What are Stablecoins and how do they work?

Cryptocurrencies and Bitcoin are notorious for their volatility. This can be attributed to this to the nascent stage of blockchain technology, speculation, manipulation owing to little regulation, very little real-world adoption or a combination of factors. But it is widely accepted that for Bitcoin to become a mode of payment or unit of accounting, it has to achieve a much more stable valuation. That is where Stablecoins come in.

What are Stablecoins?

Stablecoins are cryptocurrencies, built on blockchain technology, whose value is tied to a Fiat currency. $USDT or Tether is the most popular Stablecoin. In theory, the value of one USDT is pegged to the US Dollar.

The Need for Stablecoins

It is difficult to transact using cryptocurrencies because of the price fluctuation. A shopkeeper will find it difficult to price a loaf of bread in Bitcoin every day or even every hour. Similarly, it is difficult to keep it as a unit of accounting because the price is so volatile. Bitcoin has now become a Store of Value because it lacks the other two qualities.

A buyer and seller will trade in a particular currency only when there is no risk of devaluation of that currency in the short term. Volatility prevents such merchants from adopting cryptocurrencies.

How do Stablecoins work?

Stablecoins are blockchain-based tokens. So their premise is to enable fast transfers and low fees while providing the stability of a Fiat currency or any other valued asset like Gold, Silver or even oil. The way this is achieved is by collateralizing every token that is issued with the Fiat currency that it is pegged to.

While most popular Stablecoins are backed by assets, a new class of Stablecoins is emerging. These projects maintain their value algorithmically. At the heart of these projects is an algorithm designed to stabilise the price.

Types of Stablecoins

Stablecoins can be divided into two broad categories with nuances that differentiate projects in each category as well. Here are the categories:

Asset-backed or collateralised

These Stablecoins are backed by some kind of an asset.

Fiat collateralised

Fiat collateralised Stablecoins like USDT or Tether are pegged to one or multiple Fiat currencies. However, this involves a central authority that maintains this collateral, US Dollar in this case, for every USDT token that is issued. While this is the most popular project, it does not fit well with the ethos of crypto enthusiasts who are vying for decentralisation.

Crypto collateralised

Crypto collateralised projects are backed by other cryptocurrencies. This oxymoron is solved by over-collateralising. These Stablecoins are over-collateralised by as much as 100%. This means for $200 worth of $ETH, one would get $100 worth of Stablecoins. This is to account for the volatility of $ETH itself.

There is a flaw in this but many crypto enthusiasts prefer this because such a project can still achieve the holy grail of decentralisation.

Algorithmic Stablecoins

Projects in this category use Smart Contracts to maintain their price. The way they do it is by increasing or decreasing the supply of the coin to match its demand. When there are more buyers, the algorithm will increase the supply of this token to maintain the price and vice versa when there are fewer buyers and more supply.

Such coins have the potential to achieve complete decentralisation and yet provide a stable price for traders. However, most algorithmic stablecoins are yet to prove their mettle.

Criticism of Stablecoins

Each kind of stablecoin has drawn criticism from factions of the community. Fiat collateralised coins are suspected to be under-collateralised, crypto collateralised projects are seen to be inefficient with the capital, and there is also a fundamental question of whether pegging it to an existing asset is the right solution.

What remains to be seen is which Stablecoins will overcome these hurdles and how.

Conclusion

There are many challenges to be overcome in this race to be the ultimate Stablecoin. Heavyweights like Winklevoss Twins’ Gemini, Paxos Standard and Goldman-Sachs backed Circle’s coins US Dollar Coin or USDC have entered the arena to claim the throne.

Stablecoins may have their disadvantages at this stage but they are definitely here to stay and useful at least to the traders for now.

Learn more about Stablecoins and it functions in our growing Cryptocurrency Community. Our experts are always looking for strong projects and can help you find the right coin to invest in!