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What are Stablecoins? An Introduction, Description, and Use Cases

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A stablecoin is essentially a money substitute. A stablecoin is a token in a blockchain whose value closely tracks the value of a well-trusted currency (money), like US dollars. Therefore, a stablecoin like USDT (currently the number one stablecoin, by market cap) has a value such that 1 USDT = $1 (plus or minus 1% most of the time). 

This is op-ed is contributed by Carlos Tapang.

Photo for the Article - What are Stablecoins? An Introduction, Description, and Use Cases
Author: Carlos Tapang is veteran software design engineer, entrepreneur, and Founder and CEO of RockStable.

What is money? 

Given that stablecoins are defined in terms of money, we need to understand what money is to even begin to understand stablecoins. 

Money has several functions in an economy, but its defining function is as a “medium of exchange” (MOE). Money can be used as “store of value” (SOV – you can keep lots of it as savings) or “unit of account” (UOA – a unit of money, say PHP, is used in accounting), but its primary use is as “medium of exchange”, or MOE. In other words, money can lose its usefulness as SOV and UOA, but if people use something as a MOE, that something is still money. For example, when money inflates or loses value, it ceases to be an SOV or UOA, but if it circulates and people accept it as payment, it remains money. 

There are two opposing strands of thought with regards to how we humans started using money: 1. One idea is that money came about because the leaders of a community decreed that something (say seashells) be used when exchanging things. 

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2. The other idea is that money started spontaneously. In this view, nobody “invented” money nor did any leader decree that something should be used as money; instead, people in a community,  wanting to be able to exchange things, found it convenient, practical, and useful to do indirect  trades: in order to get an apple from a fellow trader Adam, who doesn’t want my potatoes, I  exchange my potatoes first (with a third person, Anna, who happens to want my potatoes) for  something that Adam wants, and then Adam and I can exchange with that something for his  apple. Later, something becomes commonly used in indirect trade or exchanges, becomes a popular MOE, and becomes money.  

Given that most money today was decreed by governments, most people believe in the first idea.  However, money predates the formation of governments or even the formation of smaller groups of people (tribes). 

If the second idea is correct, how did money get started? How did it come about? When we, the inhabitants of Earth, were just hunter-gatherers, we probably formed communities or tribes. Those tribes were most probably often at war with each other; not much trade occurred because most of the time there was no surplus to share or trade with another tribe. Even inside a tribe, exchanges of things must have occurred, but only as part of a give and take, family transaction. As the tribes started engaging in agriculture and raising of animals, the tribes grew in population and trade became beneficial, both inside and outside of tribes. Theories abound as to how communities settled on which object to use as money: seashells, beads strung together, dried fruits; but somehow a specific object became money in geographically close communities. Money came about because we are social, and we are very good in mimicking the useful actions of others. 

The popularity of cryptocurrencies has proven that it is indeed possible for large groups of people to spontaneously recognize value, outside of government. When a token is first introduced, it doesn’t have value because there are only very few people who exchange it. Then the more people exchange it, the greater its value becomes. This is called the “network effect” – the idea that something (like language) is only as useful as the number of people who use it. Bitcoin is a very good example of this phenomenon:  when a small group of people (including Satoshi Nakamoto) started playing with Bitcoin in their computers on January 3rd, 2009, Bitcoin had zero value. By 2011, when I first mentioned it in my blog in March of that year, thousands of other people have started exchanging it, but its value was still below one dollar. A year later it was $4.86, and everyone knows how much each Bitcoin is today (tens of thousands of dollars). The more people know about and exchange Bitcoin, the higher its value becomes.  That’s the network effect, which occurs among people, without government influence.   

In summary: 

1. Money has no meaning outside of society (human communities). If you live in an island all by yourself and are therefore self-sufficient, then you don’t need money. 

2. The value of money depends on trust by a large number of people, the larger that number, the more trusted money becomes, until everybody just accepts it with “no questions asked”. This is called the “network effect” of trust. Example: The USD became the most trusted money in the world, not because the U.S. has the strongest military in the world, but because of network effects. Another great example is Bitcoin. 

3. Money came about spontaneously because it’s a necessity when dealing with people outside of the family. Considering how long we humans have been using money, it’s only recently that money was decreed by governments, by way of central banks. 

What is the Rationale for Stablecoins? 

The idea for stablecoins did not originate from the cryptocurrency revolution. The idea for stablecoins predated blockchain by about 33 years; it was first proposed by the famous Austrian economist F. A.  Hayek, in his book “Denationalisation of Money”, in 1976. However, without blockchain, Hayek’s idea was just that, an idea that could not be realized. 

Monetary economists today would dispute my claim that what F.A. Hayek wrote about in “Denationalisation of Money” is about stablecoins. There are differences, of course, but mostly with respect to circumstances, not substance. Central Bank issued money (fiat money) relies on trust in government for its quick build-up of network effects. Cryptocurrencies, on the other hand, rely on the reputation of the underlying blockchain.  

