Stablecoins are digital assets (cryptocurrencies) that track the value of fiat currencies or other assets. For example, we can buy tokens pegged to the dollar, euro, yen, gold, or oil. A stablecoin allows its holder to consolidate profit and loss and transfer value at a stable price across peer-to-peer blockchain networks.
Cryptocurrencies are not just about volatility. Stablecoins are cryptocurrencies specifically designed to maintain a fixed price. In an industry where coins and tokens can collapse overnight, there is a huge demand for coins that combine the benefits of blockchain technology with the ability to peg them to more stable assets. For those who are not yet using stablecoins for trading or investing, it is worth learning more about them, as well as their advantages and disadvantages.
What is a Stablecoin?
Historically, Bitcoin (BTC), Ether (ETH), and other altcoins have always been considerably volatile. While this offers many opportunities for speculation, it also has some disadvantages as volatility makes it difficult to use cryptocurrencies for everyday payments.
For example, a trader might accept $5 worth of BTC for a coffee, but find that their BTC is worth 50% less the next day. For certain businesses, this makes planning and operating with cryptocurrencies difficult.
Until now, to consolidate profits or avoid volatility, cryptocurrency investors and traders had no choice but to convert their cryptocurrencies back into fiat currency; but the creation of stablecoins provided a simple solution to these two problems. Today, we can easily enter and exit the volatile cryptocurrency market using stablecoins like BUSD or USDC.
To create a currency whose value tracks the price or value of another asset, a so-called “ pegging ” mechanism is needed. There are several ways to do this and most rely on another asset acting as collateral. Some methods have proven to be more efficient than others, but there is still no 100% guaranteed linkage mechanism.
Here Are the Main Types Of Stablecoins:
Stablecoins Pegged to Fiat Currencies
A fiat-backed stablecoin holds a reserve of the respective currency, such as USD, EUR, or GBP. For example, each existing BUSD is pegged to one US dollar (USD) in reserve held as collateral. Users can convert fiat currency to stablecoin and vice versa, in proportion to their peg. If the relationship between the prices of the token and the underlying fiat currency deviates, arbitrage traders will quickly cause the defined peg value to be re-established.
Let’s assume that the BUSD is trading for more than one dollar. Arbitrage traders convert dollars (USD) into BUSD and sell them, making a profit. This increases the BUSD sell offer and lowers the price to one dollar again. If BUSD trades below one dollar, traders buy BUSD and convert it to USD. As a result, the demand for BUSD grows and its price rises again to one dollar.
Cryptocurrency-pegged stablecoins work similarly to fiat-pegged stablecoins. However, instead of using dollars or another currency as a reserve, it is cryptocurrencies that act as collateral. As the cryptocurrency market is highly volatile, stablecoins pegged to cryptocurrencies often have their reserves overcollateralized as a measure of protection against price swings.
Cryptocurrency-pegged stablecoins use smart contracts to manage the issuance and “burn” processes. This increases reliability as everyone can independently audit contracts. However, some cryptocurrency-linked stablecoins are managed by Decentralized Autonomous Organizations (DAOs), where the community can vote for changes to the project. In that case, we should either get involved with the project or simply trust DAO’s decisions.
Algorithmic stablecoins take a different approach, eliminating the need for reserves. Instead, algorithms and smart contracts manage the supply of issued tokens, similar to the monetary policy of a central bank. This model is much rarer than stablecoins linked to cryptocurrencies or fiat currencies and its implementation is more complicated.
An algorithmic stablecoin system will reduce the supply of the token when the price drops below the value of the fiat currency to which it is pegged. This can be done through blocked staking, burning, or buy-backs. If the price exceeds the value of the fiat currency, new tokens come into circulation to reduce the value of the stablecoin.
What are the Advantages of Stablecoins?
Stablecoins offer a versatile and powerful tool for investors, traders, and cryptocurrency users. And, like everything that has to do with investments, they have advantages as well as disadvantages. Its main advantages are:
- Stablecoins can be used for daily payments. Stability is something that stores, businesses, and individuals value. Due to volatility, cryptocurrencies are not widely used for payment processing. Large stablecoins have a reliable track record in terms of holding their value, making them quite safe and suitable for everyday use.
