Cryptocurrencies are decentralized, and the transactions take place in the blockchain. The network does not recognize digitized fiat money. Hence it would be best to have a stable cryptocurrency to facilitate transactions, namely stablecoins.
Cryptocurrencies are not created equally, and not all guarantee a steady price. They are considered a volatile investment because of the price jumps and crashes. That is where stablecoins come in, and they are the only type of crypto that offer price stability.
Crypto projects pegged their value to the price of fiat money to fight volatility and increase participation in the community. It turned into a bridge between cryptocurrencies and everyday money, increasing the potential of stablecoins to store and trade value.
What Are Stablecoins?
Stablecoins are digital currencies pegged to the value of stable assets such as the U.S. dollars, euros, or gold, typically on a one-to-one basis.
On a one-to-one basis means that a pegged stablecoin should always equal one on the currency that backs them. For example, a stablecoin pegged to the U.S. dollar equals $1. The idea is that the price of stablecoins will remain stable in accordance with the currency that backs it, hence the name “stable.”
Stablecoins offer the benefits of cryptocurrencies but are designed not to fluctuate and reduce volatility. They are used as stores of value and units of account. Some stablecoins are centralized, whereas others are decentralized. They are flexible as they make borderless payments, with low transaction costs and self-custody.
Cryptocurrencies like Bitcoin and Ether offer many benefits, but their prices are unpredictable. It makes it hard for people to use it because their market value can rise and fall by billions daily. In addition, investors cannot rely on their value. They fear long-term transactions because their assets might be worth a house today, but tomorrow might be worth a chocolate bar.
Therefore, people want to feel secure and know how much their money is worth. Compared to high-volatility currencies like Bitcoin and Ether, stablecoins are the solution because they offer stability.
How Are Stablecoin Used?
Like cash, stablecoins are used as a store of value and a medium of exchange. They offer solutions to traders when the market is experiencing high volatility and can be used for yield farming, lending, and liquidity provision.
Two of the most adopted use cases are:
- Facilitating Crypto Trades – Traders use stablecoins to ease exchanges between cryptocurrencies. Traders may use stablecoins instead of selling crypto for cash and buying another cryptocurrency.
- Purchasing Goods And Services Over Blockchain – Buying digital goods or services in the blockchain network might be difficult using fluctuating cryptocurrencies. Stablecoins solve this issue by offering stability in their value.
With stablecoins, investors can move in and out of any cryptocurrency without leaving its realm. They can hold them without concern about the swings on their portfolio. At the same time, international bank transfers require currency conversions with other banks, including intermediaries. This process involves many steps, consumes more time, and charges fees. Stablecoin transfers challenge these banks because they are instant, with low to no fees.
Use Cases
Stablecoins are a promising asset and very practical for real-life uses. Some of the ways to use them for money and interest are:
- Store Value – Stablecoins can be used just like a bank account because their value is consistent.
- Trade Assets – You do not need a bank account to transfer stablecoins. They are easy to transfer anywhereworldwide, including places where the pegged currency is hard to obtain.
- Earn Interest – You can earn interest on stablecoins by lending them on different platforms. Usually, you can generate more money than a bank, but the risk is more significant. Decentralized Finance requires no intermediary, so the returns are high.
- Transfer At Low Cost – You can instantly transfer money in billions, with fees that are worth less than a dollar.
- International Transfers – Low fees and fast transactions mean you can send or receive money across borders. Stablecoins can be transferred and exchanged instantly without hassle.
Stablecoins Against Inflation
Traditional money is vulnerable to inflation, especially in developing countries. But currencies like the U.S. dollar or Euro are firmer to inflation. Hence coins that are pegged to them are a good hedge against inflation. It means their money maintains more of its value, so users have a way of escaping financial prosperity.
Richard Gardner – CEO of Modulus Global, says:
“Stablecoins also allow people from high inflation economies to store the value of their savings in an asset pegged to a more stable currency, like the U.S. dollar.”
