Cryptocurrency is a relatively young digital asset class built on a blockchain network. They are not exclusively issued and controlled by a single central authority, but are rather decentralized due to the nature of blockchain technology. The decentralized and fully digital nature of cryptocurrencies form the basis for perhaps the most popular feature of cryptocurrencies — volatility. The conception of volatility around cryptocurrencies is very widespread, which makes it a source of shock for some people to find out that not all cryptocurrencies are wildly volatile. The currencies that form this class of cryptos are called stablecoins.
A stablecoin is a recently developed group of cryptocurrencies. They are those cryptos that came to be in a bid to bring stability to crypto asset prices. This is made possible by the introduction of a base resource, an underlying asset of actual value which the stablecoin is pegged against. The most popular cryptocurrencies are usually very unstable, with market movements being spontaneous and requiring a high degree of caution. This can be seen in currencies like Bitcoin and Ethereum appreciating by over a hundred percent within a month in December 2020 and January 2021, then plunging by another fifty percent a few months later. Never mind the space of months, cryptocurrencies have been known to undergo drastic price changes of up to even a hundred percent within hours. While these volatile periods make these cryptocurrencies very lucrative, albeit very risky trading markets, it also makes them more or less impossible for use in ordinary day to day transactions. This is because it is shrouded in uncertainty, and its measure of value is not easily ascertainable. For example, a unit of cryptocurrency could be worth five bottles of water today, and just two in a few days because of volatility. Thus, most people would not see it as a safe storage of value for short term transactions outside of the crypto market itself; but an investment at best. Up step the stablecoins. These coins basically try to solve this problem, by maintaining value enough to instill trust in them for them to be reliable instruments of exchange. This way, stablecoins find and maintain a middle ground between cryptocurrencies and fiat currencies.
As indicated above, stablecoins are usually pegged to an underlying asset of real value for it to maintain stability. These underlying assets are often fiat currencies, but other assets such as gold could also function in that regard. The reason fiat currencies are very common in use as underlying assets for stablecoins is because of their reserves. Fiat currencies are equally pegged to an asset as well, such as gold; or more often, forex reserves. These pegs prevent the value of these fiat currencies from succumbing to volatility, and that is the central idea applied to stablecoins as well.
However, that is not the only idea. Not all stablecoins are pegged to fiat currencies or other assets. In this case, the regulation mechanism steps in. Ordinarily, financial controllers like central banks get involved in the management of fiat currencies to regulate demand and supply to maintain stability, especially during rare moments of fiat volatility. That idea could be applied to stablecoins without necessarily compromising the integrity and decentralization of the blockchain. That is via involving a working mechanism, a smart contract that works to regulate market forces and stabilize the stablecoin’s prices, much like a central bank.
Stablecoins can be categorized based on their operational model. The three categories are:
- Fiat-Collateralized Stablecoins: These are stablecoins that are pegged against a suitable fiat currency, or some other physical asset or commodity like gold, oil, silver, etc dollar-pegged stablecoins are most common though, and these underlying assets function as collateral for issuing the stablecoin. The coin is designed for its unit to exist in correspondence with a certain value of the collateral. An example is the Tether USD (USDT) pegged to the US Dollar, and thus, one USDT is pegged to one dollar. These collateral reserves are managed and overseen by regularly audited and compliant independent authorities.
- Crypto-Collateralized Stablecoins: These are stablecoins that are pegged to other cryptocurrencies. It might seem ironic that it is that way, since the main reason for the existence of stablecoins is to rescue users from the volatility of traditional cryptos. However, crypto-backed stablecoins tend to use units of collateral in excess. This basically means it would require a higher quantity of the collateral crypto to mint the stablecoin. For instance, a stablecoin called EME could be pegged to LINK. But to compensate for LINK’s volatility, $1 worth of EME could be backed by reserves of $2 worth of LINL, accounting for 50% of LINK’s volatility. With further regulations and compliance, the stability is fully effected.
- Algorithmic Stablecoins: These stablecoins are not collateralized at all. Rather, they maintain stability solely based off of a working mechanism. This algorithm comes in the form of a smart contract that is developed to manage the supply of the coin according to demand, much like a central bank would. Algorithmic stablecoins smart contracts are usually hosted on decentralized platform where its operations can be fully autonomous.
In a nutshell, stablecoins are basically cryptocurrencies without the volatility. Stablecoins came to be with merging the prime advantages of both cryptos and fiat — the rapid processing, privacy, and security cryptocurrencies have to offer; and the stable valuations of fiat currencies. While this might not make them as lucrative to trade as traditional cryptos, they do serve several other purposes, including near risk-free investment and storage of value; and are now an integral part of the cryptocurrency ecosystem.
