What are stablecoins in Crypto?
Cryptocurrencies are not just about volatility. In fact, stablecoins are specifically designed to maintain a stable price. In an industry where coins and tokens can collapse overnight, there is a huge demand for coins that combine the benefits of the blockchain with the ability to track a more stable asset. If you haven’t started using stablecoin in trading or investing, it’s worth learning more about them, as well as the pros and cons that come with them.
What are stablecoins in cryptocurrencies?
Stablecoins are digital assets that track the value of fiat currencies or other assets. For example, you can buy tokens pegged to the dollar, euro, yen, and even gold and oil. A stablecoin allows the holder to lock in gains and losses and transfer value at a fixed price to blockchain peer-to-peer networks.
Bitcoin (BTC), Ether (ETH) and other altcoins have always been unstable. While this provides many opportunities for speculation, it also has drawbacks. The volatility makes it difficult to use cryptocurrencies for everyday payments. For example, merchants may receive $5 worth of BTC for a coffee one day, but find that their BTC is worth 50% less the next. This makes it difficult to plan and operate a business that accepts crypto payments.
Previously, cryptocurrency investors had no way to lock in profits or avoid volatility without converting cryptocurrencies back into fiat. The creation of stablecoin provided a simple solution to these issues. Today, you can easily enter and exit crypto volatility using stablecoin like TrueUSD (TUSD).
How do stablecoins work?
Creating a currency that tracks the price or value of another asset requires a matching mechanism. There are many ways to do this and most rely on another asset to act as an additional collateral. Some methods have proven more successful than others, but there is still no guaranteed match.
Stablecoin supported by Fiat
A fiat-backed stablecoin maintains a fiat currency in reserve, such as USD or GBP. For example, each TUSD is backed by a dollar, which is held as additional collateral. Users can then convert from Fiat to stablecoin and vice versa, with its exchange rate.
Stablecoin backed by crypto
Crypto-backed stablecoins work in a similar way to fiat-backed stablecoins. But instead of using dollars or other currency as a reserve, we have cryptocurrencies that act as additional collateral. As the crypto market is highly volatile, crypto-backed stablecoins usually boost their over-insurance of their reserves as a measure against price fluctuations.
Crypto-backed stablecoins use smart contracts to manage creation and consumption. This makes the process more reliable as users can independently control the contracts. However, some crypto-backed stablecoin are managed by Decentralized Autonomous Organizations (DAOs), in which the community can vote on changes to the project. In this case, you should get involved or simply trust the DAO to make the best decisions.
Let’s look at an example. To create 100 DAIs linked to USD, you will need to provide $150 worth of crypto as a 1.5x additional guarantee. Once you have your DAI, you can use it however you want. You could transfer it, make investments with it, or simply hold it. If you want your additional guarantee refunded, you’ll need to return the 100 DAI. However, if your additional guarantee falls below a certain additional guarantee percentage or the value of the loan, it will be liquidated.
When the stablecoin value is lower than $1, incentives are created for holders to return their stablecoin for the additional guarantee. This reduces the supply of the coin, causing its price to rise to $1. When it is above $1, users are incentivized to create the Token, increasing its supply and decreasing the price. DAI is an example, but all crypto-backed stablecoins rely on a combination of game theory and algorithms in the chain to incentivize price stability.
Algorithmic stablecoin
Algorithmic stablecoins take a different approach, removing the need for stock. Instead, algorithms and smart contracts manage the supply of tokens issued. This model is much rarer than crypto or fiat-backed stablecoins and is more difficult to operate successfully.
Essentially, an algorithmic stablecoin system will reduce the token supply if the price falls below the fiat currency it is tracking. This could be done through locked staking, countering or buyback. If the price exceeds the value of the fiat currency, new tokens are put into circulation to reduce the value of the stablecoin.
What are the advantages of stablecoin?
