Stablecoins A Risk-Free Cryptocurrency Investment Option. Some cryptocurrencies, known as stablecoins, aim to provide price stability to investors by being backed by physical assets or by utilizing algorithms to alter supply in response to demand dynamically. Due to stablecoins’ ability to provide the speed and security of a blockchain without the inherent volatility of cryptocurrencies, their popularity has skyrocketed since their 2014 debut.
For exchanges that didn’t provide trading pairs with fiat currencies, stablecoins were the go-to way to purchase cryptocurrency. Money printed by the government and not backed by physical assets like gold or silver is called fiat currency. The widespread use of stablecoins has incorporated them into various blockchain-based financial services, including loan systems and e-commerce platforms. A stablecoin is a digital currency that is built on the blockchain. It is programmable and can communicate with other digital currencies, apps, and smart contracts.
Understanding stablecoins
Bitcoin (BTC) ($63,216) and Ether (ETH) ($3,164) have many ups and downs. Volatility measures an asset’s price unpredictability. The price of an asset is highly steady when its volatility is low, but it might fluctuate greatly when it’s high. An asset’s percentage change in points (pips) may indicate its daily return volatility. Even the most popular cryptocurrencies can fluctuate by more than 10% in unpredictable markets, making them challenging to swap. Buying and selling goods and services makes an asset a means of exchange.
It can be used as money if it retains value, values goods and services, and facilitates commerce. It can also be a unit of account and medium of exchange. Stablecoin technology’s most significant benefit is its ability to convert fiat currency to cryptocurrency. Because they are less volatile, stablecoins can serve a different purpose than typical cryptocurrencies.
Due to their stability, stablecoins are becoming more popular as a store of wealth and means of exchange. Stablecoins increase crypto asset mobility throughout the ecosystem. Stablecoin and fiat currency owners can expect short-term price stability. Blockchain-based stablecoins distinguish themselves. Gold or fiat currencies like the US dollar underpin most stablecoins. A stablecoin that tracks the US dollar should always be worth $1 due to its pegged status.
There are several ways to secure this peg. Most stablecoins use asset backing, which is the ratio of stablecoin token supply to asset value. For a stablecoin to be “backed,” it must have assets worth the same amount as its circulation. Stablecoins backed by US dollars will remain valuable as long as they can be exchanged. However, traders seeking to profit from market price differences would intervene to close the gap if it swings significantly.
What are Stablecoins Used for?
Stablecoin holders can take advantage of many chances because it is based on the blockchain. As a fiat currency substitute on exchanges, the early stablecoins provided investors with a refuge from the unpredictability of other digital assets. One new usage for stablecoins in the decentralized finance (DeFi) sector is the ability to borrow cryptocurrency-backed loans at interest rates that outstrip conventional savings accounts. No government-backed protection is offered by stablecoin services, even though stablecoins may generate better returns than traditional savings products.
Several blockchain networks have released stablecoins, which are popular in the decentralized finance (DeFi) industry and on exchanges. Decentralized exchanges (DEXs) and other applications can be created on top of blockchain networks that support smart contracts. Direct trades between users take place on decentralized exchanges.
Stablecoins also make it easier to send money across borders. Thus, they can be used to pay salaries in cryptocurrency. The transaction fee is the only cost associated with transferring money on the blockchain. Additionally, blockchain settlement of international transactions is quicker, lasting from a few seconds to an hour (depending on many conditions). Among these considerations are the fees paid, the intricacy of the transaction, the kind of network being utilized, and the possibility of network congestion. However, settling international transactions through the conventional banking system may take days. Stablecoins allow investors to keep their money on the blockchain with less risk than other cryptocurrencies, which have no fixed price and can fluctuate greatly.
How Stablecoins Remain Stable
Regulating bodies such as central banks take measures to keep the value of government-issued fiat currencies constant. Actual commodities like gold back some stablecoins, while others are supported by algorithms or even fiat currencies issued by governments.
Stablecoins pool their resources with fiat currencies backed by the government, like the dollar, to benefit from these institutions’ security. Stablecoin reserves can be “monetized” by investing part of their value in short-term corporate debt or government-backed debt obligations, both of which provide stable income and guarantee that the assets will be redeemable in the event of a crisis. Several fundamental techniques are detailed below to ensure that stablecoins remain stable. These include fiat, crypto, commodity, and algorithm backing.
Fiat-backed stablecoins
To keep their value stable, stablecoins backed by fiat currencies have reserves of fiat currencies such as the dollar. It is common practice for fiat-backed stablecoins to have $1 in reserve for every token in circulation. Centralized companies keep track of stablecoin reserves, audit those funds regularly, and collaborate with authorities to ensure those holding stablecoin reserves follow the rules. Stablecoins purchased directly from issuers will be subject to the same Know Your Customer (KYC) and Anti-Money Laundering (AML) procedures used by exchanges. A copy of the user’s government-issued identification document is one piece of personal information collected during these operations.
Once stablecoins are in circulation, anyone can send and receive them, but their central authority can freeze payments at specific addresses. Stablecoins have been frozen in the past for various reasons, such as helping law enforcement with investigations or trying to recover stolen assets.
Cryptocurrency-backed stablecoins
Stablecoins backed by other cryptocurrencies are known as cryptocurrency-backed tokens. These tokens might follow the value of the underlying cryptocurrency or fiat currency. With the help of a crypto-backed stablecoin, one asset can be launched on a different blockchain. For example, the Ethereum blockchain supports Wrapped Bitcoin (WBTC), a stablecoin that Bitcoin backs.
