Stablecoins: What Are They, What is Thier Purpose and How Do They Work?
Stablecoins have become an increasingly popular type of cryptocurrency in the past twelve months. Currently, there are over a dozen stablecoins you can invest in if you want to store your funds in a price-stable cryptographic asset.
In this guide, you will discover what stablecoins are, what their purpose is and how the different types of stablecoins work.
What Are Stablecoins?
Stablecoins are blockchain-based digital currencies that have been created with the aim to have a stable value. Stablecoins achieve price-stability through various different methods such as a peg against a fiat currency or a commodity, through collateralization against other cryptocurrencies or through algorithmic coin supply management.
George Samman, who authored a report titled ‘The State of Stablecoins 2019,’ explained the purpose of stablecoins as follows:
“Stablecoins create connections between the legacy world and the blockchain. Thus, the raison d’être of stablecoins is to mitigate and solve price volatility which has so pervasively characterized cryptocurrencies while attempting to retain other characteristics of bitcoin such as the free flow of capital and censorship resistance.”
In other words, stablecoins exist so that users can benefit from the characteristics of blockchain-powered digital currencies, such as low-cost, high-speed transactions, but alleviates the issue of high volatility which the majority of cryptocurrencies face.
Moreover, stablecoins — most notably Tether (USDT) — is also a popular asset among crypto traders who want to place their funds in dollars during market downturns so they can avoid crypto price volatility when the market is moving against them.
Different Types of Stablecoins
There are four different types of stablecoins currently available in the market: fiat currency-backed, asset-backed, cryptocurrency-collateralized, and non-collateralized stablecoins.
The most common type of stable cryptocurrencies is US dollar-pegged coins such as Tether (USDT), USD Coin (USDC), True USD (TUSD), and the Gemini Dollar (GUSD).
The coins are backed by US dollar holdings held by the issuer. As new coins are issued, more dollars are being held by the issuer to ensure that the stablecoin’s value remains one-to-one to the dollar.
Asset-backed stablecoins are digital currencies whose values are pegged against the price of physical assets, such as a commodity.
An example of an asset-backed stablecoin is the gold-pegged digital currency Digix Gold Token (DGX), which enables holders to invest in gold in a tokenized format. The price of one DGX token on the Ethereum blockchain is pegged to one gram of gold, which is held in a vault in Singapore.
Cryptocurrency-collateralized stablecoins use cryptoassets as collateral to smooth out price volatility to ensure that the price of the coin remains stable.
The most notable crypto-collateralized stablecoin is Maker’s Dai (DAI). Dai is a decentralized, crypto-backed stablecoin that holds its value through the use of smart contracts that act in response to changes in market dynamics by buying and selling pooled digital assets such as ETH and MKR.
Non-collateralized stablecoins, also known as algorithmic stablecoins, are digital currencies that increase and reduce their coin supply automatically through the use of algorithms to ensure that their value remains stable.
Two examples of non-collateralized stablecoin projects include Ampleforth and Kowala.
What’s Next for Stablecoins?
Currently, out of the top 55 digital assets by market capitalization, five are stablecoins. In other words, almost ten percent of the largest cryptocurrencies are stablecoins. This is a testament to the demand for and the future potential of blockchain-powered stablecoins.
MakerDAO founder, Rune Christensen, argues that
“[Stablecoins] are the first step before you actually see anything else interesting happening […] because you just cannot do business in an unstable environment.”
Samman agreed with this notion and stated that “the biggest barriers to adoption of cryptocurrencies as a medium of exchange and as a store of value are price volatility from speculation and the lack of perceived advantages over traditional payment systems […],” in his report.
Whether stablecoins will be adopted as a popular online payment method, whether they will be used in fundraising or whether they will continue to be held primarily by investors to temporary store funds during market downturns will remain to be seen. What is clear, however, is that stablecoins is a growing market segment that we can expect to play a significant role in the future of cryptocurrencies.
