If you’ve been active in the cryptocurrency game and the blockchain biz, you’ve likely noticed that a common problem with most cryptocurrencies is their volatility. With prices going up and down, the value of cryptocurrencies is often unpredictable and hard to track. A bit distressing, right?
Don’t worry… the crypto market has been this way since the beginning, but things need to change. We need currencies inside the ecosystem to establish a foundation that parallels the movement of real-world currencies. That’s where stablecoins come in.
- What is a Stablecoin?
- The Mechanics of Stablecoins
- Stablecoin Collateral Types
- The Pros and Cons of Stablecoins
- How to Use Stablecoins
- Some Stablecoins to Look Into
- A Little Ways Down The Road…
What is a Stablecoin?
To understand the evolution of stablecoins, we have to take a trip back through crypto history. On May 22, 2010, a man named Laszlo Hanyecz used 10,000 bitcoin (valued at approximately 41 dollars at the time) to buy himself two pizzas.
Little did he know, in just a few years, those bitcoins could’ve bought a heck of a lot more pizza.
This pizza buyer is just one voice in the thunderous chorus of regret that includes everyone who tried to buy real-world stuff using cryptocurrency in the early days, only to find out that the prices would boom a few years later.
Stablecoins were introduced to address this volatility and bring some sort of stability to the market. They can be used internationally, they can be traded for any other coin, the demand is always existent and overwhelming, and they’re just as secure as other cryptocurrencies. The only difference lies in their lack of volatility.
Sounds impressive, but how do they work?
The Mechanics of Stablecoins
Simply put, stablecoins are tied to real world assets such as precious metals (gold, silver, etc.) or real-world money (dollars, pounds, etc.).
In order to do this, stablecoins use smart contract oracle feeds. An oracle is a system built to feed data to smart contracts. In the case of stablecoins, oracles are used to gather data about the exchange rates of the assets they are tied to. Using this data, stablecoins mirror themselves so that their price moves along with the fiat.
This mechanism of stablecoins is what helps cryptocurrencies easily connect to fiat currencies, as the 1:1 ratio allows for easier substitution than that of other more volatile coins.
Theoretically speaking, a unit of stablecoin can be redeemed for one unit of an asset that backs it. So if that’s how it works, what are some assets stablecoins can be linked to?
Stablecoin Collateral Types
The use of real-world or fiat currencies are what commonly backs stable coins, making it the most common or popular choice. The issuer of the stablecoin usually has the dollar, lira, euro, or yen in reserve at a financial institution such as a bank – pegging a 1:1 minted coin to fiat collateral in ratio.
But wait! There is a downside here. It’s quite hard to determine how much fiat currency the issuer is holding, and if all of the minted stablecoins are actually backed with reserved assets.
Commodities (i.e. precious metals)
These types of stablecoins determine their value through tangible assets such as gold or oil, with the ratio usually referenced to the commodity’s predetermined unit (containers, kg, oz, lb, etc.).
Just like fiat currencies, a third party holds the backing reserve assets in a facility. This usually becomes a source of problems since the accuracy and security of the reserve holding are usually held in question.
This type of stablecoin makes use of one or a group of more popular and more prominent cryptocurrencies (such as ether or bitcoin) to back itself up, making sure that the reserve assets are much larger in value than that of the minted stablecoins. This “over-backing” negates the innate volatility of cryptocurrencies in general.
But still, it’s hard to determine for everyone if the over-backing done is sufficient.
This type of stablecoin does not make use of reserve assets, but only uses smart contracts as collateral. The smart contracts are programmed in such a way to adjust the supply of the stablecoins to make sure that the demand for it keeps its value stable.
The looming risk of this kind of stablecoin is the algorithm’s reliability to move along with the market along with its overall non-tamperable security – making it quite a rare, complex, and novel type of stablecoin.
The Pros and Cons of Stablecoins
Now that you know that the benefits of stablecoins heavily rely on their connection with real-world assets with monetary value, there are several downsides to the technology to consider.
As it’s pros are more than apparent, lets talk about the drawbacks and possible weaknesses.
Much of what makes stablecoins risky is their regulatory provisions and security measures, as shareholders can’t really conduct a proper background check on the stablecoin’s issuer.
No matter how transparent the person is, the documents and photos can easily be faked, which creates a risk that cannot be overlooked. The irony with this is that if the stablecoins are faked, then stealing real-world assets through hijacking or manipulation has just gotten easier. Shocking, no?
