What are stablecoins and what is their place in crypto?

What are Stablecoins and how are they different from other cryptocurrencies?

One of the major criticisms of bitcoin and other cryptocurrencies is that their price is extremely volatile.

Most cryptocurrencies could see price fluctuations in the range of 1% to 1000% in a single day.

This makes them highly unsuitable for everyday use for the purchase of goods and services. By the time you receive a cryptocurrency payment, the value could be anywhere far above or below what it was sent at.

This makes cryptocurrencies to be considered as highly risky investments and practically unusable in making payments for goods and services.

Stablecoins were developed to tackle this problem with bitcoin and other cryptocurrencies as they are relatively stable with minute price fluctuations.

What Are Stablecoins?

Stablecoins are cryptocurrencies with a fixed value that is pegged to a fiat currency such as the dollar or any other underlying asset (gold, real estate, etc.) and backed by fiat or other reserve assets.

This class of cryptocurrencies provides investors with the best of the worlds of cryptocurrencies and traditional fiat –instant, secure, and private (anonymous) processing of payments and the stability respectively.

Categories of Stablecoins

There are basically 3 different types of Stablecoins, based on how they work to maintain their stable price:

Fiat-backed Stablecoins
Crypto-backed Stablecoins
Code-backed Stablecoins
Commodity-backed Stablecoins

Let’s examine them one after another below.

1. Fiat-backed Stablecoins

Fiat-backed Stablecoins such as Tether and TrueUSD maintain a fiat currency reserve which is held in custody by a regulated financial institution such as a bank and their value is pegged to the value of the base fiat currency.

These forms of Stablecoins were the first to emerge in the market and their values are pegged to one or more fiat currencies such as the US dollar, Euro, in a fixed ratio.

The number of the Stablecoin in circulation must reflect exactly what it has in its fiat currency reserve.

2. Crypto-backed Stablecoins

As the name suggests, crypto-backed Stablecoins such as MakerDAO’s DAI are backed by other cryptocurrencies the same way fiat-backed Stablecoins are backed by fiat reserves.

However, unlike fiat-backed Stablecoins, their monetary policy is determined by “voters” in a decentralized governance system and new coins are minted or created based on a smart contract rather than the decision of individuals as it is with fiat-backed Stablecoins.

Therefore, rather than trusting a single institution to act in the good interest of the users, you are actually trusting all the network participants.

Trust is minimized with smart contract regulated and decentralized Stablecoin compared to its fiat-backed counterpart.

However, it is more technically complex to implement and more prone to bugs which malicious hackers may capitalize on in to wreak havoc on the system and steal users’ funds.

3. Code-backed Stablecoins

Code-backed Stablecoins uses algorithms to control the supply and regulate the value of the Stablecoin.

These forms of Stablecoins are less popular as evidenced by the fact that I cannot find any single Stablecoin of this category in the market.

The value of the Stablecoins is adjusted by pieces of code (taking into account the forces of demand and supply) on the blockchain and no reserve whatsoever is required for the printing or minting of more of the coin.

4. Commodity-backed Stablecoins

Commodity backed Stablecoins such as Digix Gold Tokens (DGX) have their value pegged to real-world assets such as gold, silver, stocks, real estate, etc. and are harder to be inflated compared to fiat-backed Stablecoins which can be created out of thin air as Tether is mostly accused of doing.

Commodity-backed Stablecoins can be redeemed for the physical asset that they represent on-demand based on a promise to pay by unregulated individuals, agorist firms, or even regulated financial institutions.

What are Stablecoins used for?

Stablecoins are usually used for the preservation, transfer, and store of value.

By maintaining and operating with a stable value, stablecoins are mostly used as a means of payment or transfer of value within the network.

Secondly, Stablecoins can be used as a bridge between the traditional financial system and cryptocurrencies as evidenced by the fact that many people (especially institutional investors) purchase cryptocurrencies (bitcoin) with Stablecoins.

More so, cryptocurrency traders use Stablecoin as a hedge against their positions. By keeping a portion of their trade account in Stablecoins, traders are able to effectively reduce their risk and are able to take advantage of downward price movements or buy other cryptocurrencies.