Why swap to a stablecoin?

In this article we explore swapping between cryptocurrencies and stablecoins. We first introduce decentralised exchanges, where you can swap between cryptocurrencies using smart contracts. Then we introduce stablecoins, which are cryptocurrencies specifically designed to remain stable. These are both critical tools in DeFi.

From centralised to decentralised exchanges

Most people will use a centralised exchange (CEX) to buy their first cryptocurrency. Popular CEXs include Binance, Coinbase and FTX. In a CEX you can buy cryptocurrencies using traditional financial tools (e.g., bank deposits). You can also swap between different cryptocurrencies and fiat currencies. CEXs are important ‘on-ramps’ to DeFi.

CEXs are generally run by companies for profit. Buying (or swapping) cryptocurrency on a CEX is similar to purchasing foreign currency through your bank or at the airport. The CEX controls what cryptocurrencies are available, exchange rates, additional fees, and how you receive your funds.

The DeFi alternative to CEXs are decentralised exchanges (known as DEXs). Popular DEXs include Uniswap, Sushiswap and Curve. DEXs are not controlled by a single individual or company. Rather, they are a series of smart contracts. Typically DEXs have incentives for users to provide liquidity so that swaps are always available, and anyone can initiate new pairs of cryptocurrencies to trade. The prices of those cryptocurrencies are then derived from a pricing rule or algorithm (which differs between DEXs).

There are two key benefits of DEXs over centralised exchanges. First, many more tokens are available. Because adding new cryptocurrency pairs is decentralised and simply involves deploying new smart contracts on the DEX, there tends to be a greater diversity of tokens on DEXs than centralised exchanges. Second, if a cryptocurrency pair is available, then a price is always available. This feature holds even in a thin market (where there are few buyers and sellers).

Swapping to a stablecoin

Let’s say you hold a cryptocurrency, such as ETH, which is volatile. For various reasons (we discuss these below) you might want to hold cryptocurrency that is less volatile, such as a stablecoin. Stablecoins are cryptocurrencies but they are specifically designed so that their price is more stable. You will encounter stablecoins such as DAI, USDT and ##USDC as you trade in the DeFi ecosystem.

Compared to other cryptocurrencies, stablecoins are more similar to traditional currencies. Because stablecoins are more stable it is easier to perform economic exchanges.

Suppose you are an investor, you might seek to profit from rapid price movements. But for agents who are not speculating, they generally prefer an asset with a stable price. In the traditional economy, volatility presents an unwanted risk for those sending remittances, or business-to-business account settlement. In the cryptoeconomy, volatility makes it difficult to price goods and services, predictably borrow and lend over time, and creates stability issues for protocols.

There are many different types of stablecoins. While most commonly stablecoins are stable in relation to a fiat currency (e.g., the USD), they can also track other digital and non-digital assets (e.g., government bonds, or baskets of cryptocurrencies). Stablecoins generate stability in many ways. These approaches range from holding the underlying asset in a bank account, to complex incentive structures controlled by algorithms (more about this in a later step). The ways that stability is generated generates different levels of trust in the stablecoin, impacting its adoption. Stablecoins are a critical part of DeFi and the cryptoeconomy. Stablecoins help us to borrow, lend, trade and make plans without volatility. They will be a core part of your DeFi journey.