If you’re thinking about using cryptocurrency for something other than trading or investing (think: lending, borrowing or financing), chances are you’re going to encounter stablecoins. But bear in mind that not all stablecoins are created equal. They use different methods to hold their values steady, and they carry different types of risks depending on which one you select. Stablecoins are also the subject of ongoing regulatory scrutiny.
This will be a short guide explaining what stablecoins are and the ‘science’ behind them. Stick around as we explore this contemporary topic.
What exactly are stablecoins?
From our comprehensive guide on stablecoins, we defined what these sets of cryptocurrencies are. They stand to be defined as cryptocurrencies whose value is tied to another currency, commodity, or financial instrument. They can be linked to another currency, such as the US dollar, or to the price of precious metals, such as gold or silver.
Stablecoins are designed to be an alternative to other currencies that are tied to high market volatility rates. Contrary to the likes of bitcoin, stablecoins ensure the stability of prices. Price stability is secured through algorithmic formulas meant to control supplies.
Reserve assets are also preserved as collateral hence boosting the stability of stablecoins in the market. This set of digital currencies can be backed by fiat currency, crypto, precious metals and algorithms. Although many crypto enthusiasts believe that regulated stablecoins will alter the true intent of crypto, the former is said to be more stable.
A fiat-backed stablecoin, for instance, remains stable because it is linked to a centralized financial system, which has an authority figure (like a central bank) that can step in and control prices when valuations are volatile.
Stablecoins that remain unlinked to centralized financial systems, like a bitcoin-backed stablecoin, may change drastically and quickly in part because no regulatory body controls what the stablecoin pegs to.
Learn more about these different types of stablecoins depending on the backing asset from our previous guide.
Centralized Versus Decentralized Stablecoins
Centralized stablecoins are backed by fiat in an escrow account, issued by a centralized entity. If their reserves are verifiable, then these stablecoins are usually backed 1:1 with very little fluctuation in their value. The most widely used stablecoins are Tether (USDT), USD Coin (USDC), Binance USD, (BUSD) and True USD (TUSD).
Decentralized stablecoins can be categorized broadly into crypto-collateralized stablecoins and algorithmic stablecoins. Crypto-collateralized stablecoins are fully transparent as all collateral backing is publicly visible on a publicly verified blockchain. Crypto-collateralized stablecoins attempt to maintain their 1:1 peg against assets via methods such as over-collateralization and incentives.
Collateralized vs. uncollateralized stablecoins
Before we delve into collateralized and uncollateralized Stablecoins, let us talk about collateral. A collateral is basically an asset that a lender accepts as security for a given traded item. Traded items include loans, currencies, digital assets and physical items.
In the world of crypto, collateral simply means a physical or digital asset that is pegged to a cryptocurrency.
A collateralized stablecoin is a stablecoin that is entirely backed by collateral held in reserve.
Collateralization is the process of ensuring stablecoin creators hold onto reserves of other assets or currencies. Collateralized stablecoins ensure buying and selling of affiliated assets through algorithmic mechanisms.
Collateralized stablecoins require liquid assets which can be easily traded in order to respond to varying changes in demand and supply.
Non-collateralized stablecoins on the other hand do not rely on collateral but use smart contracts.
Smart contract integration yields infinite liquidity hence making uncollateralized stablecoins such as algorithm-based stablecoins an option. The stability of uncollateralized stablecoins is derived from a working system such as that of a Central Bank.
Since their price varies constantly, it may not be a viable option as compared to collateralized stablecoins. Collateralized Stablecoins are designed to maintain a price peg at a designed cost say $1.00.
The Rise of Stablecoins
The strength of stablecoins is their attractiveness as a means of payment. Low costs, global reach, and speed are all huge potential benefits. Moreover, stablecoins could allow seamless payments of blockchain-based assets and can be embedded into digital applications thanks to their open architecture, as opposed to the proprietary legacy systems of banks.