Are Stablecoins Similar to Cash?
Stablecoins have similar characteristics to cash, but are not the same. You can convert stablecoins to money and vice versa, but you cannot use stablecoins for the same function as cash.
Similarities
Stablecoins are pegged to the value of a fiat currency, and their rate is fixed on a one-to-one basis. They maintain their pegged rates using cash and its equivalents, commodity values, financial instruments, or complex algorithmic programs (in rare cases). Moreover, they aim to maintain the same price no matter the fluctuations of the pegged currency. For example, a stablecoin worth $1 will keep that price no matter the changes in the U.S. dollar.
Differences
Decentralized stablecoins differ from fiat money, which central banks or governments issue. Any country’s currency can be used to convert fiat money, but if stablecoins do not have legal recognition as a form of payment, they cannot be utilized in that country.Furthermore, if the money pegged to the stablecoin does not back it, it might create a big deal and crash at a price less than what it is worth.
Source: Axi
Types of Stablecoin Collateral
Stablecoins use a variety of assets as backing, and they all have their mechanism. Different types of stablecoins include:
Fiat-Collateralized Stablecoins
This kind of money is the most popular collateral for stablecoins. The stablecoin is pegged with a fiat currency to ensure stability. One of the most common currencies that stablecoins use is the U.S. dollar. When the money price drops, stablecoins use reserves as a backup until the peg is restored. Independent custodians maintain and audit these reserves. Some of the most popular stablecoins backed by U.S. dollars are Tether and TrueUSD.
Metal-Backed Stablecoins
Some stablecoins are pegged to the value of precious metals such as silver and gold. Moreover, there are some other stablecoins that use commodities such as crude oil as collateral.
Crypto-Collateralized Stablecoins
Some stablecoins use cryptocurrencies as collateral. For example, ether uses the native token of the Ethereum network. Reserve cryptocurrencies can be highly volatile. Hence their reserves must surpass the stablecoin market cap, resulting in over-collateralization to maintain sound economic design. A $2 million cryptocurrency might be held as a reserve for a $1 million stablecoin, ensuring a 50% decline in the value of the cryptocurrency.
Algorithmic Stablecoins
These stablecoins use algorithms and economical design to back their value. They may or may not hold reserved assets. These stablecoins maintain market value through computer programs that run a preset formula. They are unproven and have a high risk. One of the biggest algorithmic stablecoins is TerraUSD.
Other Investments
For example, Tether used to be backed one-for-one with the U.S. dollar, but over time its collateral shifted. Almost half of their reserves are in commercial paper, and all rated a-two or higher Circles’ USDC.
Most Popular Stablecoins
Some of the most popular stablecoins are:
Tether (USDT)
Tether launched in 2014; since then, it has been the most popular and oldest stablecoin. It is ranked the largest, with around $65 billion in market capitalization. Tether is pegged by the U.S. dollar and backed by gold reserves. It has a record for the most global transactions, making it the most liquid stablecoin. Tether is backed one-to-one, but there have been accusations that this is not true.
USD Coin (USDC)
As you can tell by its name, USD Coin is pegged to the value of the U.S. dollar on a one-to-one basis. In 2018, the cryptocurrency firms Circle and Coinbase launched this stablecoin jointly through the Centre Consortium. USDC has an open-source protocol, meaning any individual or firm can use it to develop their products.
Binance USD (BUSD)
Binance USS is a fiat-backed stablecoin. It is ranked third by market capitalization at $17.5 billion. It was initiated by crypto exchange platforms Binance and Paxos. The New York State Department of Financial Services approves BUSD and the U.S. dollar backs its value on a one-to-one basis.
Dai (DAI)
Dai was launched in 2017 by MarkerDao on the Ethereum blockchain. This stablecoin is cryptocurrency-backed. It uses ether as backing on Ethereum’s platform, whereas ether ties its value with the U.S. dollar. Ether is intended to be decentralized, with no authority to control the system. It uses smart contracts and other incentives to maintain its pegg and encode the rules. Even though it is decentralized, DAI can be widely used.
