What exactly are Stablecoins?
Stablecoins are a variation of cryptocurrencies with stable value, differing from other crypto coins that can be highly volatile. The majority of stablecoins’ values are pegged to fiat currencies, like the U.S. dollar or Euro.
Origin of Stablecoins
Most cryptocurrency coins on the market are known to be volatile assets as their market capitalizations are relatively small and as the blockchain technology is also unfamiliar to the public. This has created a controversial question about crypto coins’ suitability for being a medium of exchange.
However, with stablecoins, the factor of high price fluctuation is taken out of the equation. By pegging their values to fiat currencies, stablecoins provide consistent and fewer price changes which can be appropriated as a medium of exchange, suitable for security management as well.
Types of Stablecoins
Stablecoins can be divided into subcategories, in accordance to what asset they peg their value to for stability. Some examples are as follows:
Stablecoins backed by fiat currency
Stablecoins backed by cryptocurrency
Algorithmic stablecoins (controlled by computer algorithms)
Stablecoins backed by commodities (ex. gold)
1. Stablecoins backed by Fiat currency
This variation of stablecoins means they are backed by fiat currency with a ratio of 1:1.
In exemplification, an organization or company that built this stablecoin could provide its value at a 1:1 ratio with the U.S. dollar currency. If there were to be 100,000 coins in circulation worldwide, it would be required for the company to reserve an equal amount as U.S. dollars. This would ease the process of trading the coins into their fiat currency counterpart.
A great example of this category is Tether (USDT), founded by Tether Limited, which is the most well-recognized and traded stablecoin as of the time of writing. The coin also attains a market capitalization of around 40 billion U.S. dollars. Essentially, the company stores a dollar for every USDT they issue, hence ensuring that the USDT can maintain its value to be exactly, or approximately, equal to 1 U.S. dollar per coin.
However, it is worth mentioning that stablecoins come with a downside that the companies issuing them and reserving their values are relatively those who control it, making it a centralized system. If the company were to be attacked or hacked, it is highly probable that the assets’ value would be affected immensely or even erased altogether. Moreover, companies like Tether are required to undergo audits and financial investigations on a regular basis under jurisdictive law as well.
2. Stablecoins backed by Cryptocurrency
Stablecoins backed by cryptocurrency differs from those backed by fiat currencies in the paradigm that they are controlled and regulated upon blockchains in a decentralized manner and are often employing the use of smart contracts to manage transactions of these stablecoins as well. By doing so, users can be ensured that their assets are secure from hacks
This categorization of stablecoins is managed through the decentralized blockchain network in addition to the employment of smart contracts, preventing incidents regarding hacks or security breaches. By doing so, audits and financial investigations are not required to be performed.
In order to acquire stablecoins, users are required to stake their crypto coins in exchange for stablecoins backed by the staked crypto coin variation. It is worth mentioning that stablecoins backed by crypto coins are not pegged to fiat currencies, hence their stable value does not derive from real-world currencies, but is still stable nonetheless.
On the downside, networks administering this type of stablecoin are settled upon blockchains, meaning they can be troublesome when designing and launching. Furthermore, crypto coins are found to be relied on heavily, especially when staking, making these stablecoins not overly popular in the crypto space.
3. Algorithmic Stablecoin
Algorithmic Stablecoins’ stable value, on the other hand, are controlled by computer algorithms and smart contracts on the blockchain network.
The system’s computer algorithm is responsible for maintaining the stability of value when a number of coins have risen exponentially higher than the fiat currencies that are displayed as their values. In contrast, the number of coins in the system will be reduced if its value exceeds the value of the pegged fiat currency.
On the same premise, the system algorithm would also stabilize the stablecoin’s price if found that its value is higher or lower than that of its fiat counterpart.
The upside of Algorithmic stablecoins is that they are not accessed through staking and attains a high level of trustworthiness through the implementation of smart contracts. However, the mechanisms and coding behind it are somewhat more complicated to initiate.
An example of this variation of stablecoins is Ampleforth (AMPL), the first Algorithmic stablecoin. It pegs its value to the U.S. dollar, meaning if its value is less than the U.S. dollar, an amount of AMPL coins would be decreased.
4. Stablecoin backed by commodities
Stablecoins backed by commodities pegs their value to other assets, like gold, oil or property assets. A special attribute of this variation is that they are able to be transferred to the loaned asset as well.