What Are the Benefits of Stablecoins?

What Are Stablecoins?

Bitcoin was the first cryptocurrency ever invented and is sometimes referred as the "granddaddy" of crypto. However, bitcoin has several major limitations that prevent it from being widely used for payments, such as ecommerce purchases.

For one thing, bitcoin is slow. A block is produced every 10 minutes, and many sites require several blocks to be generated after the payment was made before crediting the funds.

It can also be expensive. At times, bitcoin minor fees (a fee required to send bitcoin) can reach as much as 15.00 USD or more.

But the most significant drawback of using bitcoin for payments is it's wild and unpredictable price fluctuations, that can be as high as 10% per day. Obviously, if you are an ecommerce merchant, accepting bitcoin for payments is not ideal.

And, that's why stablecoins were invented.

By definition, a stablecoin is a blockchain-based token (also referred as simply "crypto") that has its value pegged to something with stable price. Most frequently it's a national currency, such as US dollar, euro, or yen, but can also be other things, such as gold, consumer price index (CPI), and more.

Benefit 1: Price Stability

So, what are the benefits of stablecoins? The main benefit of using stablecoins as opposed to a crypto like bitcoin or ether is that the price of stablecoins is predictable and is not a subject of wild fluctuations. As such, stablecoins are a much more superior as a store of value and a medium of exchange.

The most popular stablecoins are the ones with value pegged to US dollar. At the time of this writing, Tether (USDT) is the most popular stablecoin and the third most popular cryptocurrency, right after bitcoin and ether. USD Coin (USDC) is the second most popular stablecoin and the fourth most popular cryptocurrency. See below:

Most popular stablecoins

Source: Coinmarketcap.com

Benefit 2: Transaction Cost

Sending bitcoin or ether can get very expensive. During the times of peak demand, miner fees can be as high as 15 USD per transaction. (At the time of this writing, the fees are around 0.50 USD on both of these blockchains.) One can say that even these fees are still significantly below what banks typically charge for money transfers, which is at least 25 USD for domestic and 40 USD for international. But these fees are way too high for crypto.

Most stablecoins can be transferred for fractions of a cent. For example, currently, the fee to transfer USDC on Polygon blockchain is only 0.003 USD (0.3 cent).

Of course, if you wish to transact with stablecoins on Ethereum blockchain, you still have to pay the Ethereum miner fees, which can be high. But most stablecoins exist on a number of EVM-compatible blockchains, sidechains, or rollups, so you have an option of extremely low transaction fees when using stablecoins as opposed to bitcoin or ether.

Benefit 3: Transaction Speed

Using stablecoins is also very quick in comparison with bitcoin. A time to produce one bitcoin block is about 10 minutes. Many sites, such as exchanges, require at least 6 blocks to be produced after they receive the transaction to credit funds. This requirement is to prevent double spending. So, it may take you as long as 60 minutes to send bitcoin and have it credited by an exchange.

In comparison, an average Ethereum block time is only 12 seconds. Other blockchains are even faster. Polygon block time is 2.1 seconds. NEAR block time is 1.1 seconds. Other technologies, such as Optimism and Arbitrum optimistic rollups, are able to combine more transactions in one batch and generate higher throughput.

Many of these chains and rollups provide an almost instant transaction confirmation time, which is comparable to using credit card payments, but for fractions of a cent and without chargebacks.

Benefit 4: No Hidden Conversion Fees

Did you know that when you pay with bitcoin or another unstable cryptocurrency for products, you are overpaying on average 1% - 1.5%? This happens because of something called the "spread."

You see, merchants don't want to receive settlements in unstable coins like bitcoin. When a typical payment processor receives a payment in bitcoin from a buyer, it atomically converts it into US dollar. This conversion is not free. Conversions are usually performed by exchanges. These are platforms where market makers place buy and sell orders to allow other people, "takers," to instantly convert their crypto into something else. These market makers make money by earning the spread or a difference between the buying and selling price.

The platform that operates the exchange takes a trade commission on top of the spread. Finally, the payment processor typically adds its own markup on the price of bitcoin, which by the way is not usually advertised or even disclosed to the buyers. A typical payment processor markup over the average market exchange rate is about 1% - 1.5%.

In contrast, when you pay for products or services with stablecoins, there is no conversion. If the product is priced in US dollars and the coin is pegged to US dollar, the amount you'll pay in coins is exactly the same as the price of the product. There is no markup or hidden fees for paying with stablecoins.

Benefit 5: Smart Contract Compatibility

You probably noticed that there isn't much you can do with bitcoin, except for holding it and sending to other people. This is not the case with stablecoins! Stablecoins are programmable money. This means that a program running on a blockchain can manage the flow of these coins. These programs are called smart contracts.

There are many applications of smart contracts. Some of the most common ones are lending, decentralized exchanges, and more. ATLOS is also using smart contracts to process payments. This has many advantages over other custodial payment processors. It offers:

1. Smoother payment experience, does not require manually sending funds
2. Security, the funds are controlled by a program and not stored in a hosted wallet
3. Support for advanced features such as escrow and recurring payments

But, not all stablecoins are created equal. While some are excellent at maintaining their peg, some other can suddenly collapse or "depeg" and lose their value. This is what happened to UST on Terra blockchain in the winter of 2022 for example. So, how does one select the correct stablecoin, and are stablecoins a reliable store of value?

