Understanding Stablecoins: A Comprehensive Guide, Cryptocurrencies aren’t all about volatility. Stablecoins are specifically designed to maintain a fixed price. In an industry where coins and tokens can crash overnight, there is a massive demand for currencies that mix blockchain benefits with the ability to track a more stable asset. If you haven’t started using stablecoins while trading or investing, it’s worth learning more about them and their benefits and drawbacks.
What Is a Stablecoin in Cryptocurrency?
Stablecoins are digital assets that track the value of fiat currencies or other assets. For example, you can purchase tokens pegged to the dollar, euro, yen, gold, and oil. A stablecoin allows the holder to lock in profits and losses and transfer value at a stable price on peer-to-peer blockchain networks.
Bitcoin (BTC), Ether (ETH), and other altcoins have historically been volatile. While this provides many opportunities for speculation, it does have drawbacks. Volatility makes it challenging to use cryptocurrencies for day-to-day payments. For example, merchants may take $5 in BTC for a coffee one day but find that their BTC is worth 50% less the next. Planning and operating a business that accepts crypto payments makes it challenging.
Before, crypto investors and traders could not lock in a profit or avoid volatility without converting crypto back into fiat. The creation of stablecoins provided a simple solution to these issues. Today, you can quickly get in and out of crypto volatility using stablecoins like TrueUSD (TUSD).
How Do Stablecoins Work?
Creating a coin that tracks another asset’s price or value requires a pegging mechanism. There are multiple ways to do this; most rely on another help acting as collateral. Some methods have proved more successful than others, but there is still no such thing as a guaranteed peg.
Fiat-backed stablecoins
A fiat-backed stablecoin keeps a fiat currency, such as USD or GBP, in reserves. For example, each TUSD is backed by $1 held as collateral. Users can then convert their fiat to a stablecoin and vice versa at the pegged rate.
Crypto-backed stablecoins
Crypto-backed stablecoins work in a similar way to fiat-backed stablecoins. But instead of using dollars or another currency as reserves, we have cryptocurrencies acting as collateral. As the crypto market is highly volatile, crypto-backed stablecoins usually over-collateralize the funds as a measure against price swings.
Crypto-backed stablecoins use smart contracts to manage minting and burning. This makes the process more reliable as users can independently audit the contracts. However, some crypto-backed stablecoins are run by Decentralized Autonomous Organizations (DAOs), where the community can vote for changes in the project. In this case, you can get involved or trust the DAO to make the best decisions.
Let’s look at an example. To mint 100 DAI pegged to USD, you must provide $150 of crypto as 1.5x collateral. Once you have your DAI, you can use it however you want. You could transfer it, invest it, or keep it as is. You must pay back the 100 DAI if you want your collateral back.
If your collateral drops below a certain collateral ratio or the loan’s value, we will liquidate it. When the stablecoin falls below $1, it incentivizes holders to return their stablecoin for the collateral, thereby reducing the coin supply and causing the price to rise to $1. Conversely, when it exceeds $1, it incentivizes users to create the token, increasing its supply and reducing costs. DAI is just one example, but all crypto-backed stablecoins rely on a mix of game theory and on-chain algorithms to incentivize price stability.
Algorithmic stablecoins
Algorithmic stablecoins take a different approach by removing the need for reserves. Instead, algorithms and intelligent contracts manage the supply of the tokens issued. This model is much rarer than crypto or fiat-backed stablecoins and more challenging to run successfully.
An algorithmic stablecoin system will reduce the token supply if the price falls below the fiat currency it tracks. This could be done via locked staking, burning, or buy-backs. If the fee surpasses the value of the fiat currency, new tokens enter into circulation to reduce the stablecoin’s weight.
What Are the Advantages of Stablecoins?
