Cryptocurrencies that have their values tied to actual currencies, such as the U.S.D. are referred to as stablecoins. Part of the reason for developing them is as a response to price volatility inherent in traditional cryptocurrencies, like Bitcoin.
Price volatility limits the market value of cryptocurrencies when used as a form of payment. As a response to this, stablecoins were developed and issued first in 2014. Stablecoins have since gained traction. This is because they not only help to avert the said volatility, they also ensure the speed and security that blockchain offers.
Stablecoins are now central to developing decentralized finance (DeFi) products, where transactions need no middleman, like a bank or a broker. Tether and USD Coin, are among those ranking highest on the cryptocurrency market capitalizations.
The chances of encountering stablecoins in cryptocurrency dealings are very high. So it is key to know that stablecoins are not all created equal. Various methods are employed to keep them steady in values. Also, based on which you select, they carry different kinds of risks.
So, what are stablecoins? They are cryptocurrencies. However, the difference is that they are built to give more stability and speed. They are minted on the blockchain as digital currencies typically identifiable by collateral. A known fact is that cryptocurrencies are subject to market forces. For that reason, crypto ventures always look for how to reduce risk and optimize input in the overall crypto network. That led to the development of stablecoins.
How Stablecoins Work
Cryptocurrencies, even popular ones like Bitcoin (BTC) and Ether (ETH), generally suffer from (higher) volatility: their values are usually not certain for long. In higher volatility, prices swing rapidly over time either up or down; while in lower volatility, prices tend to be stable.
But the stablecoin cryptocurrency has a fixed value. In this case, unlike in normal crypto assets, the cryptocurrency value does not fluctuate often. In theory, stablecoins can be tied to nearly anything! So we have Stablecoins latched to multiple fiat coins, or to gold, or even to silver. The decider is how the coin organizer preserves the value of the currency.
Types Of Stablecoins
Because these stablecoins are backed by fiat currencies, they also maintain reserves in fiat currencies like the U.S.D. A dollar (cash or value) is kept in reserve for every fiat-backed stablecoin token in circulation. So an issuer with $5 million in fiat currency can only issue 5 million stablecoins. Tops in this category, going by market value, are:
- Tether (USDT)
- Gemini Dollar (GUSD)
- True USD (TUSD)
- Paxos Standard (PAX)
Central entities maintain stablecoin reserves. These central entities audit their funds on a regular basis. Too, they work with regulators so as to ensure they remain compliant. So, to buy stablecoins from issuers directly, you must go through checks like Know Your Customer (KYC) and Anti-Money Laundering (AML). This means they will collect your personal info, including a copy of your government-issued ID.
Crypto Collateral (On-Chain)
The name here makes it self-explanatory: “crypto-collateral” simply means another crypto serves as their collateral. The process happens on-chain, using smart contracts rather than a central issuer. Buying this stablecoin requires you locking your crypto into a smart contract so as to get tokens of equal value.
After a transaction, you put your stablecoin back into the same smart contract, after which you can withdraw your original collateral amount. These stablecoins are also usually over-collateralized. This is to cushion against price volatility in the required collateral asset. So, if you want to buy $1,000 worth of these stablecoins, for example, you would need to deposit $2,000 worth of assets, a 200% ratio of collateral.
Here, no fiat-backing or another crypto as collateral is needed. On the contrary, price stability here comes from using specialized algorithms as well as smart contracts which oversee the supply of tokens that are in circulation. So the algorithmic system keeps the price value stable.
If the market price falls lower than that of the fiat currency it tracks, the algorithmic system reduces the number of tokens in circulation. And if the token price rises above that of the fiat currency it tracks, the system also releases new tokens into circulation to lower the stablecoin value.
Here again, the name makes it self-explanatory: “commodity-backed” means they use physical assets as collateral, like precious metals, oil, real estate, etc. The most popular collateral commodity, though, is gold. And the two most liquid-gold backed stablecoins are Tether Gold (XAUT) and Paxos Gold (PAXG).
However, note that these commodities do fluctuate in price value and so have loss potentials. These stablecoins ease investments in assets that may be locally unreachable. For instance, buying and securely storing a gold bar is a really complex endeavor in many locations around the globe. So physically trading in such precious metals is usually unrealistic. But the commodity-backed stablecoins make such transactions possible.
Advantages Of Stablecoins
The first and most obvious advantage of this tech is its value as an exchange medium; it efficiently bridges the gap between fiat and crypto. They also minimize price volatility, as their name suggests, which makes them a great value store that encourages their everyday use in transactions. Further, this tech improves the kinesis of crypto assets in the entire ecosystem. Stablecoins look set to fast-track the integration of traditional financial markets with the DeFi industry.
Blockchain technology is relatively new and not many investors know a lot about it yet. Also, sometimes it is difficult to know the appropriate thing to do with changes in market conditions. If you fall into either or both of these categories, stablecoins may be the best place to keep your digital assets.
This is because cryptocurrencies get volatile quite often. This volatility gets so high sometimes that if you do not trade most carefully, you may lose big. So you must be adept at keeping a close eye on what goes on in the market. Or you must simply get very familiar with blockchain and all. Otherwise, heed this wise advice: stablecoins is where to keep your digital assets stable.