This issue makes it very hard for people to use them frequently. People want to know how much their money will be worth in a week, month, or year from now because of security. That’s just like the traditional bank where users deposit money without the value depreciating in a week, month or year. Although currencies like the dollar do change gradually over time, the fluctuations in price of cryptocurrencies are more dramatic, where values jump up and down.
Stablecoin was developed to solve these fluctuation issues in cryptocurrency. Stablecoins try to solve price fluctuations by tying the value of cryptocurrencies to other more stable assets, like fiat. Fiat is a government-issued currency which we use for day-to-day transactions such as USD, EURO, etc., and it tends to stay stable over time.
There are ways that stablecoin can maintain its stability. In this article, we’ll talk about stablecoin, how it works, the mechanisms used, and what makes it unique. Let’s get started.
What is stablecoin?
Stablecoin can be defined as a range of cryptocurrencies that try to peg their market worth to some external value. In essence, it means that they are backed by a reserve asset like during the Gold standard era, unlike fiat money which is a legal tender that is not supported by a physical commodity. Being a backed asset allows stablecoins to maintain their values and avoid excess volatility, which invariably defines the cryptocurrency market. Stablecoin will enable users to cheaply and rapidly transfer funds around the globe while maintaining price stability.
Uses of Stablecoin
Like most cryptocurrencies, stablecoin is majorly used as a store of value and also as a medium of exchange. It gives traders temporary reprieve from volatility when the market is not stable and can also be used in the developing world of decentralized finance (Defi) for things such as yield farming, lending, and liquidity provision.
In essence, some investors and traders gain exposure to stablecoin by buying it through cryptocurrency exchange platforms. However, users can also mint fresh stablecoins by depositing the required collateral with the company issuing it like the US dollars with Tether.
Categories of Stablecoins
Stablecoins are categorized based on their working mechanism. Each of them goes about pegging their units in many ways. Below are the three categories of stablecoins.
Fiat backed stablecoins
Fiat is the most popular collateral for stablecoin, with the US dollar being the most popular among fiat currencies. The fiat currency is backed by sovereign currency like the US dollar. This means that to send a certain number of tokens of a given cryptocurrency, the sender must offer dollar reserves worth the same amount as collateral. The custodians who function independently and are audited for compliance on a daily basis can maintain the reserve. And the cryptocurrencies which are backed by dollar deposits are Tether (USDT), USDC, and TrueUSD.
Crypto backed (Collateralized) stablecoin
This imitates their fiat-backed counterpart. The only difference is that cryptocurrency is used as collateral. But because cryptocurrency is a virtual coin, a smart contract takes care of the units’ issuance. Crypto-backed stablecoins are trust minimized but note that voters determine the monetary policy as part of their governance systems. In straightforward terms, no single issuer is trusted, but you trust that the network participants will act in the users’ best interest.
For users to have access to this stablecoin, they lock their cryptocurrency into a contract, which issues the token. To get their collateral back later, they pay stablecoins back into the same contract together with any interest. For example, DAI is one of the most famous crypto-collateral based stablecoin.
Algorithmic (Non-collateralized) Stablecoins
Algorithmic stablecoins are those that don’t involve the use of any reserved asset. Instead, their stability comes from a working mechanism, like that of a central bank. For instance, the crypto base coin utilizes a consensus mechanism to know whether there should be a rise or fall in the supply of tokens on a need basis.
The algorithmic stablecoin will essentially reduce the token supply if the price decreases below the fiat currency price it tracks. And if the price rises above the fiat currency price, new tokens enter into circulation to reduce the value of the stablecoin. This is done by making use of two coins – one as a reserve currency and second one as a stablecoin token. For example, Terra uses LUNA as its reserve asset currency while facilitating UST as a stablecoin.
What are the popular Stablecoins
To give a taste of how it works, let’s look into most of the popular stablecoins.