On the other hand, stablecoins backed by cryptocurrencies can mimic the value of fiat currencies by using blockchain balancing mechanisms to keep their prices stable. To ensure stablecoins can hold their value even when the market is very volatile, they are overcollateralized in certain instances. The assets supporting a stablecoin must be worth more than the value of the stablecoins in circulation for it to be considered overcollateralized. As an illustration, a stablecoin backed by cryptocurrency may have $500 in value and $1,000 in Ether kept in reserve as collateral. Regular audits and monitoring technologies maintain stablecoin prices. Automated intelligent contracts to construct cryptocurrency-backed stablecoins eliminate the need for a central authority, making them a more decentralized alternative to fiat-backed stablecoins.
Commodity-backed stablecoins
Simply put, commodity-backed stablecoins are digital currencies pegged to physical commodities through the reserves of a central bank or other governing body. Tangible assets like oil, real estate, precious metals, and other physical assets back stablecoins supported by commodities. One commodity that is collateralized more often than any other is gold. Market conditions might affect commodity prices, so bear that in mind.
Using commodity-backed stablecoins facilitates investment in assets inaccessible to local investors. In many parts of the world, for instance, getting a gold bar and finding a safe place to keep it is complex and costly. This means physical assets like gold and silver aren’t a good choice. Those looking to convert tokens to fiat currency or acquire physical ownership of the tokenized asset can also benefit from commodity-backed stablecoins.
Algorithmic or hybrid stablecoins
Stablecoins that use complicated algorithms to balance supply and demand with funds held on the blockchain through smart contracts are known as algorithmic or hybrid stablecoins. This allows them to keep their prices stable. The algorithmic stablecoins protect their currency’s market peg like natural central banks. When the stablecoin price rises above its peg, they purchase assets; when it falls below, they sell them.
Due to a lack of over-collateralization, the market volatility for some algorithmic stablecoins spikes during unexpected events, causing them to lose their peg. When the value of a stablecoin drops below that of a fiat currency, an algorithm will reduce the supply of tokens in circulation. On the other hand, additional tokens are issued to lower the stablecoin’s value if its price rises above the value of the fiat currency it represents.
Non-collateralized or seigniorage-style stablecoins
Similar to algorithmically-backed stablecoins, non-collateralized or seigniorage-style stablecoins operate without smart contract reserves. On the other hand, seigniorage-style stablecoins use intricate mechanisms to dynamically alter the amount of coins in circulation according to market demand and supply.
Stablecoins not collateralized that follow the seigniorage model deplete and inflate the on-chain supply to keep their value fixed. Because these stablecoins are self-collateralized, no collateral is required to mint them. Take stablecoin A as an example; suppose its value is $1.00. The price has dropped to $0.70, indicating that the demand for stablecoins exceeds supply. The algorithm reduces supply by purchasing stablecoin A with seigniorage and restores the price to $1.00.
Seigniorage shares are issued when there aren’t enough profits to purchase additional coin supply and the price stays below $1.00. The increase in the supply of non-collateralized stablecoins directly results from user investments. On the other hand, stablecoins have an algorithm that increases supply by generating more tokens whenever their price goes above $1.00. This process continues until the price drops below $1.00. What we call “seigniorage” are the earnings.
Advantages of Stablecoins
There are several advantages to using stablecoins instead of fiat money or other cryptocurrencies. Among their advantages is that they connect fiat currencies to the blockchain, making them more transparent and secure alternatives that work with blockchain apps. You can use stablecoins as money, and they’re cheaper to send and receive than fiat currencies. Plus, a network of apps accepts them, and they have better returns than regular savings accounts. Stablecoin holders have additional options on blockchain-based apps, such as insured crypto assets or loans collateralized by their coins.
Because of their high liquidity and widespread acceptance on trading platforms, stablecoins facilitate cheaper and faster cross-border payments and are easily exchangeable for fiat currencies. Precious metals and other commodities can be easily stored, divided, and transacted through commodity-backed stablecoins, which keep their value constant. Stablecoins allow the use of gold as a medium of exchange and the possibility of lending it out with interest.
Disadvantages of Stablecoins
One major drawback of stablecoins is the counterparty risk they pose. One default risk is that another party to an agreement may also default. Stablecoin issuers can lie about their reserves or refuse to exchange tokens for them. Because audits can miss inaccuracies or possible issues, stablecoins depend on central entities, and auditors are vulnerable to human error. Additionally, stablecoins backed by fiat currencies are frequently held in commercial paper, an unsecured form of short-term debt. The counterparty risk is increased when commercial paper is used because the issuing company risks defaulting on its obligations.
Risk premiums can also result from periods of market volatility or audit failure. A risk premium is the extra money investors get in exchange for taking a chance on an asset (like stablecoins). Due to risk premiums, stablecoins are worth less than their peg, making them slightly more expensive than fiat currencies for cryptocurrency purchases. Algorithmic stablecoins often lead to Ponzi schemes, where new users invest collateral to create tokens. The Ponzi scheme, which uses others’ money to pay investors, is fraud. It falls apart when the original investors stop putting money into the scheme. As a result, if traffic from new users suddenly drops, the value of these assets could collapse.
Lastly, central entities that issue tokens might be able to freeze their value on specific addresses when requested by the authorities. According to law enforcement agencies, tokens may still be frozen if investigations into money laundering, counter-terrorism funding, or any other illegal activity are underway.
