Stablecoins. What, Why and How?

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In the beginning, there was bartering.

Then money was invented, prices were listed, and markets happened.  Goods, services and assets could be efficiently bought and sold.

Currency ties it all together.  While dollars used to be made of cotton and stored in our leather wallets, today the ownership of dollars is recorded in electronic bank ledgers, somewhere deep within a data center.  The transfer of dollars is accomplished by the adjustment of these ledgers.

But this is more complicated than you would think.  Can’t have dollars appearing or disappearing out of nowhere (unless you are the Federal Reserve, or a bank issuing a loan…)

The Transfer of Electronic Dollars

Consider an ACH (Automated Clearing House) transfer, used for direct deposit, bill pay, auto-deposit, etc.  The modern form of writing a paper check.  If the dollars are transferred within a single bank, from one account to another, this is a relatively simple process, just a internal ledger change.  But the transfer of dollars from one bank to another is more common, and more complicated, as demonstrated by the following:

ACH transfers involve a payer, a recipient, originating and receiving depository financial institutions (ODFI and RDFI), and an ACH operator that routes and processes the payment.

Here is how it works:

• A payer authorizes a payment and is charged a $0.20 - $1.00 fee.

• The ODFI sends the transaction details to the ACH operator and initiates the payment. Because ACH is a batch processing system, payment instructions are sent in batches rather than one by one.

• The ACH operator processes the transaction and then routes the payment to the recipient’s bank.

• The RDFI deposits the funds in the recipient’s account.

• Ledgers on both sides are updated.

Such an ACH transfer typically requires 1-3 business days to settle, while same day transfers are possible for a higher fee.  Card payments and wire transfers are more complicated, with international money transfers being the most difficult.

So now that you have some limited knowledge as to how money moves around, let’s now focus our attention on the trading of a financial asset at an exchange.

How an Exchange Works

A financial asset exchange accomplishes two things.  It allows parties to trade a financial asset with each other, remotely and anonymously, and it establishes the price of the asset.  And just as we do not exchange apples for oranges at a grocery store, virtually all trading at such exchanges utilizes an intermediate fiat currency, such as the dollar.  Which implies that everything is priced in dollars, and that trades from one asset to another are always a two-step process, one party sells an asset for dollars, while the counter-party buys it with dollars.

Which means that the dollars involved must be held by a bank somewhere…

The exchange itself is a real-time system that receives the buy and sell orders for a given asset, and then uses that information to establish a “market price”.

Some of these orders will be “limit” orders, where a “sell limit order” will only sell at or above a specified price, and a “buy limit order” will only purchase at or below a specified price.  One can think of these limit orders as establishing the “initial market price” of an asset.

Consider this very simple exchange, where “buy” and “sell” limit orders at different price points have been placed.

In this case there will be no exchange of assets, because no sellers and buyers agree on a price.  But what the exchange can do is analyze the relative weight of these buy and sell limit orders and establish the initial market price that achieves a balance between the two.

Assume that in this case the balance point is an initial market price of $9.   While there may now be a price, there are still no exchanges.  Even if a seller dropped their limit price to $9, pushing the market price down to $8.50, there are still no exchanges.

The operator of the exchange is not happy; they are not generating much trade commissions.

While these limit orders are engaged in form of exchange stalemate, others can always place “market” (or “instant” ) orders.  These are buyers and sellers willing to exchange their asset at (or close to) the established market price.

Let’s assume that a seller wants to sell 10 shares at the market price, and a buyer is willing to buy 6 shares at that same market price.  6 of the shares are immediately transferred (sold for dollars, then bought using dollars), while the remaining 4 shares are still a “sell order at market price”.  Like the limit sell order, this market sell order will also push down the price, and if enough market sell orders accumulate, the price will eventually be pushed down to $8, triggering the limit sell order of 4 shares.

And so on.

The operator of the exchange is happier.

The bottom line is that the placing of buy or sell orders, whether they are limit or market orders, will influence the price.  And if enough orders are placed, and if large enough, one can control the price.

Which is important to understand if one wishes to fix the price of an asset at an exchange…

What is a Stablecoin?

A stablecoin is a crypto-asset, a digital representation of value, whose ownership is recorded using a distributed public blockchain.  A stablecoin is a special financial asset, because contrary to all other financial assets whose prices float, the price of a stablecoin is fixed at an exchange, locked to the price of some other financial asset, commonly the U.S. Dollar.

The two leading stablecoins are USDT, issued by Tether, and USDC, issued by Circle.  Together they represent about 90% of the stablecoin market cap.  Anyone with an account at Coinbase, Binance, etc. can buy and sell these stablecoins using dollars.

