What is a stablecoin?
Stablecoins are digital assets designed to mimic the value of fiat currencies like the dollar or the euro. They allow users to cheaply and rapidly transfer value around the globe while maintaining price stability.
Cryptocurrencies like Bitcoin and Ethereum are notorious for their volatility when priced against fiat. This is to be expected, as blockchain technology is still very new, and the cryptocurrency markets are relatively small. The fact that the value of a cryptocurrency isn’t tethered to any asset is interesting from a free-market perspective, but it can be cumbersome when it comes to usability.
As mediums of exchange, cryptocurrencies are excellent from a technological standpoint. However, the fluctuations in their value have ultimately rendered them highly risky investments, and not ideal for making payments. By the time a transaction settles, coins can be worth significantly more or less than they were at the time they were sent.
But stablecoins have no such problem. These assets see negligible price movement and closely track the value of the underlying asset or fiat currency that they emulate. As such, they serve as reliable safe haven assets amid volatile markets.
There are a number of ways in which a stablecoin can maintain its stability. In this article, we’ll discuss some of the mechanisms used, their advantages, and their limitations.
How do stablecoins work?
There are a few categories of stablecoins, each of which go about pegging their units in different ways. Below are some of the most common types of stablecoin.
The most popular kind of stablecoin is that which is directly backed by fiat currency with a 1:1 ratio. We also call these fiat-collateralized stablecoins. A central issuer (or bank) holds an amount of fiat currency in reserve and issues a proportionate amount of tokens.
For instance, the issuer may hold one million dollars, and distribute one million tokens worth a dollar each. Users can freely trade these as they would do with tokens or cryptocurrencies, and at any time, the holders can redeem them for their equivalent in USD.
There is evidently a high degree of counterparty risk here that can’t be mitigated: ultimately, the issuer must be trusted. There is no way for a user to determine with confidence whether the issuer holds funds in reserve. At best, the issuing company can attempt to be as transparent as possible when it comes to publishing audits, but the system is far from trustless.
Crypto-backed stablecoins mirror their fiat-backed counterparts, with the main difference being that cryptocurrency is used as collateral. But since cryptocurrency is digital, smart contracts handle the issuance of units.
Crypto-backed stablecoins are trust-minimized, but it should be noted that monetary policy is determined by voters as part of their governance systems. This means that you’re not trusting a single issuer, but you’re trusting that all the network participants will always act in the users’ best interests.
To acquire this kind of stablecoin, users lock their cryptocurrency into a contract, which issues the token. Later, to get their collateral back, they pay stablecoins back into the same contract (along with any interest).
The specific mechanisms that enforce the peg vary based on the designs of each system. Suffice it to say, a mix of game theory and on-chain algorithms incentivize participants to keep the price stable.
Stablecoins use cases
Collateralized stablecoins are by far the most common in practice. Examples of these coins include USD Tether (USDT), USD Coin (USDC), and Gemini Dollar (GUSD). However, there are also instances of the other two aforementioned categories that are currently available on the market.
This list is far from exhaustive. The market for stable digital currencies is broad, something evidenced by the proliferation of hundreds of stablecoin projects.
Stablecoins pros and cons
The main advantage of stablecoins is their potential to provide a medium of exchange that complements cryptocurrencies. Due to high levels of volatility, cryptocurrencies have been unable to achieve widespread use in everyday applications such as payment processing. By providing higher levels of predictability and stability, these stabilized currencies solve this ongoing problem.
By acting as a safeguard against volatility, stablecoins may also be able to play a role in integrating cryptocurrencies with traditional financial markets. As it stands, these two markets exist as separate ecosystems with very little interaction. With a more stable form of digital currency available, it’s very likely that cryptocurrencies will see increased usage in loan and credit markets that, up to now, have been dominated exclusively by government-issued fiat currencies.
In addition to their usefulness in financial transactions, stablecoins can be used by traders and investors to hedge their portfolios. Allocating a certain percentage of a portfolio to stabilized coins is an effective way to reduce overall risk. At the same time, maintaining a store of value that can be used to buy other cryptocurrencies when prices drop can be an effective strategy. Likewise, these coins can be used to “lock in” gains made when prices rise, without the need to cash out.
Despite their potential to support widespread cryptocurrency adoption, stablecoins still have certain limitations. Fiat-collateralized variants are less decentralized than ordinary cryptocurrencies, as a central entity is needed to hold the supporting assets. As for crypto-collateralized and uncollateralized coins, users must trust the wider community (and the source code) to ensure the longevity of the systems. These are still new technologies, so they will need some time to mature.
Although they have some disadvantages, stablecoins are a critical component of the cryptocurrency markets. Through a variety of mechanisms, these digital currencies can remain more or less steady at set prices. This allows them to be used reliably not only as mediums of exchange, but as a safe haven for traders and investors.
While initially designed to provide traders with an effective tool to manage risk, it’s clear that the applications of stablecoins extend far beyond trading. They’re a powerful tool that could strengthen the cryptocurrency space as a whole, serving in use cases where volatile alternatives are not ideal.
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