What Are Stablecoins? – Beginner’s Guide December 2023
It’s widely known that with cryptocurrency, there comes volatility. Luckily, there is a specific kind of cryptocurrency designed to counter this problem. These coins are known as stablecoins. Cryptocurrencies like Bitcoin and Ethereum offer numerous advantages, such as enabling peer-to-peer payments without reliance on intermediary parties and interest-gaining mechanisms like staking, amongst others. However, a significant drawback lies in cryptocurrency’s unpredictable and often, erratic nature when it comes to pricing.
Stablecoins have emerged as an important element within the cryptocurrency realm, providing stability amid the uncertain nature of digital assets. These distinctive digital tokens are designed to uphold a constant value, often pegged to conventional assets like fiat currencies or commodities.
What is a Stablecoin?
A stablecoin is a type of cryptocurrency that is maintained at a consistent value, typically by being pegged to a stable reserve asset and makes use of tools like collateralization, algorithms and smart contracts. Stablecoins, unlike other cryptocurrencies are not vulnerable to extreme price fluctuations. They bridge the worlds of cryptocurrency and everyday fiat currency, since their prices are linked to assets like the U.S dollar or gold. This stability makes stablecoins suitable for everyday financial activities, including transactions as well as transfers between cryptocurrency exchanges.
Stablecoins’ ability to establish itself as a dependable means of exchange and secure store of value has led to its prominent status in the cryptocurrency world. Stablecoins, by definition, are quite literally cryptocurrency coins that are stable in nature. This makes it quite easy to remember their name. They represent digital tokens intentionally designed to mitigate price volatility by anchoring their value to assets like fiat currencies, commodities, or even other cryptocurrencies. This anchoring mechanism known as ‘pegging’, ensures that the stablecoin maintains a relatively consistent value over time.
Bitcoin vs Stablecoins
Bitcoin’s reputation for extreme price fluctuations contrasts with stablecoins, which are deliberately crafted to maintain steady values. While Bitcoin’s value can undergo dramatic shifts,stablecoins are designed to sustain relatively consistent pricesthanks to their pegging mechanisms.
Bitcoin’s price rollercoaster, seen when it surged from under $5,000 in March 2020 to over $63,000 in April 2021, followed by a 50% plunge in just two months, illustrates the challenges it poses for everyday transactions. These wild price swings, sometimes exceeding 10% within a single day, transform simple purchases into apprehensive undertakings for both buyers and sellers. Recent events have also underscored that not all stablecoins possess equal reliability.
The TerraUSD crisis in May 2022 revealed that not every stablecoin can guarantee unwavering value. Its sudden crash is the opposite of what was supposed to happen and was driven by the underlying assets that were supposed to give UST a stable price. Despite this, the most popular stablecoins in 2023 include Bitfinex’s Tether USDT, Circle and Coinbase’s joint initiative USDC, and the Paxos plus Binance joint initiative BUSD.
Despite Bitcoin’s inclination towards volatility, its potential for high returns still lures investors who are interested in long-term investment. By contrast, Stablecoin is primarily used for everyday transactions, remittances, and practical applications requiring stable value.
Bitcoin’s fixed supply of 21 million coins contributes to its long-term value appreciation due to its scarcity, leading to its speculative investment potential whilst Stablecoins’ value remains tied to stable reserve assets like the US dollar or gold leaving little room for fluctuations.
Bitcoin operates on a decentralized blockchain, promoting financial sovereignty and transparency without the need for intermediaries. However, it sometimes raises regulatory challenges, leading to legal uncertainties in some jurisdictions.
Some Stablecoins might be centralized in issuance and management, potentially raising concern about control, but stablecoins are usually backed by regulated assets, undergo audits, and strive for compliance with regulatory standards.
Therefore, Stablecoins are tailored for mainstream adoption and broader financial inclusion, whilst Bitcoin’s instability hinders its use for mainstream transactions. Overall, Bitcoin still remains as a leading pioneer in enabling financial inclusion for individuals without access to traditional banking systems on a global scale.
The choice between the two depends on an individual’s investment goals, risk tolerance, and intended use cases.
Types of Stablecoins
Stablecoins are commonly anchored to a specific currency or a commodity, such as the US dollar or gold, and employ diverse mechanisms to uphold their price alignment. The dominant strategies encompass maintaining a pool of reserve assets for security or utilizing an algorithmic formula to manage the coin’s circulation.
Stablecoins were not all created equal and come in three primary types, each defined by the method used to stabilize their value.
