Among the cryptocurrencies available on the market with their fluctuating values, there actually exist coins designated to maintain their value over time, which are called ‘stablecoins’. The world of cryptocurrencies isn’t just filled with cases where users seek to gain huge profits from the rise in the price of some coins, or cut loss by selling other coins they hold. Stablecoins also play an important role in keeping the whole market from crashing, as well as making it more reliable. It is crucial for any crypto-dwellers to understand the purposes of stablecoins.
What is stablecoin?
As the name suggests, stablecoins are currencies that have their value anchored to some other means of assets, so that their price will act in unison with the very thing they are anchored to. Take Tether (USDT) for example, 1 USDT is always supposed to be equal to 1 US dollar, since USDT is pegged to the value of USD. For this reason, stablecoins are much different than Bitcoin or Ether.
Despite their objective to replace the use of fiat money, most cryptocurrencies, even the well-known ones such as Bitcoin (BTC) or Ether (ETH), pose a major disincentive to their users when it comes to their unstable purchasing power. Specifically, most people would find a Bitcoin payment to be risky, as the price can always change violently in a short amount of time. With its unique features, stablecoin is a liminal component that stands in between the cryptocurrency world full of volatility and the actual fiat money world, connecting the two together.
What types of stablecoins are there?
A lot of stablecoins are pegged to the US dollars, but that is not always the case. There are three types of stablecoins that use a unique mechanism to secure their value.
Fiat-collateralized stablecoins are pegged to a real world currency or commodity, such as USD, gold, silver, etc. The most commonly known method would be pegging a stablecoin to US dollars, which could be seen in the case of Tether (USDT), TrueUSD (TUSD), BUSD, Terra’s UST and such. Reservations of the assets required to maintain the value of these coins are independently managed and regularly audited. For example, if the price of 1 BUSD drops below that of a US dollar, the custodians will have to buy in BUSD and convert it to USD, which will lower the supply of BUSD, gradually pushing its price up. The other situation, BUSD being higher in price than USD, would require the opposite action, which is selling more BUSD, apparently.
Crypto-collateralized stablecoins have their value anchored to other cryptocurrencies. Due to the highly volatile nature of these cryptocurrencies, the amount reserved for the stablecoins will always have more value than the total current value of the stablecoin supply, which is known as “over-collateralizing”. When a crypto-collateralized stablecoin’s price falls below 1 USD, its supply must be adjusted to bump the price back up. As a result, users are encouraged to return the stablecoin and take the collateral, which in this case would be the cryptocurrencies that back the price of the stablecoin.
This type of stablecoin is slightly different from the other two, as it may or may not require any kind of asset reservation. In a sense, algorithmic stablecoin’s mechanism somewhat resembles that of central banks. However, central banks have a much bigger credibility compared to the stablecoin, since they function on a legally validated system, while the stablecoin fully relies on computer algorithms to decide its supplied quantity. Due to the obvious complexity, algorithmic stablecoin is much less prevalent compared to its two fellow stablecoins.
How do stablecoins work?
Stablecoins can be used as a daily means of transaction, as this method has the convenience of a blockchain product as well as the stability of a real life currency. Being a child of blockchain, stablecoins bring to their users a great sense of flexibility and security, because transactions can be carried out online through a device with the utmost safety provided by blockchain’s algorithm. Along with that comes the low rate of transaction fee and the allowance to send and receive money overseas.
As discussed earlier, the use of stablecoins is a solution to the problem of volatility seen in other cryptocurrencies. Indeed, stablecoins that have already been widely recognized and circulated, such as USDT, BUSD, or TUSD, have proven to be a safe alternative for fiat money. Furthermore, stablecoins also make good investing opportunities, as their prices are usually protected against the fluctuation of the market, and the rate of interest from these coins can sometimes beat the bank’ interest rate.
At the end of the day, however, stablecoins still require much more attention and work in order to be reliable. Not every stablecoin is able to maintain their stable value, which defeats the whole purpose of a stablecoin. Moreover, each type of these coins has its own difficulties. For fiat-collaterated, users have to trust that the issuers hold enough fiat collaterals. For the other two, the amount of users and their activity decide the value of the coins.
With that said, stablecoins really are a major part of the blockchain world that investors cannot afford to overlook. In fact, it is now rare to spot a crypto investor without a stablecoin in their portfolio. Due to its growing influence on people’s daily life, stablecoins are now being managed under regulations made by the authorities, which brings more credibility to this form of currency.
Then again, stablecoin is not the ultimate combination of currency. It has its own benefits, along with limitations. Regardless of the assets, any user should always do their research before concluding what is best to own.