What Are Stablecoins?

Stablecoins are cryptocurrencies that do not change in price. They achieve this stable quality in a volatile market by being pegged to a stable asset in the real world. Cryptocurrencies were created to serve as a means of exchange, such as a fiat currency. Due to the volatility of cryptocurrencies today, they are more like speculative assets than means of exchange. They are issued by projects and companies that define the pegging mechanism.

Today, several stable coins represent decentralized versions of currencies like the EURO, the USD, and other central bank-issued national currencies.

Summary of Important Points

  • Stablecoins are non-volatile cryptocurrency assets.
  • Stablecoins are pegged to stable assets outside the cryptocurrency market—such as national currencies—or inside the cryptocurrency market using other mechanisms.
  • Stablecoins are the closest asset class to fiat currency since they can serve as a stable means of exchange.
  • The issuing company of a stablecoin usually defines the peg and how the coin arrives at its stable value.
  • Stablecoins are tokens since they exist and are used on non-native blockchains.
  • Stablecoins facilitate transactions that rely on stability and long-term potential, such as loans in DeFi.

Features of Stablecoins

Stablecoins are backed by a reserve asset such as the US dollar. They maintain their price irrespective of the cryptocurrency market’s uncontrollable swings. Their value is not subject to the uncertainties that often accompany the cryptocurrency market. Unlike other cryptocurrencies, they are also less speculative, and they are the preferred assets for loans and other long-term agreements on the blockchain that require stability.

Unlike coins like Bitcoin or Ethereum, stablecoins are tokens and do not exist on their own blockchain. DAI, issued by Maker DAO, was one of the first stablecoins. Today, it is common to see stablecoins—the most popular being USDT and USDC—exist on several blockchains, allowing users to select their preferred blockchain based on fees and convenience.

Advantages of Stablecoin

Stability Stablecoins are 100% price stable. Their prices do not go up or down in seconds, as with Bitcoin and other cryptocurrencies.

Simplicity Stablecoins make transactions easy to compute and settle since their value is the same as fiat. Sending someone an amount in a stablecoin like USDT or USDC is the same as sending that person an equivalent amount in fiat.

Low Risk Cryptocurrencies are mostly regarded as speculative assets by financial experts who are baffled by the sudden spikes and consequent downtrends experienced in the market daily. Holders of stablecoins can rest assured that they can get their money as it was kept at any time.

Less Susceptible to Hacks Since the underlying assets that hold the value of stablecoins are often kept safely off-chain, it is almost impossible for hackers to target the vaults like they often do with other cryptocurrency projects.

Bridging the Gap Stablecoins are the biggest connector of decentralized and centralized finance. Millions of dollars in stablecoins are liquidated daily since all that is needed is a simple drawing on the issuing company. Most P2P and centralized settlements of crypto to fiat and vice versa rely on stablecoins as the store of value linking traditional finance to decentralized finance.

Disadvantages of Stablecoin

Centralization Fiat collateralized stablecoins are relatively centralized. The system requires a custodian to settle transactions, taking us back to the same centralized system. Holders of USDC stablecoins, for example, have their funds stored with Circle, the issuing company in centralized institutions.

Auditing Auditing is necessary to keep check of stablecoin transactions, issuance, and usage. Since the issuing company is centralized, they will have to be checked to prevent unhealthy excesses. The cost of stablecoin auditing is huge and adds to the overall inefficiency of the system.

Instability Crypto-collateralized stablecoins like DAI are less stable than fiat collateralized stablecoins. If the underlying assets decrease rapidly during a crash, holders can lose their collateral. Overcollaterization also amounts to inefficient use of capital.

Regulation Stablecoins have been fraught with severe regulatory issues since most central banks and governments see them as a threat to fiat currencies.

Complexity Crypto-collateralized stablecoins are also complex for the average user to understand the complete mechanisms behind their issuance and operation. The issuing protocols sometimes resort to more complex strategies to maintain their peg.

Crashes Non-collateralized stablecoins can quickly go to zero during sudden market events as there will be no collateral to liquidate the coin back into. They are based on faith, which is something still lacking in the cryptocurrency space.

Types of Stablecoin

Fiat-Collateralized Stablecoins

These stablecoins are backed 100% by fiat stored in the reserves of the issuing company on a 1:1 ratio. The issuers have a dollar for every dollar issued on-chain, or they have managed to convince everyone else to believe so. Some fiat collateralized stablecoins are backed by highly liquid investment and asset classes.

Crypto-Collateralized Stablecoins

Crypto-collateralized stablecoins are backed by cryptocurrencies. They are usually overcollateralized to hedge against the volatility of cryptocurrencies. For every token that you mint, you must deposit a fixed collateral ratio such as 150% in the case of DAI.

Non-Collateralized Stablecoins

Non-collateralized stablecoins take an innovative approach to the idea by issuing coins based on a rebase mechanism or an algorithm. Rebase stablecoins like Ampleforth and Empty Set Dollar use certain mechanisms to reduce the number of tokens in circulation when it reaches a threshold. Algorithmic stablecoins are backed by faith in the code that reduces or increases token supply based on the system’s trust level.

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