What is a Stablecoin?
The term “stablecoin” refers to a new class of cryptocurrencies that are backed by and/or pegged to assets such as fiat currencies, financial instruments, metals and minerals, real estate, or even other cryptocurrencies, and through this backing offer holders price stability.
Given the recent extreme volatility in the crypto market, stablecoins are a hot topic and are seen as the latest innovation in the fast moving world of cryptocurrencies. As the value of stablecoins are relatively constant, they become extremely useful as a store of value or method of payment.
Types of Stablecoins
The main types of stablecoins are fiat-backed, commodity-backed, cryptocurrency-backed, and algorithmic.
1. Fiat-backed Stablecoin
The fiat-backed stablecoin is the most common form of stablecoins. The concept of this type of stablecoin is ‘backed’ by fiat reserves such as USD, EUR, and etc. Most fiat-backed stablecoins are backed 1:1. This means that 1 unit of stablecoin is equivalent to 1 unit of fiat money. This is the most simple and centralized type of stablecoins in the market. It is easy to understand and straightforward. A fiat-backed stablecoin is theoretically stable because it is legally backed by the government and the economy of the country issuing the fiat currency, and is seen as an easy “on-ramp” or hedge.
However, since it is fiat-backed and centralized, there are concerns we should be aware of. For instance, the single-point of failure or bankruptcy of the central entity. Another disadvantage of this type of fiat-backed stablecoin is that it requires trust with the central entity which goes against the principle of cryptocurrencies. Involving fiat can also require greater oversight and regulations and therefore, potentially diminish the efficiency of conversion process.
2. Commodity-backed Stablecoin
One of the most common commodity to be used as collateral is gold. Many people view gold as a good store of value because it retains its value relative to other assets. As for commodity-backed stablecoins, one coin could serve as a specific value of gold. For instance, 1 token is equal to 1 gram of gold. More specifically, the physical gold itself will be normally stored in a trusted third party’s vault. Other than gold, there are other types of commodity which stablecoin is backed to such as oil, coal, properties etc. For example, there is an oil-backed stablecoin called Petro launched in Venezuela, which is pegged to the price of barrels of the Venezuelan crude oil.
The advantage of commodity-backed stablecoins is that they are backed by real assets. The holders of coin could redeem these assets at the current conversion rate to take possession of real assets. Another advantage is the stability given by the underlying asset, as the price of commodities are usually more stable than cryptocurrencies.
One of the disadvantage of a commodity-backed stablecoin is being centralized. More specifically, the process of issuing commodity backed coins involve third parties such as vendors and custodians to ensure the full-functioning of the system and as a result, this might have a risk such as single point of failure.
3. Cryptocurrency-backed Stablecoin
Crypto-backed stablecoins are backed by other reserves of cryptocurrencies. More specifically, these coins are usually backed by top-ranked cryptocurrencies with huge market capitalization, such as Bitcoin. This type of stablecoin is usually backed by a mix of cryptocurrencies rather than just one cryptocurrency, to allow for better risk distribution. A single cryptocurrencie’s risk is much higher than of a combined group of cryptocurrencies. Usually, the crypto-backed stablecoins will require the holders to stake a certain amount of cryptocurrencies into a smart contract, and hence, this will result in the creation of fixed ratio of stablecoins.
Crypto-backed stablecoins have the advantages of a decentralized structure that is trustless, transparent and secure, and being very quick and efficient when it comes to conversion. However, a crypto-backed stablecoin is considered much more volatile as compared to other stablecoins that use fiat or commodities.
4. Algorithmic Stablecoin
The one category of stablecoin not backed by any asset is the seigniorage-style or algorithmic stablecoin. This type of stablecoin utilizes an algorithmically governed approach to expand and contract a stablecoin’s money supply, similar to how a central bank prints or destroys money. When the total demand for the coins increases, the supply of stablecoins will be increased to reduce the price back to stable levels. The main purpose of this type of stablecoins is usually to get the coin’s price itself to get as close as possible to $1 USD. This type of stablecoins is not as popular as the other stablecoins mentioned above, but could be increasingly popular as we start to trust the new economy more.
This type of stablecoin has some advantages such as being built on a decentralized structure. All the adjustments are made on the chain and therefore all data which is related to the stablecoin is stored in a trustless, transparent and secure ledger. Another advantage is the elimination of collateral. There is no need for any collateral in order to create new coins, the coins are created or destroyed by an algorithm. The only way to get the coin is through an exchange, and as a result, the price of this coin will remain stable since the value is determined by the demand and supply of the market.
On the other hand, the disadvantage of this type of stable coin is having a ruled-based system with a complex logic.
Why do we need stablecoins?
Historically, cryptocurrency prices are very volatile, where 5% or even 10% in a day is considered as usual. As a result, many critics have said that cryptos are mainly speculative investments rather than currencies or assets. The existence of stablecoins is an attempt to bring order to the crypto world. The cryptocurrency economist Dr. Garrick Hileman has pointed out that individuals and institutions have viewed cryptocurrencies as highly volatile and this is keeping a number of people on the sidelines. Hileman also pointed out that “Stablecoins can address that and enable a number of use cases that bitcoin or ether or other more volatile cryptocurrencies are suboptimal for — things like insurance.”
What are stablecoins used for?
The main purpose of the existence of stablecoins is as a liquidity tool for cryptocurrency exchanges. More specifically, stablecoins are managed in decentralized mechanism and store values reliably. Besides that, stablecoins are great mediums of exchange. Currently, there are many exchanges that have been shut down out of mainstream banking due to the wary of dealing with anything related to crypto because of compliance reasons. Therefore, many exchanges will not accept any fiat currencies (such as dollars or euro) as deposits. Most of the clients want to buy cryptocurrency with fiat so they could be able to trade out crypto into dollars at times of high volatility. Stablecoins will help to eliminate this issue.
Stablecoins could also allow for more complex financial products to be built on the blockchain, such as insurance and smart contract dividend payments, and even loans.
Conclusion
At the moment, the demand for the stablecoins is massive, due to the high volatility of cryptocurrencies. Stablecoins are a crucial element for a dynamic cryptocurrency landscape. They are still in their infancy, but with 50 stablecoins projects already announced and more coming soon, the stablecoins war is well and truly underway.