Parenthetically, Bitcoin is most trusted because, after more than a decade of trying, and still ongoing, hackers have not been successful in breaking the security of the Bitcoin blockchain. It’s the same with Ethereum, but for a shorter period of exposure to hackers. 

While Bitcoin gained value purely by network effects, stablecoins gain almost instant value by piggybacking on the value of existing money. Here’s the market proposition of stablecoins, in simple terms: the issuer issues a token to you in exchange for your central bank (CB) money, with the promise that you can redeem or return that token to its issuer anytime, in exchange for getting your CB money back. What is the benefit to you of doing this? The benefit is that this token is much easier and cheaper to transact with than CB money. Why is it easier to deal with? Because it’s almost frictionless (but safe) in the internet, no third-party is involved. What is the benefit to the issuer? Short-term, the issuer is after your CB money. The issuer can profit from this backing (CB money) by investing it in ways that also preserve its liquidity. (More on what the issuer’s long-term game plan is later in this article.) 

At this point it should be obvious to the reader that stablecoins as described above are necessarily centralized (as opposed to decentralized, like Bitcoin). There are two other main types of stablecoins, with the second one being decentralized (backed by another crypto, structured as a loan issued by a smart contract), and a third one that is very similar to CB money in that stablecoins of this type are either released or redeemed according to whether its value is going up or down. This third type of stablecoins is backed by a secondary token that, in essence, like the stablecoin it is backing, has not gained network effects yet. So far, no stablecoin of the third type has become successful. The latest example was Do Kwon’s TerraUSD, which crashed and lost value after going up in market cap at a dizzying pace. 

There are several examples of the second type of stablecoins, those backed by another crypto: one is DAI, another one is LUSD (Liquity). Because these are backed by another, volatile crypto, these loaned stablecoins must necessarily be over-collateralized. There is some inefficiency of capital, but if you have BTC or ETH, what these stablecoins allow you to do is borrow against your BTC or ETH without selling your BTC or ETH first. I personally know of somebody who loaned his ETH this way, to the Liquity smart contract, took the borrowed LUSD to Coinbase for conversion to USD, and used that USD to buy some real-estate. This would have been a great thing to do when ETH were going up, but he did it when ETH was high and was just about to drop precipitously. He lost his ETH (it was liquidated by the smart contract to cover his loan). At least he did not lose the real estate he bought. 

More on the Rationale for CB Money-backed Stablecoins 

What is the benefit to society of CB money-backed stablecoins of the first kind? In a word: competition. 

Put yourself back in primitive times: imagine an island where several tribes live in peace and commerce.  There exist several objects vying to be the most popular money among the tribes: seashells, dried corn, beans. That’s exactly where the world is right now, in which there are three main types of money in competition: CB money, volatile crypto, and stablecoins. The big difference is that, because of technology, network effects can accrue quickly, much more quickly than seashells, dried corn, or beans.  Also, communities that share the same form of money do not have to be in the same physical location.  Even a small community of a thousand people can benefit from using the same token in the blockchain.  In an island where physical forms of money are vying for domination, the impracticality of having to store several forms of money and the difficulty of exchanging one with the other means that it’s a winner-takes-all kind of competition. With crypto, I have at least three types of tokens in my Ledger wallet, and I can exchange one for another among thousands of other tokens, without having to walk out of my room. 

F.A. Hayek envisioned that, even if stablecoins and volatile cryptos don’t win against CB money, at the very least, because of competition, central banks that currently mismanage their money would have to change their ways, and that should be the only way they can win. Given the history of inflationary spiral among most (if not all) of CB money in the past, a CB money that is managed well for decades would benefit society in uncountable ways. Of course, this would only happen if CB money competed fairly against stablecoins and volatile crypto without using the law on its side. In other words, if lawmakers  allowed for competition in the first place, great things would happen in the world of money.    

Incidentally, not having seen any form of crypto money, F.A. Hayek could only imagine competition among the different CB moneys themselves. He proposed that different jurisdictions allow money to circulate from other jurisdictions, so that different CB moneys can compete in the same country. That this is not allowed until now is testament to the difficulty of removing the political support that CB money enjoys. 

Value Trust Transference 

I believe currency competition will be fought (and is already being fought) in the arena of stability.  Stable moneys will win and beat the less stable ones. I don’t think this is a controversial statement.   

Wait a minute, you say, if a stablecoin is backed by CB money, how can it compete against that CB money? Unlike Bitcoin and Ethereum, stablecoins are “pegged” to a fiat currency (not much different from “bank notes” issued by banks before the advent of central banks). In other words, stablecoins seem to be totally dependent on CB money. If CB money inflates, a stablecoin pegged to it must necessarily inflate, or so it seems. 

The great advantage of both Bitcoin and the other volatile cryptocurrencies is that their network effects were established in the market without reference to any other currency. Volatile cryptocurrencies stand on their own and can compete directly with any CB money. 

