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What is a stablecoin in cryptocurrency?

What is a stablecoin in cryptocurrency?

Stablecoins are digital assets that track the value of fiat currencies or other assets. For example, you can purchase tokens pegged to the dollar, euro, yen, and even gold and oil. A stablecoin allows the holder to lock in profits and losses and transfer value at a stable price on peer-to-peer blockchain networks.

Bitcoin (BTC), Ether (ETH), and other altcoins have always historically been volatile. While this provides many opportunities for speculation, it does have drawbacks. Volatility makes it challenging to use cryptocurrencies for day-to-day payments. For example, merchants may take $5 in BTC for a coffee one day but find their BTC worth 50% less the next. This makes it challenging to plan and operate a business around.

Before, crypto investors and traders had no way to lock in a profit or avoid volatility without converting crypto back into fiat. The creation of stablecoins provided a simple solution to these two issues. Today, you can easily get in and out of crypto volatility using stablecoins like USDT.

How do stablecoins work?

Creating a coin that tracks another commodity’s price or value requires a pegging mechanism. There are multiple ways to do this, and most rely on another asset acting as collateral. Some methods have proved more successful than others, but there is still no such thing as a guaranteed peg.

Stable Coin Categories

There are 4 main categories of stablecoins.

Fiat-backed Stablecoins

The most common type of stablecoin is one that’s secured or backed by a fiat currency collateral such as USD, EUR, or GBP.

Fiat-backed stablecoins are backed at a 1:1 ratio, meaning that 1 stablecoin is equal to 1 unit of currency (e.g., $1). Therefore, for each stablecoin that exists, there is real legal tender in a bank account to back it. When someone wants to exchange their coins for cash, the entity managing the stablecoin will take the legal amount from their reserves and send it to that person's bank account. The equivalent stablecoin is then destroyed or taken out of circulation.

A fiat-collateralized stablecoin is the simplest structure that a stablecoin can have, and simplicity has a big advantage. It is easy to understand for newcomers to cryptocurrencies, and this can help inspire a wider adoption of this new technology. As long as the country's economy remains stable, it is guaranteed that the value of the coin will not fluctuate as well. This means that even if the entire cryptocurrency economy collapses and Bitcoin drops to $0, it will not affect the fiat-backed stablecoin.

The most popular stablecoin is Tether (USDT), which is currently the 9th largest cryptocurrency by market cap and has the highest daily trading volume of any cryptocurrency after Bitcoin.

However, Tether has been surrounded by a lot of controversies lately. As the company has yet to agree to release a transparent audit, suspicions have emerged that Tether has issued more USDT than its actual USD reserves can back.

For this reason, many new fiat-backed stablecoins have been on the rise, trying to take Tether's throne.

TrueUSD (TUSD), for example, is currently the second most popular stablecoin and can be exchanged for USD at 1:1. TrueUSD never actually touches your money - instead, it enables users to exchange USD directly with an escrow account, providing token holders with full legal protection and the assurance that their TUSD is fully backed by U.S. dollars.

In the UK, the London Stock Exchange released LBXPeg, the first cryptocurrency to be pegged to the value of the British pound. There is even a stable coin in Mongolia called Candy, backed by Mongolian Tugrik.

Earlier this year, crypto-finance company Circle announced the release of the US Dollar Coin (USDC) backed by the U.S. dollar. USDC is accepted by various exchanges, including Coinbase, Poloniex, and Bit-Z.

In September 2018, the New York State Department of Financial Services approved and regulated two U.S. dollar-backed stablecoins. Paxos Standard (PAX) and Gemini Dollar (GUSD) became the first and second regulated cryptocurrencies in the world.

Commodity-backed Stablecoins

Commodity-backed stablecoins are backed by other types of fungible assets, such as precious metals. The most common type of collateral is gold. Of course, there is also oil, real estate, and various baskets of precious metals backing stable commodities.

Holders of commodity-backed stablecoins essentially hold tangible assets that have real value - something that most cryptocurrencies do not have. Over time, these commodities may even appreciate in value, which increases the incentive to hold and use these currencies.

In the case of commodity-backed stablecoins, anyone in the world could conceivably invest in precious metals such as gold, or even real estate in Switzerland. Such assets are generally reserved only for the wealthy, but stable money opens up new investment opportunities for ordinary people around the world.

Digix Gold (DGX), for example, is an ERC-20 token (built on the Ether network) backed by physical gold, where 1 DGX represents 1 gram of gold. This gold is stored in a vault in Singapore and is audited every 3 months to ensure transparency. The creators of DGX claim that they “have obtained the democratization of gold." DGX holders can even redeem physical gold bars, they just need to go to the vault in Singapore to do so.

Tiberius Coin (TCX) is not a commodity, but a combination of seven precious metals commonly used in technical hardware. The idea is that the value of TCX coins will rise as these metals are increasingly used to make technologies like solar panels and electric cars.

SwissRealCoin (SRC) is another example, backed by a portfolio of Swiss real estate investments. Token holders can even democratically vote to choose their investments.

Crypto-backed Stablecoins

This category is for stablecoins backed by other cryptocurrencies.

This makes crypto-backed stablecoins more decentralized than their fiat-backed counterparts, as everything is done on the blockchain. To reduce the risk of price fluctuations, these stablecoins are usually overcollateralized so they can absorb price fluctuations in the collateral.

