Stable Coins — A Way To Print Free Money.
Stable Coins are weird.
By design, cryptocurrency should vary in price.
If you don’t already know, prices go up and down because of demand and supply.
(You can read about that here).
Normally, people decide what a token is worth, I found it incredibly strange that some tokens maintain stable prices irrespective of what the market does.
I just ignored it until I started thinking about mining.
That was when I snapped.
If USDT is pegged at $1, doesn’t that mean tether can print an infinite amount of money.
Yes, they can, and they are probably already doing it.
But before that, I’ll explain what stable coins are and how they should work.
What is a Stable Coin?
A stable coin is a coin/token that maintains one price.
It doesn’t go up, it doesn’t go down, it’s always one price.
The most popular one is USDT. Each USDT is worth $1.
There are tons of others, the important thing is price stability.
Why Do We Need Stable Coins
Crypto, without the volatility.
Like I said earlier, stable coins maintain one price, because of that, they’re useful to escape crypto’s inherent volatility.
Before Stable Coins they only way to escape a bear run was to sell your crypto for fiat or exchange for more crypto.
Very difficult in the early days, when combined with steep fees, it became impractical.
Imagine losing 2% every time you enter and exit the market.
It’s slightly better now but back in the dayt oher crypto were hardly a choice too.
If Bitcoin came down, other cryptos did too.
Until Stablecoins arrived — Crypto without losing money.
That’s their primary function.
Now they’re also useful for vanilla investors that want to make 7.5% APY staking their crypto.
How do Stable Coins Work
There are 3 ways that stable coins maintain a single price:
- Collateralization
- Algorithmic Pegging (get your mind out of the gutter)
- Half and Half
Collateralization.
Collateraliztion is the original idea.
The big word just means each token is backed by collateral of equal value.
For example, to issue a new USDT, you first send a dollar to the Tether company, then they send you the USDT.
Your dollar is held in a treasurery and you can get it back at the same price, this way for every USDT there’s a dollar.
This doesn’t assure that prices remain at $1, price control is achieved by arbitrage (this means buying and selling the same thing at the same time in different markets).
For example,
If the price of USDT goes above a dollar you can buy some USDT from Tether at $1 each, then sell at the current market price. The inrush of new coins drops the price back down to a dollar.
If the price falls below a dollar, you buy the USDT at the current market price and sell to Tether for a dollar, the lack of coins causes an increase in price.
In both cases, you make money.
Collateralization isn’t limited to fiat as capital, some stable coins use gold, bonds, even crypto or a combination as their capital.
Collateralization just means each token is backed by something that exists.
The problem is that it creates centralization.
So we have methods 2 and 3.
Algorithmic Pegging
In this method, the tokens are aware of their price and adjust it as necessary.
This sounds stupid but stay with me.
It’s not magic, the algorithms just manipulate supply.
Algorithmic Stablecoins add or delete themselves as necessary.
Let’s say prices go above a dollar, everyone holding the stable coin gets new coins.
If you hold 10% of the entire market cap, you get 10% of the new mints.
If the prices go below a dollar, you lose tokens based on the amount you hold.
If you have 10% of the market cap, you lose 10% of your coins.
The losses are really only numerical, your tokens remain the same value.
When I discussed this with a friend he mentioned hard wallets.
How are new coins added to or removed from a hard wallet?
The answer: Before any transaction happens, hard wallets or not, you must be up to date with the block chain.
There’s no escape.
That’s one method of algorithmic control. There are others but they have the same principle — control the supply.
Half and Half
The technical name for tokens that use this method is;
‘Fractional Algorithm Stable Coins’. That’s a real doozy in my opinion, plus it doesn’t capture the essence of the idea.
Half and Half is much better.
Half and Half stable coins are stable coins that have some form of collateral, but the prices are also controlled by an algorithm.
The best half and half stable coin is DAI.
DAI is a stable coin pegged to a dollar, what’s special about DAI is how it maintains this peg.
The short answer is arbitrage (like collateralized coins) with an ingenious twist.
I’ll explain.
First you can only borrow DAI. You can buy DAI from people who have borrowed it, but really all DAI is borrowed.
To borrow DAI, you need lock up ETH.
When you lock up ETH you’re given DAI at $1.
That doesn’t mean you get $1 for every $1 of ETH.
Depending on the collateralization ratio you could have to pay $300 of ETH for $100 DAI.
Your ETH isn’t traded for DAI, it’s locked in a vault, paying back the DAI returns your ETH.
The vaults are over-collateralized because ETH is volatile.
If prices of ETH falls there’s always a little extra to make sure DAI is stable.
This is the first safety net.
Sometimes ETH falls low enough that the excess collateral isn’t enough, as a DAI borrower you’re expected to add more ETH or return the DAI.
If you don’t, the smart contract will liquidate your assets when the value falls below a threshold.
For example if you lock up $300 ETH and your ETH falls to $150 your ETH will be auctioned off for DAI.
As more DAI is detroyed, the amount of ETH necessary to back it reduces.
This is the second safety net.
In crazy dips, this still isn’t enough.
DAI is related to another token MKR.
If there’s still not enough collateral, MKR tokens are minted by a smartcontract and sold for DAI.
Eventually there’ll be enough collateral to back all the DAI’s.
This way no matter what’s happening to ETH there’s always collateral to back DAI.
About the peg;
The above is just how DAI remains fluid, the peg is maintained by arbitrage.
If DAI falls below a dollar you can buy the cheap DAI and send it back to the vault, you make a profit and get your ETH back.
If DAI goes above a dollar, you can lock up your ETH and get DAI for $1, then sell for a profit.
In both cases changing supply will cause price correction.
With this system, DAI is a completely decentralized stable coin.
Like I said ingenious.
(If you want a more technical explanation on DAI here’s the white paper link).
Bonus
You might have forgotten but in the beginning I hinted Stable coins were fraudulent, not exactly, it’s mostly just Tether.
Tether is the most popular stable coin, it has the 4th largest market cap only behind BTC, ETH and BNB.
Needless to say, lots of people use it.
And that’s surprising considering their history.
Like I said earlier, each USDT is supposed to be backed by $1.
Unfortunately that’s not the case with Tether.
They’ve publicly announced that only 2% of their funds are in actual dollars, the rest is split into different things.
That’s risky because even gold is volatile, what happens if those prices fall?
Plus since Tether isn’t publicly audited, nothing stops them from just minting more USDT.
In spite of all that Tether is still the strongest stable coin.
This is a subtle reminder that crypto is a speculative asset, you’re whatever you get people to believe.
Trade with caution or don’t.
That’s all on stable coins, hopefully I’ve demystified the topic and you had fun while you were at it.
Glossary
Mining: Is the process of making new crypto. (Here’s a link to the process)
Coin: A coin is a crypto currency with it’s own network or block chain e.g BTC, ETH, BNB, SOL etc.
They’re usually the bigger crypto.
Token: A token is a crypto currency built on a coin’s block chain e.g SHIB on the ETH network and most stable coins.
Arbitrage: To buy and sell the same product, in different places at the same time.
Fiat: Government issued money e.g the USD, GBP, JPY etc.