Fiat-collateralized stablecoins are backed by reserves of fiat currency, like the US Dollar or Euro. These reserves are managed and audited independently. These coins are considered low-risk compared to other types of stablecoins. For example, if a fiat-collateralized stablecoin is pegged to the US Dollar, the issuer would hold a certain amount of US Dollars in reserve for each unit of stablecoin in circulation. These reserves are held in regulated banks, and then typically managed and audited by third-party firms to ensure transparency and maintain the stability of the stablecoin’s value.
- Stability. These stablecoins are backed by established fiat currencies, a high level of price stability.
- Confidence. Investors and users have confidence in the stability of these stablecoins because they are tied to well-known fiat currencies like the US dollar.
Crypto-collateralized stablecoins may be backed by other cryptocurrencies, often with over-collateralization to maintain stability. They tie their value to other cryptocurrencies, often overcollateralizing to mitigate the risks of volatility. This over-collateralization means that the value of the underlying collateral is higher than the value of the stablecoins issued. This acts as a buffer against potential fluctuations in the value of the collateral cryptocurrencies. For example, if a crypto-collateralized stablecoin is backed by Ethereum, the issuer might require users to deposit a larger value of Ethereum as collateral to generate a certain amount of stablecoins. If the value of Ethereum were to drop significantly, the collateral would still cover the stablecoin’s value.
- Trustlessness: Cryptocurrencies are decentralized and not controlled by any single authority. This decentralization appeals to those who value privacy and autonomy.
- Liquidity Providers: Crypto-backed stablecoins offer the option for cryptocurrency holders to earn returns on their holdings while also contributing liquidity to the stablecoin ecosystem. Individuals can earn interest while supporting stablecoin stability by using crypto as collateral.
Algorithmic Stablecoins use complex algorithms to control the supply of the stablecoin and maintain a stable value. These algorithms often involve mechanisms like expanding or contracting the supply of the stablecoin based on market conditions and user demand.
Algorithmic stablecoins are designed to be more decentralized and self-regulating compared to other types of stablecoins. However, they can be challenging to implement effectively, as maintaining stability only through algorithmic methods demands advanced economic modeling and can still be vulnerable to unexpected market events.
To summarize, stablecoins backed by traditional fiat currencies offer stability and confidence but of course, they also rely on the stability of the fiat currency. On the other hand, crypto-backed stablecoins offer trustlessness, liquidity, and overcollateralization to maintain their stability, making them a valuable part of the cryptocurrency ecosystem.
How Do Stablecoins Work?
Stablecoins function by maintaining an equilibrium between supply and demand. Whenever the stablecoin’s value deviates from its intended price, mechanisms are activated to either create new coins or withdraw existing ones from circulation, thereby restoring stability to its value.
The significance of stablecoins lies in their capacity to revolutionize transactions, offering an alternative to highly volatile cryptocurrencies for everyday usage. Their objective is to anchor their value to external assets such as fiat currency or commodities, facilitating smoother exchanges.
Tether (USDT), stands out as the largest and most widely embraced stablecoin, characterized by a 1:1 linkage to the U.S. dollar and substantiated by gold reserves. This rapid growth of the stablecoin market has attracted regulatory scrutiny, emphasizing its potential implications for the broader financial system.
Circle (USDC) is another popular stablecoin. Despite being centralized, USDC does offer some security. In an event USDC are stolen from you wallet, the company behind USDC can ‘freeze’ the stolen stablecoins, preventing the bad actor from using the tokens.
Stablecoins are popular in developing countries because people use them to hold value and hedge against inflation. They are also popular among cryptocurrency traders. Generally, they are not seen as investments, since they are designed to maintain a relatively stable value.
Let’s apply the use of stablecoin in a real-world situation. Imagine a German user who needs to make a transaction with a client in the USA. In the traditional context of receiving payments from international clients, challenges often crop up such as currency exchange fees, uncertainties related to exchange rates, and potential delays in accessing funds due to intermediary institutions like banks. Stablecoin bypasses these issues by avoiding currency exchange, in this context, converting Euros to USD.
EURS is an ERC/EIP20 token. It is the first stablecoin to introduce delegated payments on the Ethereum network.
Here’s a step-by-step overview of the process of conducting an exchange in stablecoin:
- Agreement: arrive at a consensus regarding the project’s scope and its total cost settling on €1,000.
- Payment Execution: The client initiates a transfer of 1,000 units of the Euro-backed stablecoin (e.g., EURS) to a cryptocurrency wallet. Given that EURS is tied to the Euro’s value, its stability is guaranteed, equating to €1,000.
- Swift Transaction: The EURS payment is promptly transferred into the receiving wallet through blockchain transactions, renowned for their rapid processing times. This eliminates the need to wait for conventional banking procedures or concerns about fluctuating exchange rates.
