Nowadays, people can use alternatives to traditional fiat currencies. One of these alternatives, which has been talked about a lot, is the category of stablecoins. In this guide, there are answers to the following questions:
- What is the idea of stablecoins?
- What problems do stablecoins solve?
- How do stablecoins operate?
- How many types of stablecoins are there?
- In what cases will it be helpful to use stablecoins?
The concept of stablecoins
Stablecoins represent a cryptocurrency category and are backed by an external reference, like fiat money or a commodity like gold. The reason for their being popular is having the benefits of the crypto industry as well as banknotes. Stablecoins offer fast processing, security, and privacy of crypto assets, providing constant prices at the same time.
The first issuers of stablecoins were fintech and crypto corporations. Gradually the number of financial establishments interested in this type of asset has grown. Different banks and large firms all over the world are experimenting with stablecoins presently. Among them are popular social networking site Facebook and multinational investment bank JPMorgan Chase.
What problems do stablecoins solve?
Prices of crypto assets are fluctuating practically on a daily basis. So, there was a need to create a crypto asset, which users could transfer digitally without worrying much about volatility issues. Stablecoins were built to provide static price while trading crypto. They ensure high speed and certainty of a system, running on a blockchain.
Therefore stablecoins help:
- to bypass the rate variations of cryptocurrencies with completely market-driven price
- to make cryptocurrencies convenient for daily activities
- to enable more people to reach the services of digital assets
Thus, offering a lot of opportunities, stablecoins are viewed to be a digital illustration of cash.
How do the stablecoins work?
In 2014 Hedge fund manager and macro specialist Robert Sams issued a paper ‘A Note on Cryptocurrency Stabilisation: Seigniorage Shares.’
This was the first white paper describing the basic mechanism of creating a new coin, setting a peg, and then monitoring the price on the exchange.
The author wrote how to manage the process algorithmically, in a decentralized way. He also described the way of using source code that is visible and auditable by everyone.
Now let’s consider a case when there is a stablecoin 1:1 backed by the U.S dollar. If the price of the coin surpasses $1, it means the demand for the asset is extremely high. In that situation, the system begins to supply more of that stablecoin by printing. Thus, it equals the offer with demand.
If the price declines below $1, it means that the number of coins in circulation is higher than the demand. So, the algorithm is programmed to contract the number of assets in the flow until supply meets demand at the dollar price point.
Despite the fact that Robert Sams never launched Seigniorage Shares, the paper had a huge impact on the evolution of stablecoins.
The subcategories of stablecoins
Given their working mechanism, stablecoins can be algorithmic, off-chain collateralized, commodity-collateralized, or crypto-collateralized.
1. Algorithmic stablecoins
These stablecoins work on top of a public blockchain. They are not collateralized and use a price stabilization algorithm to trace a particular unit price – in most cases $1. Technical mechanisms running on smart contracts ensure the price correspondence and stabilization implementation. The algorithm issues more coins when the price rises and decreases supply when the price falls.
Algorithm-based stablecoins are mainly highly reflexive. Demand depends on market trends at that particular time, which in its turn has an impact on token supply.
The longest-running algorithmic stablecoin is Ampleforth (AMPL).
2. Stablecoins backed by fiat notes
This class is the most broadly used. The majority of them are related to the U.S dollar or Euro. For each created fiat-based stablecoin, there stands fiat capital in a bank account.
Although there are various assets fallen into this type, the most popular among them is Tether. It is backed by the dollar and ranks third by market cap.
If a user wants to get cash with his/her coins, the institution that maintains the underlying stablecoin takes the required amount of fiat currency from the store and sends it to the user’s bank account. After that, the system eliminates the identical stablecoins or excludes them from the flow.
3. Stablecoins backed by commodities
Values of these stablecoins are connected with materials, such as valuable metals. The most prevalent material for collateralization is gold. Besides, there are stablecoins linked to the prices of fuel, real estate, or other valuable minerals.
One of the best-known stablecoins in this type is DGX (Digix Gold), which is an ERC-20 token adjusted to real gold.
Tiberius Coin (TCX) is pegged by a basket of 7 valuable metals, which are often used for technology. In the case of these metals being more frequently used to build machinery such as electric vehicles, the rate of the token will grow.
4. Crypto-Collateralized Stablecoins
This category represents the stablecoins, which are linked to other supplies of crypto assets. Crypto-pegged stablecoins are mainly pegged to a combination of crypto assets. The purpose is to decrease volatility risks. The risk would be bigger if the cryptocurrency was backed by a single crypto asset than that of a bunch.
Crypto-pegged coins are mainly over-collateralized to resist price variations of underlying cryptocurrencies. This means users need to stake a definite amount of digital assets, which will create a constant ratio of stablecoins.
One of the best known crypto-pegged coins is Maker DAO. It uses smart contracts and Ethereum’s value to reach the stability of the token DAI.
The cases of using stablecoins
Stablecoins are useful tools for traders. These cryptocurrencies allow storing assets without changing them back to fiat. For instance, currently, the biggest stablecoin Tether (USDT) is pegged to a dollar. If there is a bearish trend in the crypto market, users may want to change their assets back to the dollar. However, they will need to pay high fees and taxes as changing fiat to crypto or vise versa is expensive.
In such situations, stablecoins are effective solutions. Users can change their crypto to USDT and then buy back to the market. So, the buyers will know that their coins are stable for a long time.
Additionally, stablecoins provide long term asset stability for investors and make cross-border transfers easier.
Stablecoins still need to face challenges like financial stability and regulation. Anyway, taking into account all the facts, this category has become extremely useful in the financial world.
From the moment of their creation, stablecoins have advanced immensely. While they continue to develop, regulatory authorities are making moves towards their integration. Recently, on January 4, 2021, the U. S. Federal regulator OCC (Office of the Comptroller of the Currency) validated the usage of stablecoins for transfers and operations for regulated banks.
Earlier, on 24 September 2020, The European Commission published its new Digital Finance Strategy, where it included the draft Regulation on Markets in Crypto-Assets (MiCA), designed to provide a comprehensive regulatory framework for digital assets in the European Union (EU).
So, it is widely assumed that stablecoins have a bright future and they will change global economics. What is great about these coins is that anyone can create them. However, the project’s success depends on different factors. It is essential to cooperate with skillful developers, who understand the business needs completely.