Stablecoin is a cryptocurrency with an explicitly defined value, meaning it is not subject to the whims of market cap. The value is typically pegged to either fiat or precious metal coin prices. Stablecoins are designed to be used as a store of value and traded on exchanges.
Stablecoins serve many purposes, such as giving investors a store of wealth when the markets are volatile and giving them access to quick liquidity in situations where financial institutions need large dollar amounts.
In recent years stablecoins have become popular with institutional investors. Many stablecoins are designed to provide the same or better stability as a real currency, such as cryptocurrencies like Bitcoin and Ethereum. The use of stablecoins has expanded beyond financial institutions, with merchants converting fiat into stablecoin accounts to pay suppliers and customers.
Types of stablecoins
There are multiple types of stablecoins, including fiat-collateralized, crypto-collateralized, and non-collateralized.
Fiat-collateralized stablecoins are the most prominent type of stablecoin, where the collateral is held on behalf of investors and is used to guarantee the value of a stablecoin. If a currency’s value falls below the collateral, the issuer must make up for it by either selling dollars or buying cryptocurrencies. In this structure, two parties are involved: one who borrows fiat funds and another who lends them.
Crypto-collateralized stablecoins function similarly to fiat-collateralized ones, but instead of fiat, they hold a cryptocurrency as collateral. This type of stablecoin is not as popular as fiat-collateralized ones, but some notable examples are MakerDAO, Dai, and Basecoin.
Non-collateralized stablecoins do not require any collateral backing them. Tether (USDT) is a well-known example of a non-collateralized fiat-backed stablecoin.
How do they work?
Stablecoins use various mechanisms to maintain a peg to a real-world asset. The methods used depend on their type.
Fiat-collateralized stablecoins use reserves of the corresponding fiat currency, which are theoretically infinite when backed by a powerful central bank. The value of fiat collateralized currency is based on the amount of money in circulation at any given time. Governments can alter it through monetary policy or changes in interest rates.
A crypto-backed stablecoin has an issuance unit that gives it value and can be redeemed for fiat currency or other cryptocurrencies. It also has a corresponding reserve of cryptocurrencies to guarantee its value. The reserve cryptocurrency is typically locked up in smart contracts that control the issuance unit’s supply. A non-collateralized stablecoin does not require any collateral backing. It is therefore feasible for use by individuals and merchants who do not want to be exposed to the volatility of cryptocurrencies but at the same time require a stable medium of exchange.
How are they different from other cryptocurrencies?
Stablecoins are much different from most cryptocurrencies in that they typically have a fixed value, which removes the price volatility that has plagued crypto markets. This makes them easier to use in day-to-day transactions and more attractive to traditional financial institutions. Many stablecoins can also be used as a cryptocurrency hedge against market downturns or other negative events.
Why were stablecoins created?
Stablecoins have existed as a concept since at least the 2009 financial crisis, with variations on the theme being developed and promoted since then. The primary motivation for creating stablecoins has traditionally been price stabilization and convenience. They are also viewed as a possible way to create more efficient use of cryptocurrencies by reclaiming their value by using them to back stable currencies.
How stable are stablecoins?
The stability of a stablecoin is based on the “floating peg” mechanism, which maintains its value against the underlying asset. In other words, if the market price of an asset increases relative to the pegged price, then that value must be brought back down to match normal trading.
A standard method used by stablecoins is a formula known as “collateralized debt position,” or CDP, which gives the value of the stablecoin relative to the underlying asset. In this method, the issuing organization creates a fixed number of stablecoins, which are then turned into CDP. The CDP holds the underlying asset and can issue additional stablecoins.
Are they safe?
The safety of any cryptocurrency rests solely in the hands of its creators and users. Like other cryptocurrencies, if a stablecoin lacks proper security controls or fails to have a security breach-resistant development team, it could be subject to hacking or theft. A poorly-designed system or network architecture may also expose trust issues with a stablecoin’s value.
Are they popular?
Stablecoins have been around for quite a while but have recently started to gain traction, particularly in the wake of the increased investor and institutional interest in cryptocurrencies. This has led to an increase in stablecoin offerings of all types. Examples of this growth include the launch of USDT, which is used as a way for investors to buy Bitcoins and other cryptocurrencies without having to convert their funds into an unstable fiat currency. The figure below illustrates the number of stablecoin operators that are offering tokens or coin offerings (ICO).
What challenges do they face?
Stablecoins may face challenges when paired up against other cryptocurrencies. Even though stablecoins are pegged to a specific asset, the volatility of cryptocurrencies may cause fluctuations in their value, especially in the short term. This may make stablecoins less attractive to investors and merchants who need a more predictable medium of exchange. Other challenges include;
i) The fact that cross-border payments can be difficult.
ii) The fact that stablecoins are not subject to regulation as they are not considered a medium of exchange but merely a software asset.
What advantages do stablecoins have?
Stablecoins have the advantage of being entirely digital non-fiat currencies directly linked to asset classes. This means that, unlike fiat currencies which suffer from inflation, the value of stablecoins does not change over time or be subject to manipulation by governments and central banks. Furthermore, stablecoins offer users greater security in their assets than traditional financial systems due to the decentralization and immutability of the funds held in them.
How will stablecoins evolve?
Stablecoins can be expected to develop in the future based on their demand. Stablecoins, which focus on being a secure and private medium of exchange between individuals, may appeal to the broader cryptocurrency community, especially if backed by a centralized entity or government. On the other hand, stablecoins meant to be used for more significant value transactions may develop into a new asset class with different characteristics and associated risks.
Tether Limited owns 70% of all issued USDT but is not guaranteed against instability due to security breaches or hacks. This common pitfall with many stablecoins is referred to as “tethering.” This problem is exacerbated by the fact that stablecoins do not have the legal backing of government-backed currencies, which results in an increased level of uncertainty as to their value.
What does the future look like for stablecoins?
As stablecoins continue to gain popularity, there will be increased demand for their use domestically and internationally. This will likely lead to ongoing developments in the forms of new stablecoin and cryptocurrency products.
Stablecoins could potentially function as a replacement for fiat-based currency and a means of conducting international payments. They are also expected to become integrated into more advanced blockchain applications, allowing users to engage in complex financial trading and investments without needing a traditional financial institution or intermediaries.
How does the stablecoin market look like?
The market for stablecoins is still young, so the landscape of stablecoin options is constantly evolving through new launches and developments. Below are some examples of the most popular stablecoins around this time:
In January 2018, a stablecoin named Havven was launched by haven core developer Lior Yaffe. It utilizes a new blockchain protocol known as “Nakamoto consensus” to allow for decentralized currency creation and value-pegging to its underlying collateral asset, meaning it can be used in financial markets to underpin borrowing and lending decisions. In mid-2018, Circle officially announced its intention to begin rolling out USD-backed stablecoins across its platforms. Circle USD (USDC) is a stablecoin run by CENTER, a joint partnership between Circle and Coinbase. According to Circle, CENTER was officially launched in July 2018. Maker is an Ethereum-based ERC-20 token that is the basis for Dai, the first decentralized stablecoin on Ethereum whose value is pegged to U.S. dollars. Dai can be used as collateral for Ethereum smart contracts or to pay transaction fees on various platforms, including Melonport and Bancor.
In conclusion, stablecoins represent a new technology for trading and transferring value without using traditional banking infrastructure or centralized intermediaries. Although it is hard to predict what stablecoins will become or how they will evolve, it seems possible that stablecoins will continue to take their place as a viable cryptocurrency token and an essential part of the financial industry.
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