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EducationalNovember 9, 2020

What Are Stablecoins?

Shubham Goyal
Product Specialist
November 9, 2020

Stablecoins, for all intents and purposes, are cryptocurrencies that exist on blockchains, the only apparent difference being the fact that stablecoins act like fiat currencies. A stablecoin might represent the value of a physical currency like the US dollar, or even the price of valuable physical assets, like gold. They are advocated by reserve assets/currencies, and their primary goal is to offer price stability. Currently, most stablecoins exist as tokens on the Ethereum blockchain.

Why Do We Need Stablecoins?

What’s great about stablecoins is that they possess the better features of both crypto and fiat currencies, so they allow you to connect with the crypto world, all the while enjoying the benefits of fiat money. Let’s take a look at some key characteristics that make stablecoins essential:

  1. With stablecoins, transactions happen fast, all the while maintaining security and the privacy of the counterparties, like with cryptocurrencies.
  2. Since the value of cryptocurrencies aren’t tied to any assets to keep them grounded, the prices of cryptocurrencies are ever volatile and unpredictable, dropping or soaring in the blink of an eye. This characteristic of cryptos can be bothersome, especially when sending, receiving, or storing money because you have little idea about their future value. That’s where stablecoins come into play. Stablecoins are backed by reserves/underlying assets that act as collaterals and keep them tethered. So the prices aren’t subjected to the wild fluctuations regular crypto prices suffer from.
  3. When you use stablecoins for transactions, you pay the lowest possible transaction fees regardless of the transfer amount. You can send any amount to anyone at any corner of the world without any intermediaries and for really low transaction charges.

Categories of Stablecoins

There are three basic types of stablecoins, and the main difference between them is the varying assets that keep their values tethered.

1. Fiat-Collateralized Stablecoins: Fiat-collateralized, or centralized stablecoins are the best-known stablecoins; they have fiat currency reserves or physical assets backing them up.

Fiat-collateralized stablecoins have a central authority figure (for example, financial institutions like banks) who hold a certain amount of fiat currency and issue an equivalent number of tokens or stablecoins as collateral. Precious metals like gold, silver, etc. and even commodities like natural gas, oil, etc. can be used as collaterals by the controlling authorities.

In terms of stability, fiat-collateralized stablecoins are definitely the best option one can opt for. Most of the centralized stablecoins have fiat money backing them up in a 1:1 ratio. For example, there’s the stablecoin USDT or Tether, where 1 USDT= 1 USD (US dollar). Users can use these USDTs for cryptocurrency trading, and they have the option to retrieve the value equivalent in USD any time.

2. Crypto-Collateralized Stablecoins: Crypto-collateralized stablecoins, as the title suggests, have cryptocurrencies, such as Ethereum or Bitcoin, used as collaterals.

Now, we know when it comes to digital assets, price fluctuations are bound to happen. So to keep the value of the stablecoins steady, they are over-collateralized, i.e., for a large number of crypto coins reserved, a relatively smaller number of stablecoins are issued for circulation.

As opposed to fiat-collateralized stablecoins, a singular authority does not control crypto-collateralized stablecoins’ market actions. They are trustless, just like the cryptos themselves. So the decisions are all made by the collective group of users through polls.

As for the buying/selling procedures of crypto-collateralized stablecoins, smart contracts manage that for the parties involved. For example, MakerDAO’ DAI is a fairly well-known stablecoin that has Ethereum behind it. So when you lock up your ETH into a smart contract, Dai is generated to your account, while interest is calculated in the form of pooled ether or PETH. If you want to get your ETH back, all you have to do is pay Dai in your possession back into that same smart contract along with the interest gathered over time.

3. Non-Collateralized/ Algorithmic Stablecoins: As you can assume, these stablecoins are uncollateralized, as in they don’t have any reserves backing them up. And yet they manage to keep their values stable by mimicking the mechanism working behind an institution like a central bank. This is achievable through the use of smart contracts and autonomous, distributed algorithms. The network can automatically issue new coins when the price of stablecoins starts to go up and burn existing coins to decrease the coin supply if the price goes down.

Advantages and Disadvantages of Stablecoins:

By doing away with the standard cryptocurrency’s proneness to volatility, stablecoins have undeniably given the average populace a gateway into the world of cryptocurrency, while also bringing the broader financial markets one step closer to implementing virtual currency as the common mode of payment. The fact that the transaction charges are the bare minimum is, of course, an added bonus.

With all of that said, stablecoins are not without their problems either. The primary criticism against stablecoins is that they are naturally centralized, or at least not as decentralized as the traditional cryptocurrencies. Therefore you’ll have to put up with an organization or group of individuals holding power over your money.

Theoretically, the controlling authorities can take these stablecoins away from users, since the code inside the coins allows the admins to burn or freeze these coins, and also issue more of them when they see fit. So essentially, you are putting your faith in the agencies backing up whichever stablecoins you are investing in, and hoping they have your money reserved.

The controlling aspect of stablecoins does put users in a somewhat disadvantageous position. Still, it’s also undeniable that stablecoins have been playing a chief role in bringing about a more global adoption of cryptocurrencies by erasing out the unpredictability factor. This proves them essential as mediums of exchange and capable of heralding a significant change in the traditional cryptocurrency trading methods.

For more on cryptocurrency trading, insights into how crypto derivatives work, or really all related concepts, head over to the Delta blog.

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