Bitcoin has bounded payment adoption due to its volatility, so entrepreneurs bring stablecoins into existence— coins that are fixed to assets like the US dollar. As a naturally stable cryptocurrency asset, stablecoins hold influence for both the traditional credit market and cryptos.
Like any other surfacing asset class, cryptocurrencies are vulnerable to market forces. In consequence, new crypto projects are vigorously looking for ways to minimize the risk in a broader cryptocurrency ecosystem. The solution found is an entirely new subset of the crypto market, which is stablecoins.
What are Stablecoins?
The stablecoin market skyrocketed in 2000-2021, having its market cap expand about three times. Just like what its name suggests— stablecoins— these tokens are meant to work with stability.
Stablecoins strive to produce cryptocurrencies that aren’t highly volatile. The value of these stablecoins is pegged to fiat currency or real-world currency. For instance, Tether (USDT), which is a known stablecoin, is expected to keep its fix no matter what.
To allow fast settlement, stability of fiat currency, fewer regulatory hurdles, and convenience of cryptocurrencies, stablecoin was created. Most would use these tokens as a means of exchange on a daily basis, and since these coins aren’t currently popular, no one actually accepts them as a payment method yet.
The current primary usage of stablecoins lies on crypto exchanges where traders can market volatile cryptocurrencies for stable cryptocurrencies if they want to reduce risks.
For instance, if you invest in Bitcoin and don’t want to risk the price of Bitcoin dropping against US dollars, you could exchange your Bitcoins (BTC) for Tether (USDT) to preserve your dollar value.
After getting back in the game, you could just exchange your USDT to BTC. This strategy is well-known among crypto-only exchanges that don’t provide their users with options to trade BTC for fiat currencies because of established regulation.
Through stablecoins, you can also move funds between exchanges remarkably quickly since crypto transactions are faster than fiat transactions. The option for the arrangement makes computer-assisted trading more convenient and closes the price gaps between Bitcoin exchanges.
Understanding Stablecoins
Normally, the smaller the market cap, the higher volatility its price has.
Try to visualize throwing a big rock in the pond, then doing the same thing, but now in the ocean. Obviously, the rock would make a bigger impact on the small pond compared to the ocean.
Likewise, the total market cap of cryptocurrencies is just a small pond at this moment and can greatly be affected by daily buy and sell orders compared to, for instance, the US dollar.
This builds major issues since you can’t fully enjoy the benefits of cryptocurrencies which incorporate money decentralization, and a “free for all” payment arrangement, without the value volatility that goes along with it.
This short-term volatility makes cryptocurrencies unfitted for daily public use, and users will keep away from using it if they don’t have the guarantee of its purchasing power in the future.
This is exactly where stablecoins like Tether come in.
Stablecoins brings forth a solution to reach this ideal behavior by reducing the risk of possible high inflation and having it maintain its purchasing power. This makes stablecoins suitable for spending instead of saving.
Business Models of Stablecoins
You must be wondering what drove companies to create their stablecoins. What’s their business model? Well, each company has its unique drive. Some companies use stablecoins to ask for payment for their trading coin. Some utilize it as a marketing channel to put up awareness of the company and the assistance it offers.
Gemini, Houbi, Circle, and Coinbase are just some of the many exchanges that created their own stablecoins to entice more users to their trading platforms and authorize easier transition of funds between and within exchanges.
Collateralized Stablecoins
Stablecoins are digitized currencies minted on the blockchain identifiable by one of the four fundamental collateral structures. Although collateral structures vary, stablecoins are fixed on the same goal.
To maintain trust, companies back their coins with an asset. This collateral would serve as proof that the company is good for its words and that its coins are actually worth the amount.
Stablecoins keeps a fiat currency reserve as collateral to provide a suitable number of cryptocurrency coins. Collaterals can also come in the form of valuable metals like silver or gold and also commodities like oil. At present, the most used fiat-collateralized stablecoins are dollar reserves.
These fiat collaterals should remain proportionate to the number of stablecoins in circulation and remain in reserve in the company of a financial institution or central issuer. If an issuer owns $10 million fiat currency, the stablecoins that could only be distributed amounts to 10 million stablecoins, with each stablecoins equivalent to one dollar.
Another way to collateralize a stablecoin is to back it with a cryptocurrency.
Crypto collateralization makes use of smart contracts instead of depending on a central issuer. If you purchase this kind of stablecoin, you need to lock your crypto into a smart contract to acquire tokens equivalent to the value.
To withdraw your crypto collateral, you need to put the stablecoins back first in the smart contract. Given this, DAI is the most recognized category that practices this mechanism.
In crypto collateralization, you need to be aware that stablecoins need to be overly collateralized to safeguard against price fluctuations. If you want to buy $2,000 DAI stablecoins, you would be required to deposit $2,000 worth of ETH. This crypto / on-chain collateral requires a 200% ratio.
If the market price of ETH drops yet remains higher than the laid threshold, the excess collateral will safeguard DAI’s expense in order to keep stability. On the other hand, if ETH will drop below the threshold, the collateral will be paid off the smart contract to liquidate.
Algorithmic Stablecoins
Algorithmic stablecoins do not use either crypto or fiat currency as collateral. Instead, stability of price results from the use of automated rules called smart contracts and specialized algorithms that manage the decrease and increase of token supply in circulation depending on the coin’s price.
Suppose that a stablecoin is fixed to the US dollar by an algorithm. If people would start buying that coin, the price of the stablecoin would rise, resulting in a broken algorithm. In order to cease this event, new coins are issued.
Algorithm-anchored stablecoins don’t require any asset as collateral. Smart contracts that manage the coins serve as a central bank that tries to manipulate the price by changing the money supply.
Stablecoin Criticism
A lot of criticism on the creation of stablecoins is spreading around, and the most common is relative to its incapacity to maintain its peg in the long run. In addition to this, a glance in the old days tells us that most pegged currencies are bound to fail because of their maintenance cost.
Moreover, stablecoins are known to be centralized, with companies backing them for maintenance, may it be centralized or algorithmic. For that reason, stablecoins cannot really be completely considered a cryptocurrency due to the fact that they are not decentralized.
Yet, there’s a bigger issue that surrounds stablecoins.
Once cryptocurrencies carry through a higher market cap, there will be no actual use for stablecoins, and their volatility will drop significantly.
Currently, stablecoins are trying to embrace both stability of currency establishment in a large market and flexible, free and decentralized cryptocurrency. Because of this, the possibility of getting worse from both worlds becomes greater as well— a centralized coin that’s in need of a bank to control it and a controversial ability to keep the trust of the masses in it.
Conclusion
Stablecoins appear to be a short-term utility of exchanges, giving an opportunity for traders to haven out of volatility, having no need to settle with controlled fiat options. There is still no specific guarantee of how or if these coins would really have a place in the cryptocurrency ecosystem, given that there are aspects that still need cross-examination.
The most popular stablecoins as of today include TrueUSD(TUSD), USD Coin (USDC), DAI, Paxos Standard (PAX), Gemini USD (GUSD), and USD Tether (USDT).