For example, to get $500 worth of stablecoins, you would need to deposit $1,000 worth of Ether (ETH). In this case, the stablecoin is now 200% collateralized and can withstand a 25% price drop. This still means that $500 worth of stablecoin is worth $750 of ETH.

If the price of the underlying asset cryptocurrency drops to a certain level, the stablecoin will be automatically liquidated.

Because crypto-collateralized stablecoin is decentralized, it has a more reliable, secure, and completely transparent transaction process. This is because no single party can control your funds. In addition, they are usually backed by multiple cryptocurrencies to spread the risk. Crypto-backed stablecoins also enjoy superior liquidity, which means they can be converted to their underlying assets quickly and inexpensively.

Crypto-backed stablecoins are the most complex form of stablecoin, which has led to them not gaining enough traction in the market as they are a problem in their own right. The most popular and promising cryptocurrency-backed stablecoin at the moment is Dai.

Created by MakerDAO, Dai is a stablecoin whose face value is pegged to the US dollar but is actually backed by smart contract-locked ETH.

Uncollateralized Stablecoins

Nothing is backed by a non-collateralized stablecoin, which seems paradoxical considering the existence of stablecoins.

The dollar used to be backed by gold (the Bretton Woods system mandated that $35 could be exchanged for 1 ounce of gold and the rest of the currency was pegged to the dollar), but that ended decades ago and now the dollar remains stable because people believe in its value. The same idea can be migrated to unsecured stable coins.

These types of coins use an algorithmically controlled method to control the supply of stablecoins. This is a model called seigniorage stocks.

As demand increases, new stablecoins are created to bring the price down to normal levels. If coins are traded too low, then the market is bought out to reduce the number of coins in circulation. Theoretically, the value of these stabilized prices will remain stable, driven by market supply and demand.

This is the most decentralized and independent form of stablecoin because it is not collateralized by any other asset. This means that this form of stablecoin can survive and remain stable even if the US dollar and the crypto market as a whole collapse.

However, non-collateralized stablecoins need to continue to grow in order to be successful. In the event of a crash, there is no collateral to guarantee the value of the stablecoin and the market ends up in shambles.

An example of an uncollateralized stablecoin is Basis, which adjusts its supply algorithmically to keep its price stable. It describes itself as a “stable cryptocurrency with an algorithmic central bank."

What are the advantages of stablecoins?

Stablecoins are versatile and powerful tools for investors, traders, and cryptocurrency users. Their main strengths include the fact that:

1. Stablecoins can be used for day-to-day payments. Shops, businesses, and individuals value stability. Due to high volatility, cryptocurrencies haven’t achieved widespread use for payment processing. Large stablecoins have a track record of maintaining their peg, making them fairly trustworthy and suitable for daily use.

2. Stablecoins have the benefits of being blockchain-based. You can send a stablecoin to anyone globally 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 qualities, and more, make stablecoins incredibly versatile.

3. Stablecoins can be used by traders and investors to hedge their portfolios. Allocating a certain percentage of a portfolio to stabilized coins is an effective way to reduce overall risk. Your portfolio as a whole will be more resistant to market price swings, and you will also have funds on hand in case a good opportunity shows up. You can also sell crypto for stablecoins during a market downturn and repurchase them at a lower price (i.e., shorting). Stablecoins allow you to enter and exit positions conveniently, without the need to take money off-chain.

What are the disadvantages of stablecoins?

Despite their potential to support widespread cryptocurrency adoption, stablecoins still have limitations:

1. Stablecoin aren’t guaranteed to maintain their peg. While some large projects have a good track record, there have also been many projects that have failed. When a stablecoin has constant issues maintaining its peg, it can dramatically lose all its value.

2. Lack of transparency. Both Tether (USDT) and USD Coin (USDC) have yet to release full public audits, and most large stablecoins provide only regular attestations. Private accountants carry these out on behalf of the stablecoin issuers.

3. Fiat-collateralized stablecoins are usually more centralized than other cryptocurrencies. A central entity holds the collateral and may also be subject to external financial regulation. This gives them significant control over the coin. You also need to trust that the issuer has the reserves they claim.

4. Crypto-collateralized and uncollateralized coins rely heavily on their community to function. It’s common to have open governance mechanisms in crypto projects, meaning that users get a say in the development and running of each project. As such, you need to get involved or trust the developers and community to run the project responsibly.

Stablecoin use cases

Quick access to market stability

If the price of Bitcoin or other crypto assets is falling fast, you’re able to trade quickly to USDT instead of trying to cash out.

Easily move funds between exchanges

With Tether, you’re able to move your funds between exchanges very quickly. This can also be useful for arbitrage trading with other coins.

Trade on crypto-only exchanges

Some exchanges do not have facilities for fiat deposit and withdrawal but do allow USDT trading. By obtaining Tether first, you’re able to trade on these exchanges without worrying about the market volatility of placing your main trading funds in BTC (or other cryptos).

Forex-style trading

Since USDT is pegged to the USD, you can do Forex-style trading by exchanging local (non-US) currencies into USDT when their value is high against the USD. You can then cash out to local currencies when the local currency drops or exchange for other assets.

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