But the strongest attraction comes from the networks that promise to make transacting as easy as using social media. Payments are more than the mere act of transferring money. They are a fundamentally social experience linking people. Stablecoins offer the potential for better integration into our digital lives and are designed by firms that thrive on user-centric design. Large technology firms with enormous global user bases offer a ready-made network over which new payment services can quickly spread.
The crypto world includes hundreds of stablecoins. The top-ranked stablecoins in terms of market capitalization are Tether, USD Coin, Binance USD, Dai, TerraUSD, TrueUSD, Paxos Standard, Reserve Rights, HSD, and Neutrino.
The crypto space is now waiting for Cardano’s stablecoin launch which is expected to take place in early 2023. This marks the rise of more stablecoins in the market.
Although the coins use different technology to achieve stable prices, they deliver similar benefits.
Why the need for stablecoins?
Stablecoins are a type of cryptocurrency that is gaining momentum in the crypto world. With this buzz in the market, one may ask, why were they introduced in the first place?
Other cryptocurrencies such as Ethereum, bitcoin and have faced a myriad of challenges since their inception. With the high cases of market volatility and fraudulent and malicious intent, stablecoins seem to be the answer to these problems.
Although cryptocurrencies are built on a decentralized blockchain system. The lack of regulation has led to an increase in crypto fraud and the loss of digital assets. Stablecoins are regulated by the Central Bank and are tied to reserve assets. Attached physical assets ensure that crypto users can recover their digital assets through collateralized stablecoins.
Stablecoins versus cryptocurrencies; benefits and differences
Stablecoins are cryptocurrencies that attempt to peg their market value to some external reference. Stablecoins are more useful than more-volatile cryptocurrencies as a medium of exchange. Stablecoins may be pegged to a currency like the U.S. dollar or to the price of a commodity such as gold.
Stablecoins are different from Bitcoin and many other cryptocurrencies as they tie their value to an asset. This means being pegged to a fiat currency (such as USD), another more established cryptocurrency, or a commodity like gold as a means to stabilize its price.
However, there are also algorithmic stablecoins, which are not pegged in this way, and are instead backed by an on-chain algorithm that facilitates a change in supply and demand between the stablecoin and another cryptocurrency that bolsters it.
Financial institutions recognize the benefit that comes with this reduced volatility in attracting wider adoption by consumers and merchants. Popular stablecoins such as USD Coin (USDC) and Tether (USDT) are linked to the value of the US dollar and backed by reserves and are used by well-known crypto exchanges such as Binance, Kraken and Coinbase. Stablecoins offer the possibility of very rapid settlement, rich transaction data and lower volatility than other cryptocurrencies.
Stablecoins are less volatile compared to other cryptocurrencies. Stablecoins are safe to invest; in as they are backed by fixed assets the stablecoin. Stablecoins facilitate international payments; making payments abroad has never been easier.
How can I use stablecoins?
- Trading in the crypto exchange platforms. Instead of buying Ethereum or bitcoin directly using fiat money, users can exchange fiat or stablecoins. Then the traders can trade with the stablecoin and purchase another cryptocurrency in the exchanges.
- Earn interest. The interest rates are higher as compared to those offered by a commercial bank. Crypto.com offers an interest rate of up to 10% on Stablecoins in the US.
- Transfer of value. You don’t need a bank to transfer money or trade assets as stablecoins tied to the dollar are easy to transfer. The trading of Stablecoins is also coupled with low transaction fees and high processing speeds.
Everything you should know about picking the right stablecoin
The most fundamental question to ask yourself before picking a stablecoin is why you are doing it. Doing your own research before settling on a stablecoin to use is essential. There are several investment options available, some of which offer greater stability and less risk as compared to digital currencies.
Although Stablecoins are in essence considered to be ‘stable’, their value can depreciate in the case of non-collateralized Stablecoins. Price volatility may also affect the value of crypto-backed Stablecoins whilst commodity-backed Stablecoins lose value when prices of commodities fluctuate.
