What Are Stablecoins?

22 June 2023

7m read


Not all cryptocurrencies are volatile. In actuality, stablecoins are made precisely to keep a set price. There is a huge market for currencies that combine the advantages of blockchain technology with the ability to track a more stable asset in a sector where coins and tokens can crash overnight. It's worthwhile to understand more about stablecoins, including their advantages and disadvantages, if you haven't already started using them for trading or investment.

Crypto Stablecoin

Digital assets known as stablecoins follow the value of fiat money or other assets. For instance, you may buy tokens backed by the dollar, euro, yen, gold, and even oil. On peer-to-peer blockchain networks, a stablecoin enables the holder to lock in profits and losses and transfer value at a stable price.

The past volatility of Ether (ETH) and other altcoins is well known. This offers a lot of room for speculation, but there are negatives as well. It is difficult to use cryptocurrency for daily transactions due to volatility. As an illustration, businesses might accept $5 in ETH for a coffee one day but if ETH is suddenly worth 50% less the following day, it makes it difficult to organize and run a company that accepts cryptocurrency payments.

Before, traders and investors in cryptocurrencies lacked a means of locking in profits or avoiding volatility without first turning their holdings into cash. These problems were easily fixed with the development of stablecoins. Today, stablecoins like TrueUSD (TUSD) make it simple to enter and exit the volatile cryptocurrency market.

How Stablecoins Function

A pegging mechanism is necessary to make a coin that tracks the cost or value of another asset. There are several ways to do this, and the most depend on using another asset as collateral. Although certain techniques have been more effective than others, a guaranteed peg still does not exist.

Pegged or Fiat-Backed Stablecoins

A fiat-backed stablecoin maintains reserves of a fiat currency, like the USD or the GBP. For instance, $1 in collateral is retained for each TUSD. At the pegged rate, users can then convert their fiat to a stablecoin and vice versa.

Crypto-Backed Stablecoins

Stablecoins backed by crypto operate similarly to stablecoins backed by currency. But we now have cryptocurrencies that serve as collateral rather than using dollars or another currency as a reserve. Due to the significant volatility of the cryptocurrency market, crypto-backed stablecoins typically over-collateralize the reserves to protect against price fluctuations.

Smart contracts are used by cryptocurrency-backed stablecoins to control minting and burning. As a result, users can independently audit the contracts, increasing the process's reliability. Though some cryptocurrency-backed stablecoins are managed through Decentralized Autonomous Organizations (DAOs), which allow the public to vote on project improvements. You have two options in this scenario: get engaged, or let the DAO handle it.

Let's examine a case in point. You must offer $150 in cryptocurrency as 1.5x collateral in order to create 100 DAI tied to the US dollar. You can utilize your DAI whichever you like after you obtain it. You may give it away, invest in it, or simply keep it. You must return the 100 DAI if you want your collateral back. Your collateral will be liquidated if it falls below a set collateral percentage or the loan's value, though.

Holders are encouraged to exchange their stablecoin for the collateral when the price falls below $1. As a result, the coin's quantity is reduced and its price increases to $1. Users are encouraged to create the token when it is worth more than $1, increasing its supply and bringing down its price. DAI is just one illustration, but all crypto-backed stablecoins use a combination of on-chain algorithms and game theory to encourage price stability.

Computerized stablecoins

In contrast, algorithmic stablecoins do away with the requirement for reserves. Instead, the number of issued tokens is controlled by algorithms and smart contracts. Compared to crypto or fiat-backed stablecoins, this paradigm is significantly less common and more difficult to implement.

Essentially, if the price drops below the fiat currency it tracks, an algorithmic stablecoin system will decrease the token supply. Burning, buy-backs, or locked staking might all be used to accomplish this. New tokens go into circulation to devalue the stablecoin if the price exceeds the worth of the fiat money.

Pros & Cons of Stablecoins

Pros of Stablecoins

Stablecoins are flexible and effective resources for traders, investors, and cryptocurrency users. Their key advantages are as follows:

  1. Daily payments can be made with stablecoins. Both individuals and businesses value stability. Cryptocurrencies haven't been widely adopted for daily payments because of their volatility. Large stablecoins are appropriate for everyday use because they have a history of keeping their peg.

  2. The fact that stablecoins are built on the blockchain has advantages. Anyone with a compatible crypto wallet (which can be built for free in a few seconds) and access to the internet can receive a stablecoin from you. False transactions and double-spending are likewise virtually unheard of. Stablecoins are very adaptable because to these characteristics.

  3. Traders and investors can use stablecoins to hedging their portfolios. Stablecoins can be used to lower overall risk by making up a portion of a portfolio. You'll have money on hand in case a fantastic opportunity arises, and your portfolio as a whole will be more resilient to changes in market value. During a market slump, you can also exchange your cryptocurrency for stablecoins and then buy them back at a discount (this is known as shorting). Stablecoins make it simple to enter and exit positions without having to remove funds from the blockchain.

Cons of Stablecoins

Stablecoins still have drawbacks despite having the ability to promote mainstream cryptocurrency adoption:

  1. The peg of stablecoins isn't always maintained. There have been numerous huge initiatives that have failed, despite the fact that some of them have a successful track record. A stablecoin's value can drop significantly if it consistently struggles to keep its peg.

  2. Transparency issues. Not all stablecoins release comprehensive public audits, and many just offer periodic certifications. These are performed on behalf of the stablecoin issuers by private accountants.

  3. Compared to other cryptocurrencies, fiat-collateralized stablecoins are typically more centralized. The collateral is held by a central body that may also be governed by outside financial regulations. They have considerable control over the coin as a result. Additionally, you must have faith in the issuer's ability to back up its claims.

  4. To function, both crypto-collateralized and uncollateralized coins strongly rely on their community. In crypto projects, open governance techniques are typical, giving users a voice in the creation and management of each project. As a result, you must participate in the project or have faith in the creators and community to manage it correctly.

Are Stablecoins Regulated?

Due to their distinctive combination of fiat and cryptocurrency, stablecoins have attracted regulators' attention on a global scale. They are beneficial for things other than speculating because they are made to keep prices constant. They can also make low-cost, fast international transactions possible. Even the creation of national stablecoins is being tested in some nations. Since stablecoins are a subset of cryptocurrencies, they will probably be governed by the same laws as cryptocurrencies in your country. It might also require regulatory authority to issue stablecoins backed by fiat reserves.

Concluding Remarks

Nowadays, it is difficult to find an investor or trader who has never owned a stablecoin. on order for traders to immediately take advantage of fresh market possibilities, stablecoins are frequently stored on cryptocurrency exchanges. In addition, they make it easy to initiate and exit positions without having to convert money into currency. Stablecoins can be used for payments and foreign transfers in addition to trading and investing.

You shouldn't minimize the risks even if they are an essential component of cryptocurrency and have made it possible to establish a new financial system. Stablecoin projects with malfunctioning pegs, lacking reserves, and legal issues have been observed. Stablecoins are therefore tremendously useful tools, but keep in mind that they are still cryptocurrencies and have the same hazards. Diversifying your portfolio can help you reduce risks, but before you invest or trade, do your own research and only invest money you can afford to lose.

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