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After hearing the news that Terra Luna’s token’s value plunged overnight, leaving investors with only a sliver of their original investment, you may be wondering: “What are Stablecoins, and why do they matter?”
Good question. Let’s find out below:
What are stablecoins, and can you trust them?
Stablecoins are a newer type of cryptocurrency that attempts to reduce the never-ending price volatility that has plagued Bitcoin’s (BTC) and other digital currencies, such as Ethereum (ETH), hope of developing into a stable medium of exchange that can be both used, trusted, and relied on across the globe.
Fiat currencies currently fit the criteria of a stable medium of exchange due to the widespread rules, regulations, and policies that keep a country’s currency stable. Consider it this way: a 2% change in fiat value is considered a landslide.
Cryptocurrency is, well, a completely different ballgame. Prices rise and fall like mountainous peaks – often at rates of 10% up or down within the space of a few hours! Back in 2017/2018, Bitcoin went below $6,000, back up to $19,000, then down to below $7,000, all in the span of 3 months.
That’s where stablecoins come in: they aim to provide price stability to encourage wider use. Stablecoins offer cryptocurrency fans stable value without fiat’s centralised control.
Tether (USDT) was the original stablecoin – or at least the first genuinely successful one – that dates back to 2014. Now there are a host of these coins, including:
- Dai (DAI)
- USD Coin (USDC)
- True USD (USDT)
- Digix Gold
- Havven’s Nomin
- Paxos Standard
- Binance USD (BUSD)
How do stablecoins work?
As we said above, stablecoins are cryptocurrencies with a stable value (hence the name!) As stable currencies are better value stores and exchange mediums, these coins reduce volatility massively through various means.
Did you know that gold once backed some currencies? For every coin or note distributed, there was an equivalent value of gold stored away in a country’s vault. Today, currencies no longer do this, with the U.S. following Britain off the gold standard in 1931, replacing it with a USD’s reserve currency process.
There are a few different ways stablecoins ensure their stability. These are:
Stablecoins backed by fiat
Fiat-backed stablecoins are the most popular. The USD coin (USDC) is fiat-backed and pegged to the USD 1:1, but there are other ones linked to the euro, pound, and yen. By holding U.S. dollar reserves as collateral, stablecoins reduce their volatility.
Stablecoins backed by commodities
Commodity-backed stablecoins are supported by commodities like gold, oil, or even real estate. Commodity investors love these coins because they can invest in gold without sourcing and storing it (not bad!)
Commodity-backed stablecoins include Tether gold (XAUT), backed by Swiss gold, like the olden days, with one XAUT = 1 oz gold.
Crypto-collateralized stablecoins are somewhat similar to fiat-backed ones. However, their underlying collateral is another cryptocurrency or basket of cryptocurrencies, not fiat money. In other words, crypto-backed stablecoins are pegged to another cryptocurrency.
Stablecoins backed by other cryptocurrencies tend to be something called over-collateralized, which sounds like a bad thing but is actually very good. It simply means that the collateral’s value exceeds the tokens’ by a predefined ratio.
Putting it into actual numbers, if $1 million of that stablecoin is issued, a $2 million Bitcoin reserve may be needed. Why? As it helps secure cryptocurrencies in the event of volatile price shifts.
Stablecoins not backed by commodities in the real world often use algorithms to modulate supply based on market demand. These algorithms automatically burn or mint new coins based on the fluctuating stablecoin demand.
Even if they are collateralised, these coins use an algorithm to control token supply and maintain value too. This mechanism is very similar to how a central bank adjusts its interest rates to maintain price stability.
What are stablecoins used for?
Cryptocurrencies love to swing – it’s a part of their nature at this point in time. Although this magnitude of swings can lead to a tremendous amount of profits for those lucky enough (or clued in enough) to make the right investments, it means these cryptocurrencies aren’t stable. Given this, it makes you wonder: do cryptocurrencies have a purpose beyond high-risk investing and speculation?
The answer is an emphatic yes – and for many reasons. Including…
- Stablecoins – if they genuinely do become as stable as fiat currencies – could help popularise the entire system of cryptocurrency as a medium of exchange. This means real-world financial transactions become a much more accessible reality for crypto-users than they currently are
- Stablecoins could be used as a reliable source to back several processes, including decentralised insurance solutions and consumer loans, to name but a few. Currently, the volatile nature of cryptocurrencies means they aren’t suitable for these uses because they risk losses for the parties involved
- These coins have the potential to revolutionise international payments as users don’t need multiple international bank accounts with insanely pricey exchange rates as middlemen between them to send crypto to themselves, family, or friends. One crypto wallet will often do the trick
- Similar to the above point, stablecoins enable peer-to-peer digital transfers without intermediaries slowing things down, leading to reduced unnecessary fees, speedier transfer times, and a lower risk of potential privacy breaches commonly found with central banking
What are the best stablecoins?
Overall, stablecoins make cryptocurrency more predictable. Stablecoins were designed to counter crypto’s volatility and allow users to pay for everyday goods and services in crypto without the entire drama of fluctuating finances.
So, where do you start? Even for experts, choosing which coins to buy, trade or use for everyday transactions is difficult.
Often, you’ll have to do your own research to find a stablecoin project that you personally trust. Look for where you can currently buy the coin, what platform mints it, and be sure to investigate the details of the creators and their level of transparency when it comes to the project.