In contrast, because we have to base the value of our stablecoin on CB money, the only advantages of stablecoins are ease of use and safety. These two advantages are even in doubt because ease of use only pertains to money transfer and does not pertain to ease of recovery if you lost your crypto. Safety can also be a concern too because, even though Bitcoin has not been hacked successfully after more than a decade of trying, if you lose your Bitcoin private key you also lose your BTC. When you do, your chance of recovering lost money in blockchain is tiny compared to your chance of recovering money deposited in a bank. If a bank loses your money, at the very least you can sue for damages. Can’t sue the blockchain that keeps your crypto money intact, much less a smart contract. 

Nevertheless, this issue (ease of recovery) will eventually be fixed. Already, the proposal for “Account Abstraction” standard will make it very easy to recover your money even if you lose your private key.   

Stability will be the main arena for competition and in this, stablecoins can win, even against volatile cryptocurrency. If the CB money to which a stablecoin is pegged inflates, the stablecoin does not have to inflate also. It depends on what the issuer decides to do. If the issuer keeps the peg, of course the stablecoin inflates also. However, what if the issuer decides to fight inflation? The value of the stablecoin can be raised simply by raising the redemption rate with the CB money. This turns out to be very difficult because, to prevent runs, the issuer will have to increase the amount of backing also. Therefore, to fight inflation without the risk of runs, it seems that a lot of capital would be necessary; but, using smart contracts, I’m sure a method can be devised for raising the exchange rate with the reference CB money without the risk of runs. 

Once a stablecoin has gained network effects (derived from the reference CB money in the beginning), it can establish its own value. I call this “value trust transference” and it has already happened in history.  The latest instance of this was when USD was disassociated from gold. This is significantly material to this discussion because, rather than removing the USD peg to gold because gold was losing value, the peg was abandoned because USD could not keep up with the increasing value of gold. Even then, because of network effects of USD, it subsequently became the number one currency in the world.   

The long-term game plan of every stablecoin issuer, therefore, should be to become the most stable money there is. To do this, the issuer will have to devise ways to become independent of the CB money it is pegged to, thereby becoming its own, private central bank. These private “central banks” will be in constant competition, much like banks issuing notes of old. These private central banks will coexist with public central banks. If this happens, the world would be a trillion times better off than we are now.   

Use Cases 

How did Tether’s USDT stablecoin grow to become number one in terms of market cap? By being used as money in crypto exchanges. Before USDT came along, Bitcoin was the de facto medium of exchange (MOE) in crypto exchanges like Mt. Gox. Nowadays, in terms of velocity of money (as measured in any crypto exchange), stablecoins beat any volatile crypto hands down. 

Stablecoins, being cryptos also, found early use in crypto exchanges. Now, these moneys are starting to crawl out of their cribs. There are other exciting, potentially profitable use cases that can now be explored. 

One use case which is the focus of my stablecoin startup (https://sendroks.com/) is cross-border money transfers. This has not been an easy use case to get started, because we must be compliant in both the source and destination countries. With our meager resources, we have managed to setup a pilot from four states (California, Montana, Washington, and Wyoming) to a single destination, the Philippines.  

Another use case is for helping both sides of the market for real-estate like condos in the Philippines.  Builders are incentivized to sell units in large condo projects even before completion because it helps in the capital formation to build. This benefits the buyers also by allowing them to buy without down payment. The down-payment can be amortized while the condo is being built. However, the banks cannot be involved in this pre-sale until the unit is completed and ready for move-in. (From the standpoint of the banks, the collateral doesn’t exist until move-in.) This then, is a perfect use case for stablecoins: amortization that is necessary prior to a bank getting involved. 

Another example of a very good use case is “just in time” payroll. We discovered this while doing exploratory meetings with a public-private partnership (PPP). CB money is efficient for regular, monthly pay. Banks and payroll companies can also accommodate weekly pay. However, beyond weekly pay, like daily pay, CB money becomes impractical and inefficient. Using stablecoins, we can do better than daily pay. How about “just in time” pay? How about paying your construction workers as soon as they complete installing an I-beam? 

This last use case is unique to the Philippines but may find application elsewhere: nobody would pay for merchandise ordered through a website before shipment. Here in the U.S. this is how Amazon surpassed every other web retailer, by relying on the trust placed on it by Amazon customers, who are willing to pay for merchandise, base only on internet images, even before an item is shipped. This is not the case in the Philippines, where nobody would prepay before shipping. We propose an “escrow” smart contract to which the customer would send her money. The smart contract would only release the money to the seller once the buyer confirms that she received the merchandise. In case of disputes, normal escrow procedures can be followed. This guarantees that the seller is paid, and the buyer is also protected. 

This article is an opinion piece submitted by Carlos Tapang and published on BitPinas: What are Stablecoins? An Introduction, Description, and Use Cases

Disclaimer: BitPinas articles and its external content are not financial advice. The team serves to deliver independent, unbiased news to provide information for Philippine-crypto and beyond.

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