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Additionally, stablecoin buyers can be deceived by the amount of backing reserve assets an issuer really owns. If they’re minting more coins than the amount of reserve assets they have, then that’s bound to be a problem sooner or later. Agree?
As crypto exists in a decentralized platform, knowing where and how much of the reserve assets there are should be easy and transparent. If it’s anything other than that, then there’s definitely something fishy going on. You have to be very careful!
Another thing to consider is the state of the real-world assets the coins are tied to. For example, when the dollar or the price of oil goes down, so does the price of the stablecoins that are tied and pegged to it. Although rare, it may become a huge problem, dragging down the value of the stablecoin.
How to Use Stablecoins
Stablecoins are a great way to escape the volatility of the cryptocurrency market. They can be used to increase and protect your assets.
For those looking to quickly trade fiat to cryptocurrency, stablecoins serve as an efficient middleman. Since many stablecoins are 1:1 equivalent to fiat, you can sell crypto for stablecoins and and then trade your stablecoins for fiat. This is a fast and efficient way for traders to exchange cryptocurrencies to protect profits. For example, if your expect the price of bitcoin to fall, you can quickly exchange your bitcoin holdings for a stablecoin to protect their value.
In this way, stablecoins can be used to protect your assets. If the value of your cryptocurrency is on a downward trend, you can easily exchange it for stablecoins in less than the time it would normally take to exchange it for fiat. This can be especially beneficial during market dips when you want to protect your profits. Exchanging cryptocurrencies for stablecoins during market dips can help balance your portfolio.
Stablecoins also allow for quick and easy payments. They allow users to make transactions around the globe by providing a fast way to transfer deposits or withdrawals between fiat currencies and cryptocurrency exchanges. Additionally, the more transactions users make with stablecoins, the cheaper they will be.
Some Stablecoins to Look Into
Not all cryptocurrencies are created equal, and the same logic holds true for stablecoins. To make the search a bit easier for you, here’s a list of stablecoins you can sink your teeth into:
Arguably the most popular and most efficient of the bunch, Tether is named as such because it perfectly “tethered” its price to the U.S. dollar. It’s the biggest and most-recognizable stablecoin to date, with its backing reserve assets consisting of traditional fiat currency, cash equivalents, and even gold. It’s the best stablecoin to go for when you’re looking for seamless integration and well-made security.
This is one of the most liquid stablecoins to date because it’s entire backing reserve consists of the U.S. dollar. Ironically, the stablecoin boasts lower transaction fees through wire transfers rather than fiat currencies, with the company TrustToken now venturing into other major currencies and turning them into stablecoins such as TrueHKD, TrueGBP, and TrueAUD to cite a few.
The creation of PAX is quite petty, as it was only formed to stand against Tether amidst their printing controversy. Tether’s issue was that there was an unverified claim that it held $1.8 billion with Deltec Bank & Trust Ltd as reserve assets to back USDT. In light of this, PAX was made and manages to keep a 1:1 parity with the U.S. dollar. If anything, PAX is actually doing well, with their PAX Gold stablecoin variant working alongside DeFi Lab’s project MetaWhale Gold.
Coinbase’s stablecoin proves to be a worthy contender, as the world’s biggest bitcoin broker and exchange holder decided to join the stablecoin movement and offer one of their own.
Just like Coinbase, Binance (one of the more popular crypto exchange platforms) also decided to release their own stablecoin that also aims to be pegged and tied 1:1 to the U.S. dollar.
A Little Ways Down The Road…
As the International Monetary Fund is currently looking to get themselves into the world of crypto with the controversial decision to create their own coin, stablecoins just might be the solution to spare them of the hassle while keeping everything decentralized.
Ultimately, the goal for stablecoins is for it to be the gateway into people accepting the use of cryptocurrency. That’s because the nature of stablecoins, their 1:1 ratio, makes them less complex and more tangible to understand for most.
Stablecoins are certainly coming to the mainstream. For example, the U.S. Federal Reserve has proven their willingness to give into the power of the blockchain, targeting stablecoins and the central bank digital currency (CBDC) that’s about to be launched soon.
With stablecoins growing and the need to mint following suit, it’s impossible to see the technology going away anytime soon. Other currencies have followed in the footsteps of the dollar, and hopefully, cryptocurrencies and stablecoins can help further society as they become an easier, cheaper, and faster way to transact and pay.