the use of smart contracts, the stable coin can sell if its price falls below and the pegged currency will supply some more tokens if its value rises above that of the pegged currency.
Some of the best-known stable coins are:
- Tether (USDT) – fiat-collateralized
- MakerDao (DAI) – crypto-collateralized
- TrueUSD (TUSD) – fiat-collateralized
- Gemini dollar (GUSD) – fiat-collateralized
- Carbon Protocol and Basis Protocol – non-collateralized.
How Do Stable Coins Work?
Like we already mentioned above, stable coins are pegged to a certain stable asset. How they function differs just a little bit depending on the virtual currency involved. However, they all demand some form of system which can actually balance all the scales and put every other thing in order.
Basically, for every fiat-collateralized coin issued, there has to be an equivalent amount of fiat (USD, EUR, ..) in reserve fund. For every crypto-collateralized coin issued, there shall be an appropriate amount of that cryptocurrency (to which a stable coin is pegged to) in reserve.
Generally, the centralized stable coins such as Tether (USDT) demand a custodian who will issue the currency and even keep a specific amount of collateral in reserve. What Tether does is it keeps US dollars in an account in the bank and the total amount being held must actually be equal to all USDT issued. It is doubtful, however, whether Tether is indeed 1:1 USD collateralized according to the recent events with Bitfinex – in March this year Tether has updated the terms on the website, stating that USDT may not be backed 100 percent by fiat reserves, meaning that the reserves have been used and replaced with other assets and receivables, from loans made by Tether to third parties. This implies that Tether used the collateral (USD in reserve fund) for something and replaced it with receivables – the money is no longer in reserve fund, instead, there is a legal claim to receive it back from the borrower, making the collateral much weaker and riskier.
Notwithstanding the above, stable coins can accomplish all of their goals without the aid of a central authority. They make use of smart contracts on the blockchain in a bid to manage all of the collateral and practically maintain order, but only if the stable coin does indeed keep the reserves as guaranteed. If the strategies change and the reserves are used, the type of collateral should be eligible to suit the goal and reserves replaced with something that does not have a volatile value.
Is Libra A Stable Coin?
Whenever people ask this question, the answer remains “could be”. Similar to virtual currencies, the question of Libra being a stable coin is still a grey area. Libra is shall be a global cryptocurrency built on blockchain to promote financial inclusion. Libra Coin is being (self) declared as digital, mobile, stable, low-inflation, fast, cheap and secure, and it is backed by a reserve made to keep its value stable.
And what will Libra be backed by? As stated in Libra Whitepaper, “instead of backing Libra with gold, it will be backed by a collection of low-volatility assets, such as bank deposits and short-term government securities in currencies from stable and reputable central banks.” This means that Libra is not going to be completely non-volatile, but much less than other cryptocurrencies we know. It is not yet official, which bank deposits and securities shall be in the basket and what kind of proportion will they take in the basket. According to Reuters, the unofficial statement form Libra was given, namely that U.S. dollar will represent up 50% of the basket of currencies backing Libra coin, following with the Euro (18%), Yen (14%), GBP (11%) and Singapore dollar (7%). China’s Yuan was left out of the basket for now. It is expected that the reserve fund shall be partially in cash and partially in short-term government security denominated in U.S. Dollars, Euros, Yen, Sterling and Singapore dollars. The basket will be interchangeable meaning that Libra will have policies and procedures in place governing the composition of the reserve basket.
The Whitepaper provides that “Libra is designed to be a stable digital cryptocurrency that will be fully backed by a reserve of real assets — the Libra Reserve — and supported by a competitive network of exchanges buying and selling Libra. That means anyone with Libra has a high degree of assurance they can convert their digital currency into local fiat currency based on an exchange rate, just like exchanging one currency for another when traveling.”
Differing from most of the stable coins we know, Libra is not pegged to a specific currency at the end of the day. As written above, it is pegged to some low volatility assets. Although there is a Libra reserve, Libra, on the other hand, does not seem like it is necessarily pegged to any value. The reserve tends to function as a sort of lower bound on the value of Libra.
Libra association will manage the Libra reserve, which will have a monetary policy of minting and burning coins only in response to demand, which would come from authorized resellers. Such resellers will always be able to sell Libra coins to the reserve at a price equal to the value of the basket, which means that the Libra Reserve will function as a “buyer of last resort.” This could be seen as one of the components of stability.
As we have already seen, basically any virtual currency that is pegged to a Fiat currency or any kind of government-supported security, such as a bond counts as a stable coin. The idea here is that there is so much more stability due to the fact that fiat currencies are backed by something stable. How will this work for Libra, remains to be seen.
Due to the abrupt crashes and gains that Bitcoin tends to suffer, some advocates believe that stable coins can erase all doubts about the rate of conversion. At the end of the day, all of these make virtual currencies much more practical for the purchase of services and goods. Governments are already testing stable coins as the Central Bank Digital Currencies, which would function as a virtual representation of the current Fiat money that we use and we are certain that we can expect the development to go even faster now that the governments are under the fear of how Libra coin could affect the centralized government-determined monetary systems.
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