What Are Stablecoins: An Ultimate Guide
Cryptocurrencies have been revolutionary in the entire financial world. It is no secret that cryptocurrencies have taken over utmost industry verticals. But, despite all its advantages, there is only one thing acting as an obstacle for the adoption of cryptocurrencies.
This one thing is so deeply intertwined with the crypto system that it has become a part of humor!
How about this:
Well jokes apart, we are talking about the volatile nature of cryptocurrencies. This is the biggest drawback, cryptocurrencies are facing today. When you think of this, you will understand why stablecoins are so important?
Defining them, stablecoins are Crypto tokens designed to reduce the effect of volatility and backed by a fixed assets or stable fiat currency. Stables are often called as “Fixed-price cryptocurrency” or “Pegged Cryptocurrency”.
In this guide we will discuss:
- What is stablecoin?
- What are the different types of stablecoins?
- Why stablecoins are so important?
- How stablecoins work?
- Real-world application of stablecoins
Let’s get started...
What is stablecoin?
Stablecoins are new types of cryptocurrencies whose value is backed with another fixed asset like the US dollar. These coins can be pegged to fiat currency, for example, the US dollar, different digital forms of money, valuable metals or a combination of the three. Fiat is likely a mainstream alternative in the marketplace nowadays, which means one unit of a stablecoin equals $1.
Stablecoins are designed to overcome the issue of volatility seen in cryptocurrency prices. They are collateralized, which means the total number of stablecoins circulating in the market is backed up by fixed assets. For example, if there are 2,000 USD-pegged coins in circulation, there should be at least $2000 sitting in a bank.
Why do we need stablecoins?
Other popular cryptocurrencies like Bitcoin or Ether experience great volatility. In the last six months, the price of bitcoin is reduced from $10000 to $6000 approximately. This shows prices are not stable, but investors or users need stability in the market.
For instance, consider you pay $100 for booking flight today and the same price would be $150 tomorrow as the value of cryptocurrency went up. Small financial investors can’t deal with such volatility. Consequently, stablecoins are designed as an alternative to driving a better approach to the adoption of cryptocurrencies.
Whenever there is a fluctuating condition in the crypto market, stablecoins offer a secure place to its owners in order to store their assets. Customers can rapidly and effectively convert from unpegged cryptocurrencies to stablecoins when they are stressed about the market. This conversion can be affordable as compared to converting crypto into fiat.
What are the different types of Stablecoins?
There are three types of stablecoins: 1. Fiat Collateralized Stablecoins 2. Crypto Collateralized Stablecoins 3. Non-collateralized Stablecoins
1. Fiat Collateralized Stablecoins
Fiat Collateralized Stablecoins are backed by a real-world currency like US dollar. It works by depositing dollars into a bank account and issuing stablecoins in a one-to-one ratio against these dollars. When a user needs to exchange their stablecoins again into USD, you destroy their stablecoins and wire them the USD. This asset should definitely trade at one dollar. It just like a digital representation of a dollar. Some examples of this type of stablecoins are tether, True USD.
--- This is the simplest type of stablecoin, which a great advantage both in helping people understand how it works and in implementing those solutions.
--- It also 100% price table, because for each coin, there is a $1 reserved that can be redeemed at any time.
--- It is less vulnerable to hacks because no collateral is actually held in the blockchain.
--- Fiat collateral stablecoins are inherently centralized because they need trusted custodian to store the real money, otherwise, they will be vulnerable to theft.
--- You will also need to have auditors who will periodically check in on custodian and make sure there’s enough money stored in reserve, which can be expensive.
--- Fiat collateral stablecoin is highly regulated & constrained by legacy payment rails. If you want to exit the stable coin & get your fiat back out, you’ll need to wire money or mail check, a slow & expensive process.
2. Crypto Collateralized Stablecoins
To remove the centralization from stablecoins, the idea of crypto collateralized stablecoins comes in. They operate in the same way, as fiat collateralized stablecoins, but are backed with reserves of another cryptocurrency as opposed to a fiat currency like USD.
This way, the entire system can live on the blockchain & remain decentralized. MakerDao’s Dai is the most prominent example of a crypto collateralized stablecoin.
One major difference to note between fiat collateralized and crypto collateralized stablecoins is the ratio is between collateral and the stablecoin, also known as collateralization ratio. Because fiat currency is generally stable, we can use a one-to-one collateralization ratio, where for each coin we have one dollar stored in reserved. Using a one-to-one collateralization ratio for crypto collateralized stablecoin would make it just volatile which would defeat its purpose.