Tether or USDT is one of the oldest stablecoins. It was unveiled in 2014 and remains the most popular stablecoin till today. In terms of market capitalization, it is presently one of the most valuable. The major uses of Tether are to move money between exchanges quickly and easily, which is to take advantage of arbitrage opportunities when the cryptocurrency price begins to crash. Also, when the crypto price differs on two exchanges, traders can make money on this discrepancy using the USDT via transfer across exchanges. Tether Ltd, a USA-based company, is responsible for the issuance of USDT.
True USD, represented as “TrueUSD,” is 100 percent backed by the US dollar and is one of the most liquid stablecoins currently on the market. The TrueUSD offers lower transaction fees than wire transfers of fiat currency and higher interest rates on stored balances. TrustToken is the company behind True USD. The firm also has stablecoins pegged to other major currencies like TrueAUD, TrueHKD, TrueGBP, etc.
USD Coin, which is referred to as USDC, is a stablecoin that is backed by Coinbase, the world’s major BTC broker and largest exchange holder of Bitcoin. It was launched in 2018, and the cryptocurrency firms Circle and Coinbase jointly manage it through the Centre consortium. Like the USDT, the USDC value is also pegged to the US dollar.
Also referred to as BUSD. It is a USA-regulated stablecoin that was launched in partnership with Binance and Paxos. The value is pegged 1:1 to the US dollar.
It is also known as PAX. The stablecoin seeks to keep a 1:1 parity with the US dollar. It was developed to answer the Tether printing controversy, which saw the Tether come under a dispute over claiming that it held $1.8 billion with Deltec Bank and Trust Ltd to back its stablecoin.
Advantages of Stablecoin
The major advantage of stablecoin is that it provides a medium of exchange that complements cryptocurrencies. Also, the benefits include;
They are relatively stable: That is because they are backed by a fiat currency which gives investors confidence that their tokens will always sell for one dollar each. That is, the price won’t crash. Since coin prices are driven by belief, it means that investors believe their stablecoins are worth and backed by one USD each.
They are a safe haven for Storing Asset: Investors that are worried about their assets can store them in stablecoins. Also, some crypto exchanges like Binance don’t allow traders to buy fiat currency but only allow them to buy and sell cryptocurrencies. So, it means that it is tricky for investors to cash out their cryptocurrencies when a token price begins to crash. So, the only way is to transfer across several exchanges, which might take days. But with stablecoin, they can convert their assets to stablecoin to reduce or prevent loss.
Traders and investors can also use Stablecoins to hedge their portfolios: What it means is that investors or traders can allocate a certain percentage of a portfolio to stabilized coins so as to reduce the risk of enormous loss. Also, it can be used to maintain a store of value that can be used to buy other cryptocurrencies when the price drops. After, these coins can be used to lock in gains made when the price rises without the need to cash out.
Centralization: Stablecoins, unlike some cryptocurrencies, are developed mainly by centralized organizations that own the currency. For instance, DAI, a well-known stablecoin that projects itself as decentralized, has faced scrutiny for its centralized organization.
Less Growth: Unlike other cryptocurrencies that can grow in value, stablecoins doesn’t provide the potential for high return on investment (ROI) to investors since it is pegged to a fiat currency.
It requires third-party Audit: Stablecoin must be audited through third parties that may lead to trust or decentralization issues.
With the volatile nature of cryptocurrency, investors are increasingly looking towards stablecoins as a safer way to store their assets. Although stablecoin has some disadvantages, stablecoins are a critical component of the cryptocurrency markets. By putting various mechanisms in place, these digital currencies can remain more or less steady at a set price. Thus, this allows these coins to be used not only as a medium of exchange but also as a store of value for traders and investors.
Although initially created to provide a shield for risk reduction among investors and traders, it is clear that the application of stablecoins goes beyond trading. They are now a powerful tool that could develop the cryptocurrency market as a whole, serving as a hedge against volatility in the crypto space.
Written by: Narender Charan