Stablecoins have risen in popularity in the past years. But what is all the fuss about the stablecoin? The biggest concern that most crypto skeptics have had is that cryptocurrencies such as Bitcoin and Ethereum are always subject to volatility. Due to such significant price fluctuations, most of these crypto critics feel that cryptocurrency is an impractical medium of exchange.
This is not to say that the dollar and euro don’t face price fluctuations, but consumers barely feel the impact in most cases. That’s because, with the dollar and euro, there is never crazy inflation and deflation as with cryptocurrencies.
While prices will move to either side of the spectrum, the changes are always very subtle. For this reason, crypto enthusiasts tried to answer these volatility concerns and came up with stablecoins.
So, what is a Stablecoin?
Stablecoins are the new class of cryptocurrencies. Their value is pegged to stable assets like fiat currencies or tangible assets like gold. That helps to deal with the issue of price volatility that other cryptocurrencies like BTC and Ether have to deal with.
What are the Different Types of Stablecoins?
Stablecoins come in four main categories. They include;
- Fiat-collateralized stablecoins
- Commodity-collateralized stablecoins
- Crypto-collateralized stablecoins
- Non-collateralized stablecoins
- The Fiat-Collateralized Stable coins
The most popular stablecoins are pegged to fiat currencies like USD, GBP, and EUR. One of the best-known stablecoins is Tether (USDT), pegged to the value of the US dollar. USDT is pegged to the reserves of the US dollar on a ratio of 1:1. But that’s not the only stablecoin there is. A couple of others use similar models like TrustToken’s TUSD, Binance BUSD, Circle’s USDC, Gemini dollar, and Paxos Standard.
Fiat-backed stablecoins have the simplest structure, and this simplicity comes with many advantages. Simply, when someone redeems their cash with stablecoins, the entity managing stablecoins take out an equal amount of fiat from reserves and send it to the user’s bank account. On the other hand, the equivalent stablecoins are then taken out of circulation.
If you are still new to cryptocurrencies, stablecoins are the easiest to understand. For stablecoins, as long as the economy of the country the stablecoin is linked to stays stable, so will the collateralized coin.
- The Crypto-Collateralized Stable coins
There is also another group of stablecoins that are pegged to other cryptocurrencies. Crypto-backed stablecoins are always more decentralized compared to fiat-backed stablecoins as they dwell on the blockchain.
Due to the high volatility risks, crypto-collateralized stablecoins are often over collateralized. That helps to absorb the price fluctuations in the collateral. However, if the price of the underlying crypto drops very low, the stablecoin is liquidated automatically.
The most popular decentralized stablecoin pegged to cryptocurrencies is MarkerDAO’s DAI. This stablecoin depends on users depositing their crypto to Collateralized Debt Positions in the Ethereum-based smart contracts. However, stablecoins that are tied to volatile assets like crypto are linked conservatively.
The only advantage of crypto-backed stablecoins is that they allow trustless, secure, and transparent processes. That’s because there is no central entity controlling your money. Often. You will even find that different cryptocurrency back crypto-collateralized stablecoins to distribute risk. That way, it becomes easier to cushion and redeem stablecoins in circulation even if the Bitcoin’s value dips.
- The Commodity-Collateralized Stable coins
These kinds of stablecoins are often backed by interchangeable assets such as gold. All in all, these stablecoins could also be pegged to other commodities like oil, precious metals, or real estate. Holders of commodity-collateralized stablecoins must hold a tangible asset with real value, which lacks in most cryptocurrencies.
The fact that the assets are likely to appreciate over time incentivizes people to hold and use stablecoins over time. The commodity-collateralized stablecoins make it possible for anyone to invest in real estate and precious metals. While these assets are mostly reserved for the wealthy, stablecoins open up investment opportunities for ordinary people.
Some of the popular commodity-collateralized stablecoins include; Digix Gold (DGX), SwissRealCoin (SRC), and Tiberius Coin (TCX).
- The Non-Collateralized Stable coins
Unlike every other form of stablecoins, the non-collateralized stablecoins are not pegged to anything. And for this reason, these stablecoins always feel contradictory to the nature of stablecoins. However, the US dollar was pegged to gold decades ago, but that ended. Still the dollar is stable on its own and this is the idea that applies to non-collateralized stablecoins.
All in all, the non-collateralized stablecoins utilize an algorithmically governed approach that helps to control the supply of these stablecoins. The model is popularly known as the seignorage shares. Simply, as demand increases, there is the creation of a new stablecoin that helps to level the price of the stablecoin.
On the other hand, if the stablecoin is trading lower than expected, the coins already in the market are bought up. That helps to reduce the circulation supply and, in turn, create demand. Theoretically, the price of non-collateralized stablecoins should remain stable as they depend on the supply and demand chain in the market.
Basis was the earliest example of stablecoins. But it was forced to shut down its operations due to regulatory issues even after securing over $100M in its ICO.
Does Stablecoins Have any Limitations?
Stablecoins have a few drawbacks that you need to always have in mind. Essentially, the way stablecoins are established, they have unique pain points from other cryptos. That includes;
- Fiat-backed stablecoins are essentially centralized. That means users need to trust the exchanges that the coins are backed by fiat even when no audit results are released. Also, these fiats pegged stablecoins have to deal with the same constraints as the underlying fiat currencies.
- Fiat-backed stablecoins are likely to fall if the economy fails as the two are pegged closely together. The same case applies to the crypto-backed and commodity-backed stablecoins as their value is dependent on underlying assets.
- On the other hand, commodity-pegged stablecoins are harder to redeem as there are less liquid. That means, if you’d like to exchange your real estate pegged stablecoin for real estate in another country, you have to endure a long, potentially cumbersome process.
Many people see stablecoins as the safe space in the cryptocurrency world. However, stablecoins are likely to cause significant damages to crypto that we can’t just overlook. So, as you invest in stablecoins, you need to understand that each stablecoin comes with its own set of unique drawbacks and benefits. There is none we can say is perfect, but their stability remain ideal for individuals and businesses globally.