Stablecoin Types

Baked by the Same Asset

This type of stablecoin is the easiest to understand and also has proven itself to be the most reliable. It is a token with a price tied to some asset, which also backed in 1:1 ratio by the same asset. For example, the USD Coin (USDC) stablecoin is backed 1:1 by US dollar. That means that for each USDC token in existence, there is exactly one US dollar kept at a bank by an organization that issues USDC token, in this case a joint venture between Coinbase and Circle.

Tether (USDT) is another example of an asset-backed stablecoin. In fact, USDT was the first stablecoin invented and still remains the most popular stablecoin. However, USDC is gaining in popularity. The reason is that USDC is issued by a licensed US company with easily auditable reserves. Tether is issues by a Hong Kong-based company, iFinex Inc. It has also been becoming more transparent with its reserves lately, but many still prefer a US-issued coin.

If you are a crypto novice, same asset-backed stablecoins should be your go to tokens for payments and store of value.

Backed by a Different Asset(s)

This type of stablecoin is pegged to the value of one asset, but is backed by another asset or several other assets. Typically, the value of assets backing the stablecoin exceeds the value of issued tokens, so this type of tokens is also often called "overcollateralized" stablecoins.

For example, DAI stablecoin is pegged to the price of US dollar. However, it is backed by other cryptocurrencies such as Ethereum (ETH). Since the price of ETH fluctuates relative to USD, it would not be a good idea to back DAI by ETH in 1:1 ratio. If the price of ETH falls, it can become undercollateralized, and DAI can lose its value. Overcollateralization in addition to the liquidation rules, which we will not get into here, ensures that there is always enough ETH to back DAI value of at least 1 USD.

DAI is good example of a reliable stablecoin. However, if you are considering using another overcollateralized stablecoin, find out first how the collateral works and what rules ensure that the price of the collateral will never drop below the peg. If you are novice, it's best to skip it, till you have more experience with crypto.

An example of an overcollateralized stablecoin that depegged and lost its value is UST on Terra blockchain. At a time, it was a hugely popular stablecoin with billions of dollars in market capitalization paying 19% annual interest to people who wished to stake it (lock it up in a deposit). It was backed by LUNA, the native Terra coin. In addition, Terra founders boasted that they had other reserves, such as bitcoin, that could be deployed to buy up UST and bring its price up, should the algorithm fail. However, a couple of very large crypto funds figured out that if they waited for the right moments and started selling UST in huge quantities (hundreds of millions of dollars) they could bring the price of UST down, cause a broad market selloff and the collapse of LUNA, the collateral token. They executed the attack in the winter of 2022. In spite of Terra founders deploying their other reserves, the price of UST never recovered and ultimately went to zero.

Not Backed by Anything or Algorithmic

The main drawback of asset backed stablecoins is that they require other assets to be locked up and sitting idle somewhere in order to issue the stable tokens. So, the holly grail of stablecoins are tokens that do not require any collateral to maintain their peg. These stablecoins are called "algorithmic" or sometimes "uncollateralized."

An algorithmic stablecoin maintains its peg with a help of a community of crypto enthusiasts, which is incentivized to sell tokens when the price rises above the peg and buy tokens when the price falls below the peg. A typical incentive mechanism involves issuing bonds to users that buy tokens to bring the price up. These bonds, in turn, are redeemable at a future time for more stable tokes, hence providing the incentive to acquire them.

As you can probably see, algorithmic stablecoins can maintain their peg for as long as the community of enthusiasts does not move on to something bigger and better and for as long more enthusiasts join the community to support the future bond payments.

There are other variations of algorithmic stablecoins. While one can be invented in the future that will be reliable and work in perpetuity, as of now, none of them have proven to be reliable stablecoins. You should definitely stay away from them as a merchant.

Hybrid

There are also stablecoins that use a combination of some of the approaches described above. For example, Frax is a fractional reserve stablecoin. It uses both, an algorithmic stability mechanism, and a fractional reserve to maintain its peg. The rationale behind the fractional reserve is to provide a safety net should a force majeure or some type of attack occur that creates a panic the community and causes a selloff.

These coins are more reliable than purely algorithmic, but still cannot guarantee stability in the long run.

Risks of Centralization

A discussion of stablecoins or any tokens would not be complete without mentioning some risks caused by centralization. As we explained earlier, same asset-backed coins such as USDC and USDT are issued and controlled by a centralized entity. That means that if anything should happen with that entity or its assets, the issued coin can lose its value. Let's say if the government decided to shut down Circle for some violations, the USDC would probably cease to exist.

This is in not the only risk associated with centralized stablecoins. In order to comply with government regulations, USDC and USDT issuers had to provide a built-in mechanism in their smart contracts that allows them to freeze all of their tokens at a given wallet address. The idea was that these coins would be similar to money in a bank account that the government can freeze upon request.

On the other hand, decentralized overcollateralized stablecoins, such as DAI, don't have that built-in mechanism for freezing funds in a given wallet.

Should you not use centralized stablecoins, such as USDC or USDT? It's up to you to decide. In general, the risk of holding these coins is probably similar to the risk of holding money at a bank account. Although, one could argue that before they freeze funds in your wallet, they'd have to find it first.

Are Stablecoins Safe?

Yes, stablecoins proved themselves to be a reliable store of value and a medium of exchange. And, that's why they are some of the most popular cryptocurrencies out there. In fact, even very large companies, such as Visa, are now providing an option to settle funds in stablecoins for merchants.

One word of caution, stick to only well-known reputable stablecoins. Remember anyone can launch a new token on blockchain and call it a "stablecoin." The name alone does not guarantee anything. As an ecommerce merchant, you should stick to the same asset-backed and overcollateralized stablecoins.