Stablecoins are digital assets that are intended to resemble the value of fiat currencies such as the dollar or the euro. They enable customers to send money throughout the world inexpensively and quickly while maintaining price stability.
When compared to traditional currencies, cryptocurrencies like Bitcoin and Ethereum are known for their volatility. This is to be expected, given how fresh blockchain technology is and how small the cryptocurrency markets are. The fact that a cryptocurrency’s value isn’t tied to any asset is intriguing from a free-market standpoint, but it can be inconvenient in terms of utility.
From a technological sense, bitcoins are ideal as mediums of exchange. However, the volatility in their value has made them high-risk investments that aren’t appropriate for making payments. Coins can be worth much more or less than they were when they were sent by the time a transaction settles.
Stablecoins, on the other hand, have no such issue. These assets have very little price movement and closely reflect the value of the underlying asset or fiat currency they are modelled after. As a result, they act as dependable safe-haven assets in times of market volatility.
A stablecoin can maintain its stability in a variety of ways. In this post, we’ll go through some of the mechanisms that have been used, as well as their benefits and drawbacks.
What are stablecoins and how do they work?
Stablecoins are divided into several groups, each of which approaches unit pegging in a unique way.
The Stablecoins that are directly backed by fiat currency at a 1:1 ratio are the most popular. Stablecoins with fiat collateral are sometimes known as fiat-collateralized stablecoins. A central issuer (or bank) keeps a certain amount of fiat cash in reserve and issues tokens in proportion.
For example, the issuer could have a million dollars and distribute one million dollar tokens. Users can freely trade them as they would tokens or cryptocurrencies, and holders can redeem them at any moment for USD equivalents.
There is clearly a significant level of counterparty risk here that cannot be mitigated: the issuer must be trusted at the end of the day. A user has no way of knowing with certainty whether the issuer has funds in reserve. When it comes to publishing audits, the issuing business can try to be as transparent as possible, but the method is far from foolproof.
Crypto vs Fiat
The fundamental distinction between crypto-backed stablecoins and fiat-backed stablecoins is that bitcoin is utilised as collateral. However, because cryptocurrency is digital, the issuance of units is handled via smart contracts.
Although trust is lessened with crypto-backed stablecoins, it should be remembered that monetary policy is established by voters as part of their governance systems. This implies you’re not putting your faith in a single issuer, but rather that all network participants will always operate in the best interests of the users.
Users lock their cryptocurrency inside a contract that issues the stablecoin in order to obtain it. They pay stablecoins back into the same contract later to obtain their collateral back (along with any interest).
The mechanisms that enforce the peg differ depending on the system’s design. To summarise, participants are incentivized to keep the price consistent using a combination of game theory and on-chain algorithms.
Stablecoins supported by algorithms are not backed by cash or cryptocurrency. Instead, algorithms and smart contracts govern the supply of the tokens released to maintain its peg. Their monetary policy is functionally similar to that of central banks in managing national currencies.
If the price of the token falls below the price of the fiat currency it follows, an algorithmic stablecoin mechanism will cut the token supply. If the price rises above the value of the fiat currency, additional tokens are released into circulation, lowering the stablecoin’s value.
Non-collateralized
Non-collateralized stablecoins are a term used to describe this type of token. They are collateralized, but not in the same sense as the preceding two entries, therefore this is technically inaccurate. In the event of a black swan occurrence, algorithmic stablecoins may have a pool of collateral to deal with extremely volatile market movements.
In practise, collateralized stablecoins are by far the most frequent. USD Tether (USDT), True USD (TUSD), Paxos Standard (PAX), USD Coin (USDC), and Binance USD are examples of these currency (BUSD). However, there are now available examples of the other two aforementioned groups on the market. Crypto-collateralized coins like Bitshares USD and DAI exist, whereas algorithmic coins like Carbon and (the now-defunct) Basis exist.
This is by no means an exhaustive list. The market for stable digital currencies is large, as proven by the hundreds of stablecoin projects that have sprung up.
The advantages and disadvantages of stablecoins
The main advantage of stablecoins is their ability to serve as a complementary means of exchange alongside cryptocurrencies. Cryptocurrencies have been difficult to gain widespread adoption in common applications such as payment processing due to significant levels of volatility. These stabilised currencies alleviate the problem by delivering better degrees of predictability and stability.
Stablecoins may be able to help integrate cryptocurrencies with traditional financial markets by acting as a hedge against volatility. These two markets currently exist as independent ecosystems with limited contact. With a more solid form of digital currency on the horizon, cryptocurrencies are likely to gain traction in lending and credit markets.
Stablecoins can be used by traders and investors to hedge their portfolios in addition to their use in financial transactions. Allocating a portion of a portfolio to stable coins is a good strategy to reduce overall risk. Maintaining a store of value that can be used to purchase other cryptocurrencies when prices fall is also a viable strategy. Similarly, without having to cash out, these coins can be used to “lock-in” gains achieved as prices climb.
Stablecoins, despite their promise to facilitate mainstream bitcoin adoption, have some drawbacks. Because a central institution is required to keep the supporting assets, fiat-collateralized variations are less decentralised than traditional cryptocurrencies. Users of crypto-collateralized and uncollateralized currencies must have faith in the larger community (and the source code) to ensure the systems’ long-term viability. Because these are still new technologies, they will take time to develop.
In summary
Stablecoins are a vital component of the cryptocurrency marketplaces, despite significant drawbacks. These digital currencies can maintain more or less constant pricing through a number of ways. This enables them to be utilised as a safe haven for traders and investors as well as a means of exchange.
While stablecoins were created to give traders with a useful tool for risk management, it’s evident that their applications go well beyond that. They’re a potent tool that has the potential to enhance the cryptocurrency ecosystem as a whole, as they can be used in situations where volatile alternatives aren’t suitable.