Why Use a Stablecoin?

Why convert a “real” dollar into a “not-so-real” crypto-dollar?

The answer is simple.  It is a lot quicker and cheaper for a crypto exchange to convert from one crypto-asset to another, then from a crypto-asset to a dollar, or vice-versa.  Because only banks can keep track of dollars.  So, when you transfer dollars to your Coinbase account, what is really happening is that Coinbase has a “custodial” account with a bank where it stores all its customer’s dollars, including yours.  Coinbase maintains its own ledger where it keeps track of how many dollars it is holding for each of its own customers in that one custodial bank account.

Which works well enough as long, if you don’t mind paying the bank fees.   And if Coinbase does not make any custodial account mistakes.  And if all Coinbase’s customers are using the same currency.

What if instead you were to convert your custodial dollars into custodial stablecoin dollars using the USDC/USD exchange managed by Coinbase.  And then moving forward, you did all of your crypto trading using just USDC stablecoins.   This means that the dollar-tracking bank, plus its fees and settling times, have all been removed from the process.   Your crypto trades now settle quicker and cheaper.

Any crypto exchange that does not use stablecoins will be at a competitive disadvantage.

Finally, rather than hosting thousands of separate, not so liquid exchanges for every crypto-asset / fiat currency pair, an exchange only needs to host a single exchange for each crypto-asset.  At most, 180 exchanges to convert any fiat currency into a stablecoin.

Which means that crypto trading is now efficiently available worldwide, even for those that live in countries with mismanaged fiat currency.

How is a Stablecoin Price Fixed at $1.00?

In addition to the customer custodial account it manages, Coinbase also has its own supply of USDT, that it previously purchased directly from Tether.  This stash of USDT provides liquidity to its trading platform, and as you will see, helps fix the price of USDT to $1.00.

As previously explained, at a normal asset exchange the market price adjusts, reflecting the balance between buy and sell orders.  But at a stablecoin exchange, the price is fixed, meaning that the buy and sell orders need to be quickly adjusted.

How is this done, given that over 100 crypto exchange support USDT alone, meaning that there are at least 100 independent USDT/Fiat Currency exchanges that need to be continuously “balanced”?

The solution is that Tether guarantees a redeemable price of $1 USD per USDT to its affiliated exchanges and institutions (such as Coinbase), which themselves hold stockpiles of USDT.  If at the Coinbase USDT/USD exchange the price of USDT were to fall to, say $0.98, Coinbase (and other arbitraging institutions) will buy that USDT on the Coinbase exchange and sell it back to Tether for $1.00, netting a quick 2% profit. These additional buy orders at the Coinbase exchange will quickly push the USDT price back up to $1.00.

And the same arbitrage is happening at all other USDT/USD exchanges.

This works if Tether has enough dollars to guarantee the redeemable price of $1.00, which it claims to have.  Mostly in the form of U.S. treasuries, other sovereign debt, gold & bitcoin.

How are Stablecoins Stored?

Like any other crypto-asset, you can store your own USDT “on-chain”, meaning that using your personal Trezor hardware wallet or whatever, it is permanently stored directly on the blockchain.  You control the wallet containing the associated private keys.

Or you can rely on your exchange’s custodial “off-chain” wallet to hold your USDT, meaning that they manage the private keys for you.  While less secure, off-chain transactions enjoy the benefits of near instant settlement and significantly less fees.

Tether maintains smart contracts for USDT across the supported blockchains, including Ethereum, Solana, etc.  These contracts track total USDT supply, mint new USDT and redeem USDT.  Tether doesn't maintain a centralized database mapping every individual wallet to a real person for all circulating USDT.  It only knows the details for direct customers (e.g., large institutions or exchanges) that mint/redeem directly with them.

Acting as a custodial, centralized exchanges (e.g., Binance, Coinbase, etc.) pool their users USDT in a single on-chain wallet, while separately keeping an off-chain ledger listing how much USDT each user owns.  Transferring USDT from one user to another is a simple edit of this ledger.

Most USDT exists off-chain in this manner.

Conclusion

Stablecoins have made crypto exchanges faster, cheaper and more international.

Stablecoins can be pegged to the price of any asset, including dollars, euro’s and gold.

Stablecoins need to be backed by a not so volatile, very liquid asset to insure that their pegged value can be maintained.  As the number of stablecoins in distribution increases, so will the amount of assets required to back them.

In my next blog I will cover the “tokenization” of more traditional financial assets, and how stablecoins will be used to trade them.