Stablecoins are versatile and powerful tools for investors, traders, and cryptocurrency users. Their main strengths include the following:
1. Stablecoins can be used for day-to-day payments. Businesses and individuals value stability. Due to its volatility, cryptocurrencies haven’t achieved widespread use for everyday payments. Large stablecoins have a track record for maintaining their peg, making them suitable for daily use.
2. Stablecoins have the benefits of being blockchain-based. You can send a stablecoin to anyone globally with a compatible crypto wallet (which can be created for free in seconds). Double-spending and false transactions are also almost impossible to run into. These qualities make stablecoins incredibly versatile.
3. Traders and investors can use stablecoins to hedge their portfolios. Allocating a certain percentage of a portfolio to stablecoins is an effective way to reduce overall risk. Your portfolio will be more resistant to market price swings, and you will also have funds on hand in case a good opportunity comes up. You can also sell crypto for stablecoins during a market downturn and repurchase them at a lower price (i.e., shorting). Stablecoins allow you to enter and exit positions conveniently without taking money off-chain.
What Are the Disadvantages of Stablecoins?
Despite their potential to support widespread cryptocurrency adoption, stablecoins still have limitations:
1. Stablecoins aren’t guaranteed to maintain their peg. While some significant projects have a good track record, there have also been many projects that have failed. When a stablecoin has constant issues maintaining its peg, it can lose its value dramatically.
2. Lack of transparency. Not all stablecoins release full public audits, and many provide only regular attestations. Private accountants carry these out on behalf of the stablecoin issuers.
3. Fiat-collateralized stablecoins are usually more centralized than other cryptocurrencies. A central entity holds the collateral and may be subject to external financial regulation. This gives them significant control over the coin. You also need to trust that the issuer has the reserves they claim to have.
4. Crypto-collateralized and uncollateralized coins rely heavily on their community to function. It’s common to have open governance mechanisms in crypto projects, meaning that users get a say in the development and running of each project. As such, you must get involved or trust the developers and community to run the task responsibly.
Examples of Stablecoins
Crypto-backed stablecoin: MakerDAO (DAI)
DAI is a crypto-backed stablecoin that tracks USD on Ethereum. The coin is managed by the MakerDAO community that holds the governance token MKR. You can use MKR to create and vote on proposals to change the project. Users enter into Collateralized Debt Positions (CDPs) to manage their collateral, and they over-collateralize DAI to address crypto volatility. Smart contracts run the entire process.
Fiat-backed stablecoin: TrueUSD (TUSD)
TUSD is an independently verifiable dollar-pegged stablecoin. It is the first stablecoin to programmatically control minting with instant on-chain verification of USD reserves held off-chain. TUSD’s reserves are monitored using Chainlink Proof of Reserve so holders can autonomously verify that their TUSD is backed by USD held in accounts.
Are Stablecoins Regulated?
Stablecoins have caught regulators’ interest worldwide due to their unique mix of fiat and crypto. As they are designed to maintain a stable price, they are useful for reasons other than speculation. They can also facilitate high-speed transactions internationally at a low cost. Some countries are even experimenting with creating their stablecoins. As a stablecoin is a type of cryptocurrency, it will likely fall under the same regulations as crypto in your local jurisdiction. Issuing stablecoins with fiat reserves may also need regulatory approval.
Closing Thoughts
It’s hard to find an investor or trader nowadays who hasn’t held a stablecoin at some point. Traders often hold stablecoins in crypto exchanges to capitalize on new market opportunities quickly. They’re also beneficial to enter and exit positions without having to cash out into fiat. In addition to trading and investing, people can use stablecoins for making payments and international transfers.
Even though they are an integral part of crypto and have enabled the creation of a new financial system, you shouldn’t underestimate the risks. Stablecoin projects have failing pegs, missing reserves, and lawsuits. So, while stablecoins are incredibly versatile tools, remember they’re still cryptocurrencies with similar risks. You can mitigate risks by diversifying your portfolio, but do your research before investing or trading, and don’t invest more than you can afford to lose.