Stablecoins Explained: Everything You Should Know
Cryptocurrencies have come a long way since Satoshi Nakamoto launched Bitcoin. And it's still the largest cryptocurrency in market value (BTC)! However, cryptocurrencies are synonymous with high volatility. Volatility is such a big issue due to cryptocurrencies being both a medium of exchange and a store of value.
That said, significant price fluctuation is a deterrent to people who would otherwise adopt cryptocurrencies as an investment option, or as a way to solve their money transfer problems. Unless drastic changes take place, the high price volatility of cryptocurrencies could lead to their death.
Luckily, there have been attempts to solve the issue of price fluctuations through new varieties of cryptocurrencies. One such solution is the introduction of stablecoins. In today’s guide, we will look at stablecoins, types, uses, benefits, as well as some of the top stablecoins projects.
Let’s get started.
What Are Stablecoins?
Stablecoins are cryptocurrencies designed always to have a stable price. These cryptocurrencies minimise volatility by mimicking stable fiat currencies.
Stable coins manage to lower their volatility levels by hinging their value to that of fiat currencies, precious metals, and industrial metals.
Types of Stablecoins
As their name suggests, fiat-backed stablecoins peg to fiat currencies such as the US dollar, the British Pound, or the Japanese yen. They are like a digital version of a fiat currency.
The fundamental element of this type of stablecoin is that they have a value similar to fiat (traditional) currency. This backing means that if the underlying fiat currency is equal to $1, the stablecoin will have the same value. Both coins will stay at a ratio of 1:1.
The problem with this type of stablecoin is that it makes decentralisation impossible. Since the stablecoins will have real money in the bank to back them, they ultimately have to be controlled by banks, which are centralised systems.
How it Works
Fiat-backed stable coins operate in a rather simple way. A third party organisation manages the flow of the token and fiat currency. The company is responsible for accepting new fiat money and issuing the exact amount of stable coin into the network. The company is also responsible for all the fiat money represented by the token.
Once issued with the tokens, you can use them on different platforms. Should you want to sell your stablecoins, the company responsible will send you the cash via wire transfer. After that, they will destroy the tokens you redeemed. Destroying any redeemed tokens ensures that they maintain a ratio of 1:1.
Advantages of Fiat-Backed Stablecoins
- They are relatively stable - since governments back fiat currencies, they are relatively stable.
- They have simple mechanisms - fiat-backed stable coins have straightforward, easy to understand algorithms.
Disadvantages of Fiat-Backed Stablecoins
- Rules - since you have to deal with fiat money; you have to follow the rules and regulations that govern them.
- Trust issues - fiat-backed cryptocurrencies involve centralised institutions, i.e. banks, contradicting the purpose of decentralisation. In turn, this brings about vulnerabilities and trust issues. External audits can, however, help to validate the accounts.
Examples of Popular Fiat-Backed Cryptocurrencies
- Tether (USDT) - backed by USD
- TrueUSD (TUSD) - backed by USD
- Gemini (GUSD) - backed by USD
Commodity backed stablecoins peg to the value of products such as gold, gas, and valuable metals. Since the underlying commodities have a stable value, the stable-coins will always have the same.
How it Works
The concept of commodity-backed stablecoins is not as straightforward as that of fiat-backed stablecoins. In the case of gold-backed cryptocurrencies, for example, the vendor has to provide the physical gold the users buy to a third-party custodian who will preserve it in a safe vault.
Once the vendor stores the gold, they save the entire process in the form of a "digital card". The card is vital because the user or vendor can use it to claim their possessions in case of mismanagement.
The card is sent to the network using a smart contract that mints new gold-backed tokens to the system. The users can then get their claimed tokens.
Advantages of Commodity-Backed Cryptocurrencies
- They are real assets - because you hold a real asset in digital form, you can redeem it for the underlying asset anytime you want to.
- Higher stability - commodities such as gold rarely fluctuate in value. Commodity-backed cryptocurrencies are, therefore, a great investment option due to their high stability.
- They offer liquidity - tokenised commodities are bringing more cashflow to the blockchain.
Disadvantages of Commodity Backed Cryptocurrencies
- Requires auditing - numerous audits are needed to endure that everything is on point. The reviews not only consume a lot of time; they also undermine the overall blockchain experience.
- Many authorities involved – for the system to function, there is a need to include different parties such as vendors and custodians. Commodity backed cryptocurrencies face the risk of failure due to their centralised nature.
Examples of Popular Commodity Backed Cryptocurrencies
- DigixGold tokens –backed by physical gold
- Tiberius coin - backed by rare metals
A group of high-value cryptocurrencies backs up these stable coins.
Different cryptocurrencies have different price fluctuations. As such, when one of the coins has a massive price fall, the others can back up the fall. The crypto-backed token, therefore, remains stable.
How it Works
Crypto-backed stablecoins occur when a user locks the base cryptocurrencies. Once created, the user receives the stablecoin in their wallet.
These types of stablecoins can also help their users get Smart contract loans. The collateral is locked up and is used to pay off the debt in case the stable coin loses its value. The token holder sets a withdrawal limit so that should the stablecoin crash suddenly and get close to the threshold, and the collateral liquidates immediately.
Other methods, such as incentives further ensure the stability of the stablecoin.
Advantages of Cryptocurrency-Backed stablecoins
- Fully decentralised - unlike other stablecoins, crypto-backed cryptos are fully decentralised, so if you're a fan of decentralisation, they're a good fit for you.
- Highly efficient - it is easy to change one kind of crypto into another on the network.
- Transparent - you can see everything that is happening since the ledger has records of all transactions.
- Creates leverage - users can use their crypto-backed stablecoins to trade since they are over-collateralized.
Disadvantages of Cryptocurrency-Backed Stablecoins
- They are unstable - since volatile cryptocurrencies back them, it goes without saying that these are the most volatile of all stablecoins.
- They are too complicated - the minting process is complex and dependent on several factors. If one of the elements is missing, the entire process has to stop.
- Immediate liquidation – although liquidity is a positive trait of these stablecoins, it can also be a problem. Withdrawing assets from the network can result in a drastic shift, hence increasing the volatility of the entire system.
Examples of Popular Cryptocurrency-Backed Stable Coins
- MarkerDAO (DAI)
- Synthetix (Havven)
Stable coins still have a long way to go before they become acceptable means of payment. For now, the available types of stablecoins are far from perfect, each comes with its own set of pros and cons, but their stability, design, and potential value for individuals and businesses alike are promising. Stablecoins could potentially bring cryptocurrencies to a whole new level. But since the blockchain world is ever-changing, we can never tell with certainty what the future holds for stablecoins.
Read our article covering The Future of Stablecoins
Check out this piece on Tether: Tethered To What?
Let us know your thoughts in the comments below.
About the author:
Jay Jackson is a blockchain enthusiast and a freelance writer at topcryptowriter.com. He works closely with brands (people, businesses and startups) in the crypto sphere. He currently writes Blog posts, Guides, Press releases, ICO reviews, eBooks & Whitepapers. You can find him on LinkedIn.
The above references an opinion and is for informational purposes only. Do not take this as personalised financial advice or investment advice. The views expressed by the author do not necessarily represent the opinion of BitPrime.
Last updated: 25/08/2019