Stablecoin are flexible and powerful tools for cryptocurrency investors and users. Their main advantages include the following:
- Stablecoin can be used for everyday payments. Stablecoin can be used daily for daily transactions. Due to high volatility, cryptocurrencies have not achieved widespread use for everyday payments. Large stablecoins have a history of maintaining their connection, making them suitable for daily use.
- The stablecoin are based on blockchain and this has its advantages. You can send a stablecoin to anyone worldwide who has a compatible crypto wallet (which can be created for free in seconds). Double spending and false transactions are also almost impossible to do. These properties make stablecoin extremely flexible.
- Stablecoin can be used by investors to hedge their portfolios. Allocating a certain percentage of a portfolio to stablecoin is an effective way of reducing overall risk. Your portfolio as a whole will be more resilient to market price fluctuations and you will also have funds available should a good opportunity arise. You can also sell crypto for stablecoin during a market downturn and buy them again at a lower price (i.e. shorting). Stablecoins allow you to enter and exit positions comfortably, without having to take money out of the chain.
What are the disadvantages of stablecoin?
Despite their ability to support widespread cryptocurrency adoption, stablecoin still has limitations:
- There is no guarantee that stablecoin will maintain their connection. While some large projects have a good track record, there have also been many projects that have failed. When a stablecoin has ongoing problems maintaining its connection, it can lose value dramatically.
- Lack of transparency. Not all stablecoins publish full public audits and many only provide regular attestations. Private accountants perform these actions on behalf of stablecoin issuers.
- Stablecoins with additional fiat guarantees are usually more centralized than other cryptocurrencies. A central entity maintains the additional guarantee and may also be subject to external financial regulation. This gives it significant control over the currency. You also have to trust that the issuer has the reserves it claims to have.
- Crypto and non-additional guarantee currencies rely heavily on their community to operate. It is common to have open governance mechanisms in crypto projects, which means that users have a say in the development and operation of each project. Therefore, you need to engage or trust the developers and community to execute the project responsibly.
Examples of stablecoin
Crypto-backed stablecoin: MakerDAO (DAI)
DAI is a crypto-backed stablecoin that tracks USD on Ethereum. The MakerDAO community, which holds the MKR governance token, manages the coin. You can use MKR to create and vote on project change proposals. DAI has additional additional collateral to address crypto volatility, and users enter collateralized debt positions (CDPs), which manage their additional collateral. The whole process is executed through smart contracts.
Stablecoin supported by Fiat: TrueUSD (TUSD)
TUSD is an independently verifiable stablecoin linked to the dollar. It is the first stablecoin that programmatically verifies the creation with direct in-chain verification of USD reserves held outside the chain. TUSD reserves are tracked using Proof of Reserve Chainlink so that holders can autonomously verify that their TUSD is backed by USD held in reserves.
Are the stablecoin controlled?
Stablecoins have attracted the interest of regulators worldwide because of their unique mix of fiat and crypto. As they are designed to maintain a stable price, they are useful for purposes other than speculation. They can also facilitate high-speed international transactions at low cost. Some countries are even experimenting with creating their own stablecoin. As stablecoin is a type of cryptocurrency, it will likely fall under the same regulations as cryptos in your local jurisdiction. Issuing stablecoin with fiat reserves may also need regulatory approval.
What are stablecoins – Conclusions
It’s hard to find an investor these days who hasn’t held a stablecoin at some point. Stablecoins are often held on crypto exchanges so that investors can quickly capitalize on new market opportunities. They are also very useful for entering and exiting positions without having to cash out in fiat. In addition to trading and investing, stablecoins can be used for payments and international transfers.
Although they are an integral part of cryptos and have allowed the creation of a new financial system, the risks should not be underestimated. We have seen stablecoin projects with failed connections, non-existent reserves and problems with lawsuits. So while stablecoin are incredibly flexible tools, don’t forget that they are still cryptocurrencies and have similar risks. You can reduce the risks by diversifying your portfolio, but be sure to do your own research before investing or trading and don’t invest more than you can afford to lose.
