What are stablecoins?
What if there was a way you could buy a cryptocurrency that was essentially cash? Meaning the value didn’t change but was still transferable and tradable as crypto? Meet the stablecoins! In this article, you will learn what stablecoins are and their pros and cons.
Definition
Stablecoins are utility tokens built on the blockchain. The entire goal of a stablecoin is to create a cryptocurrency that is the same price as another reference point. Reducing volatility and tracking the reference point as close as possible is the goal. In most cases, stablecoins are pegged (meaning they track the price closely) to the US dollar. The US dollar serves as a great reference point as it is the most widely used fiat currency. Stablecoins can technically be pegged to anything, but when you hear people talking about stablecoins they are usually almost always referring to tokens that track the US dollar.
They offer the convenience, privacy, and security of the crypto ecosystem while offering the stability and trust of fiat money.
Bitcoin is the opposite of a stablecoin. It is extremely volatile and its price is not meant to track anything. Bitcoin was created to be used as a store of value.
Advantages
What if you want to store money using crypto technology but you don’t want to deal with the massive volatility and price fluctuations of crypto in today’s world? What if you have converted your life from fiat to crypto but need a way to make everyday transactions for things like groceries and rent? Well, you can use a trusted stablecoin.
Using bitcoin for everyday transactions would be the fiat equivalent of checking out your groceries by pulling out a gold bar from your coat and slicing off a piece for the cashier. It doesn’t make sense since gold is a store of value and should be worth more next year than it is today. Well, people who use bitcoin for everyday transactions are doing the same thing. Like in 2010 when a guy paid 10,000 BTC (worth 600 million USD today) for two pizzas at Papa John’s. Ouch.
Stablecoins let you store your crypto in much less volatile assets.
Making profits
Let’s say you purchase 100 KogeCoin for 1 dollar on a decentralized exchange like Quickswap. KogeCoin then goes up to 10 dollars per token. So you trade 50 of those Kogecoins to DAI or USDC for example, which are stablecoins, for 500 dollars. You’ve now realized some profit and could transfer this money out of your crypto account to your fiat account. If you were to trade back into a volatile asset like Matic, you may or may not still have that 500 dollars after a week since Matic may have gone up in price or may have plummeted. You may have to hold another month for your 500 in profit to return to its original value.
How do stablecoins work?
Stablecoins work in two different ways: collateralization and algorithmic mechanisms, also known as smart contract manipulation. Those were a lot of big words, but I’m going to break it down for you.
Collateralized Stables
First off, fiat collateralization means that each coin is backed by something. In most cases, it’s the US dollar. In some, though, it’s other countries’ currencies like the euro or even gold.
Not all collateralized stablecoins are created equal though. Tether’s stablecoin USDT, has the biggest market cap of all stablecoins but even though they are one of the biggest players in the stablecoin market, there are some rumors that they do not have a dollar for every USDT that they have minted. You can check this interesting info here.
USDC from Circle is another collateralized stablecoin, and some consider the collateral behind it to be more trustworthy. Of course do your own research.
The pros of a fiat collateralized stablecoin are that they are quite stable, usually only fluctuating by a cent or so. However, they still have weaknesses.
- Money left on the table: The first is that the money required to be collateralized for each USDT or USDC cannot be invested. This could mean millions of dollars for that company that is not earning interest.
- Theft: Another problem is someone at the company could embezzle or steal a bunch of that collateral.
- Centralization: Since collateralized stablecoins such as USDC and USDT are centralized, they are subject to future government regulation.
Algorithmic Stables
Some people also call them algorithmically pegged stable coins. Now the benefit of this method is that it can be publicly audited, you just take a look at the smart contract code. Another benefit is that there are no physical assets to steal.
However, smart contract controlled stable stablecoins are usually much more volatile simply due to how they work.
The 3 main algorithms
Algorithmic stablecoins must manipulate the supply of their coins to adjust the price. The algorithm differs among each stablecoin but there are three main algorithms.
- It changes the amount of coin in your wallet each time that you check it so that the value stays roughly the same: one dollar.
- It uses a money printer and a bond reward system to incentivize the purchase of the stable back up to a dollar or the selling of the stable back down to one dollar.
- A third is very similar to the second, however, it uses something called coupons.
If the algorithm breaks because of a bug in the code, an algorithmic stablecoin would go “off peg” and either go way up above a dollar or way below a dollar. Neither scenario is desired. In addition, algorithmic stable coins that use incentives (bonds, coupons, etc.) can take more time to stabilize since people must actively buy or sell the token or bonds to stabilize the price. This may result in the price stabilizing slower than desired.
How do you buy a stablecoin?
In short, stablecoins are bought and sold on exchanges, both centralized and decentralized. It’s very easy to buy USDT, DAI, or USDC on a centralized exchange like Coinbase, or a decentralized exchange like QuickSwap.
Another method is you could buy some cryptocurrency like Ethereum on Coinbase, transfer it to your private wallet, and then use a decentralized exchange like Uniswap to trade that Ethereum into a stable coin.
General Cons
While stable coins do have many benefits, there are a few things that you should think about before fully ditching your savings account and tossing all your fiat into a stablecoin, and becoming crypto native.
Lack of insurance
When you put your money into a bank savings or checking account, it’s normally insured by the government, at least if you’re in the USA. Some banks are FDIC insured, meaning they’ll repay up to 250,000 worth of money that is stolen or lost from the bank in the case of a bank failure.
Stablecoins do not have this advantage yet. If the company behind the stablecoin you are using goes bankrupt, then you’ll most likely lose all of your investment and be left empty-handed.
While there are some crypto insurance programs popping up, they are still in their infancy.
Collateralization issue
If an algorithmic stablecoins algorithm has a bug or a collateralized stablecoin is discovered to not have true assets backing it up it could unpeg from a dollar. All of the sudden your stablecoins might not be so stable.
Conclusion
Stablecoins are a great advancement for cryptocurrencies at the current moment and I’m pretty excited to see where they go from here. If you’re putting your money into them, I recommend being cautious and as always, doing your own research.
If you have any other questions about stablecoins, please stop by the KogeFarm Telegram or Discord communities, where you’ll always find someone willing to help you out.
