The cryptocurrency’s ability to provide instant payments with complete privacy and security is a big part of its appeal as a digital currency, whether the assets are big players like Bitcoin and Ethereum or any of the myriad smaller projects on the market.
The problem that these digital currencies encounter most frequently is volatility. It’s hard for most investors to be interested in cryptocurrencies when prices can go up and down hundreds of dollars a day for something like Bitcoin.
In response to the problem of volatility, a new class of cryptocurrencies has emerged and is increasing in popularity: stablecoins.
What are stablecoins?
Stablecoins (or stable coins), are cryptocurrencies that attempt to offer price stability in response to the inherent volatility experienced by most cryptocurrencies. This is done by pegging the value of the currency to something more stable, such as fiat currencies such as the USD or the price of a commodity such as gold. They are then guaranteed by having a backing of assets held in reserve, for example if a company issues $1 million dollar stablecoins, then they should theoretically also hold $1 million dollars in reserve.
Type of Stablecoin
There are three main types of stablecoins: commodity-backed, fiat-backed and cryptocurrency-backed. Here’s a look at each individual type in more detail:
Stablecoins backed by commodities
Commodity-backed stablecoins are either backed or backed by commodities such as gold or silver, which are far less likely to experience inflation than fiat-backed stablecoins. This is due to the inability to create more gold and silver as opposed to the ability to print more money. Commodity-backed stablecoins should theoretically be redeemable for real activity, meaning that the company issuing the coin must maintain, store and protect the commodity to secure equivalent reserves for potential redemption of all coins issued.
Stablecoins with Fiat support
Fiat-backed stablecoins are guaranteed or guaranteed by a fiat currency such as the USD or Euro and are pegged to the value of the fiat currency. Reserves are held by a third-party regulated financial entity and must match the value of the number of stablecoins issued, as shown in the example in the main paragraph of this section. Fiat-backed stablecoins are reliable as long as the custodian of the supporting asset is trusted to maintain reserves that reflect the number of coins issued.
Stablecoins supported by cryptocurrency
Cryptocurrency-backed stablecoins are issued with cryptocurrencies used as collateral. They work similarly to fiat-backed stablecoins, but due to the inherent volatility of holding cryptocurrencies as a reserve, many of them require a higher value of cryptocurrency in reserve than issued stablecoins. For example, a cryptocurrency-backed stablecoin can issue stablecoins worth $1000 and hold $2000 in reserve to account for wild fluctuations that may occur. In addition, cryptocurrency-backed stablecoins run on the blockchain using smart contracts, making them much more decentralized than fiat-backed stablecoins.
How do stablecoins work?
Stablecoin issuers ensure the stability of their coins by holding a reserve equivalent to the number of coins they issue. If a company issues $1 million of stablecoins pegged to the value of gold, then they must hold $1 million worth of gold or more in the real world to ensure that their digital currency retains value and can be redeemed when a user decides to cash out their stablecoin for the actual asset. This is true for all fiat-backed and commodity-backed stablecoins.
Cryptocurrency-backed stablecoins work slightly differently than their fiat and commodity-backed counterparts due to their existence as a digital asset that undergoes greater fluctuations in its stock reserves. As mentioned above, cryptocurrency-backed stablecoins run on the blockchain using smart contracts and often require collateral reserves much higher than the number of stablecoins issued due to the volatility experienced by cryptocurrencies.
What are some of the uses of stablecoins?
It is common in the cryptocurrency space to pay developers with the token they are building. There are several problems with this, the main one being that most people feel uncomfortable taking their salary into an unstable asset. Stablecoins offer employees the advantage of having a stable salary, as well as receiving cryptocurrency. Stablecoins therefore offer an easy entry ramp for cryptocurrency beginners, as stablecoins inherently have fewer risks associated with holding them. Employees can then take the stablecoins and do whatever they want, either cash out or diversify their crypto holdings.
Taking out a loan is another great example. Stablecoins backed by cryptocurrencies often allow users to take out a loan by locking in collateral. This is a loan like any other. Regular payments must be made on the loan as the amount the user receives is subject to interest. The user could be liquidated by the escrow service if the value of his collateral decreases to an amount too close to the value of his loan.
Finally, a great use for stablecoins is to protect against volatility. Since the value of the stablecoin fluctuates little, a cryptocurrency holder can mitigate their losses during a bear market by turning their unstable cryptocurrencies into stablecoins and wait for the market. Also, if they believe that the value of a cryptocurrency they hold will decrease, they can convert it all into stablecoins and then buy back the asset at a cheaper price.
Can I buy Bitcoin with Stablecoins?
Yes! You can buy Bitcoin with stablecoins like Tether and you can also buy those stablecoins with Bitcoin. Most exchanges offer Tether to Bitcoin pairings, as well as other lesser-known stablecoins like TrueUSD. They also often offer Tether pairings to all the other cryptocurrencies they sell on exchanges.
What are some of the downsides of stablecoins?
The main disadvantage of stablecoins is the reserves, or lack thereof, that underpin the coin. The premise of all stablecoins is that for all coins issued there is an equivalent reserve of that activity. If a company issues a stablecoin but does not actually hold reserves that can cover all the coins it has issued, when a user goes to redeem their stablecoin for the asset to which it is anchored, it could be unlucky. This is why most stablecoin issuers regularly perform external audits so that their users are sure they have enough reserve.
Can I buy Stablecoins with USD?
Yes! You can buy some stablecoins with USD. Exchanges like Binance offer users the option to purchase Tether directly with their credit card. Some stablecoin issuers also offer to purchase their coin directly through them, although they require Know Your Customer protocols.
Are stablecoins actually stable?
It depends on what you consider stable. Some stable coins like DAI or USDT are known to fluctuate up to $1.10 and up to $0.90. Some argue that this fundamentally destroys the notion of a stable currency, while others point to the fact that these coins always return to their baseline of 1.00 USD after periods of extreme market fluctuations.