TrueUSD (TUSD)
TrueUSD is a stablecoin on the Ethereum blockchain and backed by fiat money. TUSD has a one-to-one ratio with the U.S. dollar. TUSD lovers can mint and purchase tokens on the TrustUSD official website.
Why Are Stablecoins Important?
Stablecoins offer stability to buyers and sellers. Cryptocurrencies are volatile, and this is risky for traders. In the long run, the assets invested in cryptocurrencies might be worth two chocolate bars, and no investor wants to experience such a loss. At the same time, stablecoins offer more assurance to traders and investors because the prices do not fall. Some important features are:
- Stablecoins are available 24/7 to anyone on the Internet.
- They are open and global.
- They are fast, cheap, and programmable.
- They offer security.
- They are native to the digitized world of the Internet.
Do Stablecoins Have Any Drawbacks?
Stablecoins seem like the best solution for the new emerging financial system. However, they have a few disadvantages that are different from those of cryptocurrencies.
- Depegging – Stablecoins are pegged to fiat money, and aim to keep a constant value on ratio. In cases when the intended value falls, we refer to those stablecoins as depegged.
- Regulatory Risks – Although stablecoins are pegged to fiat money, they are still decentralized assets. And just like other decentralized assets, stablecoins are susceptible to regulatory risks.
- Lack Of Transparency – It is difficult to know if other secure assets peg stablecoins unless they show proof. A lack of oversight in this matter might collapse stablecoins and affect the entire market.
- Intermediaries – Stablecoin has added this new option to stop transactions back into the mix when the coins are being used illegally. A case happened in 2020 when Circle froze $100,000 of stablecoins on behalf of law enforcement.
- Relatively Stable – Stablecoins are not 100% stable. At times, coins have fallen as low as $0.51 on some exchanges. This fall in value makes stablecoins “relatively stable,” not “absolutely stable.”
The Future of Stablecoins
Stablecoins play an important role in the new financial economy. Since the crypto explosion in 2017, investors have been trying safe ways to experiment with technology, including stablecoins. In June 2020, the supply of stablecoins hit $11 billion. Now even the regulators are in support of stablecoin, and they are advising national banks and associations to hold reserves for stablecoin issuers.
Takeaways
- Stablecoins are digital currencies pegged to the value of stable assets on a one-to-one basis.
- They are designed not to fluctuate and reduce volatility and are used as stores of value, units of account, and a medium of exchange.
- They are used to facilitate crypto trades, purchase goods and services over blockchain, and store the value of savings in an asset pegged to a more stable currency.
- International bank transactions require currency conversions with other banks, but stablecoin transfers are instant, with low to no fees.
- Stablecoins are promising and practical assets for real-life users, such as trading assets, earning interest, transferring at low cost, transfer internationally, and avoiding inflation.
- They are similar to cash but not the same because stablecoins are decentralized, whereas central banks or governments issue money.
- They maintain their pegged rates using cash and its equivalents, commodity values, financial instruments, or complex algorithmic programs.
- Stablecoins use a variety of assets as backing, including fiat-collateralized stablecoins, metal-backed stablecoins, crypto-collateralized stablecoins, algorithmic stablecoins, and other investments.
- The most popular stablecoins are Tether, USD Coin, Binance USD, DAI, and TrueUSD.
- Stablecoins offer stability and security to buyers and sellers, as they are available 24/7, open, global, cheap, fast, programable, and native to the Internet.
- Stablecoins are a promising solution to the emerging financial system, but they have drawbacks such as depegging, regulatory risks, lack of transparency, intermediaries, and relative stability.
- They play an important role in the new financial economy, with the supply of stablecoins hitting $11 billion in June 2020.
- Regulators support stablecoin and advise national banks and associations to hold reserves for stablecoin issuers.
