In a 2013 paper published by David Yernack, the professor of finance at New York University stated that, for any currency to be useful to society, it should be able to function as a medium of exchange, a store of value and a unit of account. At the time, he was using these three criteria to discredit Bitcoin as a feasible currency for everyday use. And there is some merit to this.
Although popular cryptocurrencies can be used as a medium of exchange on a small scale and in certain ecosystems, it struggles as a store of value or a unit of account. The reason for this is the inherent instability of cryptocurrencies. Possible price fluctuations of 20% or more on any given day make it unsuited to comply with the latter two functions of a usable currency.
To address this price volatility, a certain subset of cryptocurrencies started to emerge, i.e. stable coins. Being defined by Brigitte Luginbühl, CEO of SwissRealCoin:
Unlike cryptocurrencies such as Bitcoin, which are highly volatile, stable coins provide people with the pragmatic, helpful benefits of a cryptocurrency, without having to worry about distressing price changes since they are grounded in the real world.
A stable coin is designed to have a stable price or value over a period of time, therefore, less volatile.
These coins aim to mimic the relative price stability of fiat currencies on one hand, but still keep the core values of cryptocurrencies such as decentralization and security, on the other hand.
Why do we need stable coins?
Without price stability, cryptocurrencies may struggle to achieve mass adoption, widespread circulation and, ultimately, everyday use.
While volatility is fine for speculation, it’s not great for everyday payments. Nobody wants to be exposed to that sort of risk on a daily basis. Imagine your salary is paid exclusively in crypto. If the price of said crypto drops overnight by 20%, everything will have effectively become a fifth more expensive by the time you wake up the next morning.
As Rafael Cosman, CEO of TrustToken puts it:
Stable coins are one of the keys to bringing the benefits of cryptocurrencies to everyday people, both in terms of price stability and decentralization of capital.
It’s not just for payments. Price stability is a fundamental requirement if you want to bring traditional financial products, such as loans and reliable savings options, onto the blockchain. So an ultimate goal of a functioning stable coin, which does not compromise on the key characteristics of a cryptocurrency, is to ease widespread adoption among everyday users.
There are a number of so-called stable coins on the market trying to achieve this, with varying degrees of success. All of them will fall under one of three, broad categories:
- Fiat collateralized
- Crypto collateralized