For this reason, crypto collateralized stablecoins are over-collateralized, which means that for every dollar of a stablecoin, there is more than one dollar of cryptocurrency in reserve. The more volatile a cryptocurrency is, the higher this ratio has to be to ensure that even if the price drops there will be one dollar in reserve for every stablecoin in circulation.
--- It is fully decentralized & can benefit from the properties of the blockchain.
--- Crypto collateralized stablecoins can be liquidated quickly & cheaply into the underlying crypto collateral with simple blockchain transactions.
--- The entire system is also transparent. Everyone can easily inspect the history transactions, collateralization ratio of particular crypto assets & how much reserves actually exist in the system at a given time.
--- These are not as stable as fiat collateralized stablecoins.
--- These stablecoins can be auto-liquidated during a price crash of the underlying collateral which would mean that the holders of the stablecoin would lose their collateral.
3. Non-collateralized Stablecoins
As its name suggests, it aims to maintain stability without relying on collateral in reserve. Currently, fiat currencies control the supply of money with the help of central banks. Central banks try to ensure that a currency’s price stays stable by printing new money when the price of the currency goes up and buying back and destroying money when the price of the currency goes down.
Non-collateralized stablecoins want to do the same thing. By coding logic into smart contracts, they can perform the function of the central bank. These smart contracts will monitor the price of stablecoin on exchanges & will create new coins when the price goes up & buyback & destroy coins if the price goes down.
Non-collateralized stablecoins are independent of all other currency systems. These coins could survive the US dollar or Ether, even if they collapse with a stable store of value.
This system has complexity & can be rather opaque & difficult to analyze.
Why stablecoins are so important?
When all crypto coins experience fluctuating increment or decrement in their price, stablecoins stay stable in its price, almost equivalent to the US dollar.
Stablecoins don't have a fixed supply, like other crypto coins. Rather, stablecoins are dispersed depending on financial market conditions. To protect investors from crashes occurring in the crypto market, these stablecoins are backed with any fixed asset.
For example, Tether is a stablecoin that states to have the same number of dollars in a particular account as there is the number of tether coins in circulation. Stablecoin’s property of non-volatility implies that it can be utilized to buy things or trade fiat currencies or to purchase different cryptocurrencies.
In a few trades like Bitfinex, the initial step to buy currency is buying Tether, which trades at equality with the US dollar. Then, this Tether coin can be utilized to purchase different cryptos.
In addition to this, the possibility of new business models involvement in this stablecoins gives a way to make profits for venture capitalists and regular investors.
How stablecoins work?
Steps in the life of a typical stablecoin can be described as shown in the following diagram:
1] Users deposit fiat currency into a bank account (For this example, we are assuming the fiat is USD).
2] Bank issues an equivalent amount of stablecoins and deposits it into the users’ stablecoin accounts.
3] Users can transact with one another.
4] Users looking to exchange their stablecoins for USD can redeposit their tokens into their stablecoin account.
5] Stablecoin bank destroys the deposited coins and gives the users an equivalent amount of USD.
Real world application of stablecoins
1. Cryptocurrency trading platform
The primary use of stablecoins today is cryptocurrency trades. Utilizing stables coins, traders can exchange volatile cryptocurrency for stable cryptocurrency when they need to bring down their risk. For example, suppose I have invested in Bitcoin and I don’t want to risk the price of Bitcoin falling against the US dollar, I can simply trade my Bitcoins for USDT (also called Tether), which is pegged to USD value) and hold my dollar value. When I need to "get back in the game" and hold Bitcoins, I can simply trade my USDT back to BTC. This strategy is popular with crypto-only exchanges as there is restriction to users to exchange bitcoins for fiat currency because of regulation.
2. Protection from local currency crash
Stablecoins carries the ability to protect the people from hyperinflation. Hyperinflation is described as rapid, excessive and out-of-control price growth of goods & services. So, instead of holding the currency which reduces the purchasing power of resident one can preserve the value of the currency by converting local fiat currency into stablecoins.
3. Faster, less expensive global remittance
The current system requires people to depend on banks and financial institutes for cross border transactions. This is a slow and expensive procedure – it takes three to five days to clear a transaction, and charges normally 4% to 4.5% of volume. On the other hand, stablecoins give a superior option. Foreign workers over the globe can use crypto wallets to transfer stablecoins to their home country instantly, with low fees and with no price volatility.