- Stablecoins have the benefits of being based on blockchains. It is possible to send stablecoins to anyone who has a cryptocurrency wallet (which can be created for free and within seconds). In addition, double spending or false transactions are virtually impossible. All these qualities make stablecoins incredibly versatile.
- Stablecoins can be used by traders and investors to protect their portfolios (hedge). Allocating a percentage of a portfolio to stablecoins is an effective way to reduce risk. Our portfolio as a whole will be more resistant to market price fluctuations and we will also have funds on hand if a good opportunity arises. In a period of a market downturn, we can also sell cryptocurrencies for stablecoins and buy them back at a lower price ( shorting ). Stablecoins allow you to conveniently enter and exit positions without having to withdraw your funds from the blockchain.
Despite their potential to spur the general adoption of cryptocurrencies, stablecoins still have some limitations:
- There is no guarantee that a stablecoin will keep its value pegged. While some great projects have a great track record, there have also been projects that have failed. When a stablecoin has constant problems maintaining its pegged value, it can lose all of its value.
- Lack of transparency. Both Tether (USDT) and USD Coin (USDC) have yet to release full public audits and most major stablecoins only provide a few regular attestations. Private accountants act on behalf of stablecoin issuers.
- Fiat-collateralized stablecoins are generally more centralized than other cryptocurrencies. A central entity is responsible for the cryptocurrency and holds the collateral value. It may also be subject to external financial regulation. This gives you significant control over the stablecoin. In addition, the trust that the issuer owns the disclosed reserves must be trusted.
- Crypto-collateralized and non-collateralized currencies rely heavily on their community to function. Open governance mechanisms are common in crypto projects. In other words, users influence the development and execution of each project. So, we either get involved directly or we simply have to trust the developers and the community to manage the project responsibly.
Stablecoin Use Cases
Let’s take a closer look at two popular stablecoins on the market: BUSD and DAI.
Binance USD (BUSD) is a dollar-pegged (USD) stablecoin created by the partnership between Paxos and Binance. The New York State Department of Financial Services (NYSDFS) regulates BUSD and regular attestations confirm that fiduciary reserves equal the supply of BUSD on the market. On the Paxos website, it is possible to issue new BUSD or burn BUSD for the underlying collateral value. This mechanism allows arbitrage traders to keep the BUSD pegged value.
On the other hand, DAI is one of the most famous cryptocurrency-linked stablecoins that tracks the value of USD on the Ethereum blockchain. The coin is managed by the MakerDAO community, which owns the MKR governance token. We can use the MKR token to create and vote on proposed project changes.
The DAI token is overcollateralized to handle cryptocurrency volatility and users enter Collateralized Debt Positions (CDPs) that manage their collateral value. The entire process runs through smart contracts.
Are Stablecoins Regulated?
Due to their unique ability to combine fiat and cryptocurrencies, stablecoins have attracted interest from regulatory bodies across the world. Because they maintain a stable price, they are useful for reasons other than speculation. In addition, they can also be transferred internationally quickly and cheaply.
Some argue that stablecoins can act as competitors to fiat currencies, even though they cannot be directly controlled by a country’s central bank. To prevent this possible competition, some countries have already tried to create their stablecoins.
As a stablecoin is a type of cryptocurrency, it will likely operate under the same regulatory parameters as cryptocurrencies in your local jurisdiction. Issuing stablecoins with fiat reserves may also need regulatory approval.
It is currently difficult to find an investor or trader who does not have or does not use stablecoins. Usually, traders store stablecoins on cryptocurrency exchanges (exchanges) so they can quickly capitalize on new market opportunities.
As mentioned earlier, they are also very useful for entering and exiting positions without having to withdraw fiat currencies. In addition to trading and investing, they are used for payments, international transfers, or passive income generation through staking in the Defi ecosystem.
Read More: 21 Best Cryptocurrencies To Invest