Mar 16, 2024

Stablecoins on Bitcoin: An Overview

Driven by blockchain technology, stablecoins offer open, global, and 24/7 accessibility through the internet

Stablecoins on Bitcoin: An Overview

Bitcoin stands tall as a monument to decentralization and financial sovereignty. Yet, its volatility in terms of fiat currencies can be a challenge for those seeking financial stability. Stablecoins were created precisely to satisfy this need, offering an instant, borderless, and low-cost payment solution that tracks the underlying value of fiat currencies without having to rely on their infrastructure.

Defining Stablecoins

Stablecoins are digital assets anchored to a “stable” counterpart, such as the US dollar, euro, or even gold. In terms of fiat money, this "peg" helps them maintain a consistent value, unlike Bitcoin which is often subject to significant price fluctuations.

Driven by blockchain technology, stablecoins offer open, global, and 24/7 accessibility through the internet, tearing down barriers inherent to traditional payment infrastructure. 

When compared to legacy financial systems, they shine in terms of speed and convenience, offering near-instantaneous transactions with minimal friction. Additionally, their digital nature unlocks unique capabilities such as "smart contracts", which are programmable agreements that automate and execute transactions based on predefined conditions.

There are four main categories of stablecoins:

  1. Fiat-backed: Pegged to real currencies like USD and held in bank accounts by the issuer. Examples: Tether (USDT), USD Coin (USDC).

  1. Commodity-backed: Gold, silver, or other real-world assets secure these stablecoins, mirroring their price fluctuations. Examples: PAX Gold (PAXG), Tether Gold (xAUT).

  1. Digital Asset-backed: Unlike their fiat counterparts, these rely on other digital assets such as BTC or ETH as collateral, using smart contracts to manage their supply. Examples: Dai (DAI), Wrapped Bitcoin (WBTC).

  1. Algorithmic: The most complex, these use smart contracts and algorithms to adjust their supply based on demand, aiming to maintain their peg without any physical collateral. Example: USDD.

Differences Between Stablecoins and Bitcoin

Both Bitcoin and stablecoins are digital assets that exist on a blockchain, however their core characteristics differ greatly.

Bitcoin serves as a decentralized digital currency and long-term store of value. Its price fluctuates with market demand, making it less suitable for everyday transactions on a fiat standard.

Being decentralized means it has no single entity controlling its issuance or management. This feature enhances transparency and censorship resistance, while posing challenges on  scalability, due to the susceptibility to congestion and higher transaction fees.

Stablecoins however are designed for relative stability by pegging their value to traditional assets. This makes them ideal for payments, settlements, and decentralized finance applications.

Although used in decentralized applications, many of these stablecoins are ironically issued by centralized counterparties (entities such as Tether or Circle). While convenient, they come with the downside of increased counterparty risk, due to the necessity of relying on issuer trust and transparency.

Stablecoins on the Lightning Network: Taproot Assets

Taproot assets are digital tokens built on top of Bitcoin. They can represent anything from stablecoins to gold-backed assets or even loyalty points. They can all be deposited and transacted instantly on the Lightning Network, just like Bitcoin.

This protocol enhances instant value transfers given its built on top of the Lightning Network, enabling the use of stablecoins on top of the most secure network, Bitcoin.

As additional stablecoins are minted on the Lightning Network, routing nodes earn higher fees and are thus incentivised to settle higher transaction volume, helping enhance liquidity for the entire network.

How It Works

Taproot Asset channels hold your assets, enabling instant transfers. However, unlike traditional payment networks, assets can be routed across different chains on top of the Lightning Network.

The parties in a payment channel decide the exchange rate, offering flexibility and competition. All transactions are secure and atomic, thanks to the flexibility of Bitcoin and the design of Lightning Network protocols.

Image Depicting Alice Paying Bob on the Lightning Network

Source

Users can pay for goods and services with stablecoins or receive payments in the preferred asset type directly on the Lightning Network.

Taproot assets offer businesses the possibility of accepting payments in a variety of assets, helping expand a firm’s addressable customer base and offering stablecoin options for price-sensitive users.

These types of assets are still in the early design stages, however they hold immense potential to revolutionize the Bitcoin and Lightning Network ecosystems. By enabling fast, secure, and multi-asset transactions, they pave the way for a more diverse and accessible financial future.

Other Promising Layer-2 Solutions: Liquid Network

Blockstream’s Liquid Network sidechain is another promising Layer 2 network that enables fast and confidential trade settlements. Like Taproot assets, Liquid has the potential to bring diverse assets to Bitcoin.

Liquid’s target audience include institutional investors seeking efficient arbitrage opportunities, traders looking to minimize front-run risk, and entrepreneurs wanting to issue their own security tokens.

What is a Sidechain 

The best way to describe a sidechain is to think of the Liquid Network as a separate lane alongside the main Bitcoin highway. Assets can be securely transferred between them, ensuring a 1:1 peg for Bitcoin locked on the mainchain. While independent, Liquid leverages Bitcoin's security, offering the best of both worlds.

Bitcoin can be slow and lack certain functionalities for specific needs. Sidechains like Liquid offer more flexibility and faster innovation without compromising Bitcoin's core strengths.

What You Can Do with Liquid

The Liquid Network was developed as a Bitcoin scaling solution. It allows one-minute block times and two-block transaction finality, positioning itself as an interesting alternative for individuals and businesses interested in carrying out small-medium sized transactions.

Blockstream describes the mechanics of Liquid as “using something called a two-way peg, BTC can be “transferred” back and forth between the Bitcoin mainchain and the Liquid sidechain.”

A Visualization of Liquid’s Two Way Peg

Source

The primary benefit of the Liquid network is that it enhances privacy, shielding transaction amounts and asset types from prying eyes, thus adding a layer of discretion to financial activities.

Like Taproot Assets, Liquid allows the issuance and trade of stablecoins, security tokens, in-game items, and more.

Conclusion

For those seeking a decentralized, long-term store of value and are comfortable with price volatility, Bitcoin is the optimal choice. However, its fiat-based price fluctuations can often be a challenge for use as a medium of exchange for everyday transactions.

Stablecoins, anchored to established assets like fiat currencies, offer stability and practicality as a medium of exchange. Their centralized nature introduces counterparty risk but facilitates smoother integration with traditional financial systems.

Emerging solutions like Taproot Assets on the Lightning Network and the Liquid Network aim to bridge the gap, introducing multi-asset functionality and enhanced transaction speed while leveraging the security of the Bitcoin Network.

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