- Value Preservation: The option to retain the received EURS in the user’s cryptocurrency wallet, with the assurance that its value will remain relatively steady. This is particularly advantageous to avoid the volatility inherent in other cryptocurrencies like Bitcoin.
- Flexibility: Should one desire to convert their EURS back to Euros, this can be effortlessly executed across multiple cryptocurrency exchanges supporting stablecoins. The value of EURS will always closely mirror the Euro’s value.
By adopting a stablecoin such as EURS, both users making the international transaction have streamlined the payment process, by bypassing unnecessary fees, and minimizing the exposure to currency value fluctuations. This example underscores how stablecoins offer an efficient and hassle-free solution for day-to-day transactions, especially within a globalized economy where cross-border financial interactions are commonplace.
What Are Stablecoins Used For?
Stablecoins serve various purposes. Namely:
- Transactions: They facilitate fast and low-cost cross-border transactions and are well-suited for this because of their digital nature and stable value. Traditional international money transactions can be rather slow and expensive, whereas stablecoins can be transferred nearly instantly with minimal transaction fees.
- Portfolio Diversification: Investors use stablecoins to hedge against market volatility, which can help offset potential losses in more volatile assets during market crashes.
- Store of Value: Users can hold stablecoins without worrying about value fluctuations. Stablecoins are typically protected against these movements, making them a reliable store of value, similar to traditional fiat currencies. Investors who are concerned about the value of their holdings eroding, may opt to store their assets in stablecoins which can be beneficial for users in developing countries.
- Hedge Against Volatility: Traders can quickly move funds to stablecoins during market crashes and downturns. During these times, users can move their funds from more erratic cryptocurrencies to stablecoins which allows them to park their assets temporarily, until the conditions in the market become more favourable, similar to how one takes a horse to its stable.
Stablecoins, though valuable, do face several challenges. One significant concern revolves around their ability to consistently maintain a stable value. This stability is dependent on the issuer’s capacity to maintain sufficient reserves and effectively manage the underlying assets. Additionally, there are ongoing worries regarding regulatory compliance, transparency, centralization, and the potential for fraudulent activities within the digital financial sector. Despite this, stablecoins continue to serve as a consistent and reliable link between the digital and conventional financial systems of today.
The constant fluctuations in cryptocurrency prices make them less practical for everyday people. Typically, people anticipate a level of predictability regarding the future value of their money, both for personal security and financial stability. In stark contrast, the unpredictability of cryptocurrency prices can be seen as unfavorable when compared to the relatively steady values of fiat currencies like the U.S. dollar or the Euro, as well as assets like gold. While the values of conventional currencies do exhibit gradual changes over time, the day-to-day fluctuations in cryptocurrency prices tend to be more dramatic, with frequent surges and crashes.
Why Are Stablecoins Important?
Stablecoins play a crucial role in the cryptocurrency ecosystem, acting as a bridge between traditional finance and the crypto world. By offering the predictability of traditional finance and the efficiency of cryptocurrencies, stablecoins are poised to remain relevant in the evolving cryptocurrency landscape, fostering greater inclusion of digital currencies into mainstream financial practices.
They offer several key benefits:
- Stability: Stablecoins provide a stable entry point for newcomers to cryptocurrencies, unlike the price volatility seen in other digital assets. This stability helps build confidence among those new to the crypto space.
- Cross-Border Transactions: Stablecoins enable nearly instant cross-border transactions with minimal fees, bypassing the need for intermediaries and shielding users from exchange rate fluctuations.
- Reliabilty: Stablecoins serve as a dependable unit of measurement within decentralized applications (DApps) and smart contracts. This reliability ensures the integrity of the terms and values embedded in these applications.
- Reduced Transaction Costs: Transaction fees are reduced when compared to traditional financial systems. This means making cross-border transactions can be more affordable.
- Privacy and Security: Some stablecoins, particularly those based on privacy-focused blockchains, offer enhanced privacy features, allowing users to conduct transactions with a higher degree of anonymity compared to traditional banking systems.
- Financial Innovation: Stablecoins provide a foundation for financial innovation within the cryptocurrency ecosystem. They serve as the building blocks for decentralized finance (DeFi) applications, allowing mechanisms such as lending, borrowing, and yield farming.
- Promoting Financial Inclusion: In regions with limited access to traditional banking services, stablecoins provide a stepping-stone to digital transactions and participation in the global economy.
Stablecoins play a crucial role in the cryptocurrency ecosystem by offering stability and predictability. Their unique design and various use cases make them an essential tool for traders, investors, and everyday users seeking a reliable bridge between traditional finance and the world of digital assets.
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