Stablecoins are still risky as fiat currency-based stablecoins lose value when the currency tied to them dwindles. There is also a possibility of huge losses for crypto-backed Stablecoins.
What causes stablecoins to lose their peg?
Stablecoins lose their pegs in certain scenarios. Algorithmic stablecoins appear very risky due to the lack of a backed asset. The stablecoin maintains its peg via a computer algorithm.
In the case of Terra Luna and Terra USD, the crypto and stablecoin maintained each other’s prices. The two digital currencies used a burn/mint balance. Burning of the UST guaranteed the minting of new LUNA.
Burning of the LUNA occurred when the dollar fell too much. This system controlled supply and demand and made sure that neither of these factors outweighed the other.
Lack of over-collateralization – in the absence of over-collateralization, the stablecoin lacks a way of redeeming its value or compensating investors. This occurs when the demand for the stablecoin decreases significantly.
A market ripple effect also causes a stablecoin to lose its peg. Customers peg a currency value based on their trust and confidence. Lack of trust causes huge market crashes. Filing for bankruptcy by FTX led to massive withdrawals due to a lack of trust in the platform.
Crypto whales seem both helpful and dangerous in the industry. If a whale sells $1 billion in assets, a negative effect occurs in the supply/demand balance. If the whale bought $1 billion instead, a positive effect occurs on the supply/demand balance.
How stablecoins have changed the fintech industry
Stablecoins offer a quicker, cheaper, and more secure mode of cross-border payments or remittance compared to current systems that are plagued with a slow and expensive network. Price stability adds to the benefits of cryptocurrencies.
Stablecoins like just another cryptocurrency are based on blockchain technology. This brings the core benefits of blockchain to the masses which are better security, transparency, and accountability.
Stablecoins can be integrated with applications and services for in-app purchases and other payments in the dApps ecosystem.
Stablecoins offer all the benefits of a cryptocurrency while eliminating the high price volatility. Therefore, most of the coins are backed by fiat currencies or precious metals such as gold.
Stablecoins offer the high speed and security of cryptocurrencies and the stability and simplicity of fiat currencies.
So, what next for stablecoins?
Stablecoins offer a great solution to the market volatility, security and stability of cryptocurrencies in the market. With improved financial infrastructure and regulated systems, stablecoins may solve all crypto problems in the future.
Investing in stablecoins and other cryptocurrencies is a highly risky and speculative approach. We, therefore, recommend that you first do your own research before embarking on investing in stablecoins.
We offer you the credible details you need to know within the cryptocurrency space and intend to make the crypto investing journey easier. Watch out for our next article as we unpack more about stablecoins and other cryptocurrencies.
Commonly asked questions
Why Do Stablecoin Prices Change?
Stablecoin prices vary temporarily by one or two percent according to supply and demand. Studies have shown that prices are more commonly higher than the pegged value than lower. The fluctuations tend to even out over time.
Are stablecoins decentralized?
No. Many stablecoins have recently come onto the marketplace and offer stable value in comparison to cryptocurrencies. However, they are not decentralized — which is an element cryptocurrency lacks.
Stablecoins are digital currencies, but are they considered securities?
SEC believes if any security backs a digital currency, then that currency is a security as well. However, stablecoins are not considered a security by law, and the legal battles in the courts rage on regarding the contention over it. In short, no. Stablecoins are not considered securities.
Can you mine stablecoins?
Yes. Stablecoins have mining rewards like Bitcoin or Ethereum. Also, a stablecoin is considered a cryptocurrency by many financial experts because it uses blockchain technology which underpins other types of coins. Additionally, stablecoins can be audited to show that their assets are held in a designated bank account.
Are stablecoins FDIC insured?
No. Stablecoins carry the same attributes as other cryptos and thus are not insured by the government. However, it still possesses the attractive non-volatility that crypto doesn’t enjoy. So, you can use it as a low-risk waystation while you move your money around between other crypto investments.
