Stablecoins explained - Complete guide

Cryptocurrencies are arguably the most volatile financial asset in the markets today in the markets today and are capable of wide variations in price. This may be great news to speculators on the right side of trades, but bad news for other categories of traders, especially those whose trading accounts are inadequately financed. These price movements can be very sudden and can even create problems for traders in a lot of ways. Imagine withdrawing your cryptocurrency from your trading account and a short while later, you find out its value has dropped by up to 30%! What a shocker.

The desire to come up with cryptocurrencies that were more stable, had a slightly lower volatility factor and which were also backed up by a physically quantifiable store of value led to the creation of stablecoins. Tether was the first stablecoin created; it was pegged to the US Dollar at parity. It remained the sole stablecoin for several years. In 2019, issues pertaining to its pegging dynamics arose and nearly jeopardized its status, eventually leading to the development of new stablecoins.

Today, more than a dozen stablecoins exist and some have even been developed to receive backing from currencies other than the US Dollar. This guide will show you what stablecoins are, how they work, how they are traded and the stablecoin evolution within the cryptocurrency ecosystem.

What Are Stablecoins?

Stablecoins are blockchain-derived digital assets which have the inherent nature of having a more stable value than traditional cryptocurrencies. The price stability that is displayed by stablecoins is generally achieved via a peg, usually to a fiat currency or other asset that has a stable value such as a commodity that is traded on an exchange. In a few cases, we may see a stablecoin which may have its value pegged to other price stability mechanisms, although this is not as common as the former. Similarly to other types of cryptocurrencies, even stablecoins can be staked as offered by various cryptocurrency exchanges. This is just one of the features they share.

The essence for creating stablecoins were as follows:

  • To solve the issue of extreme price volatility that is inherent in traditional cryptocurrencies such as Bitcoin, while retaining other characteristics of blockchain-based digital assets such as decentralization.
  • Fiat-backed stablecoins may provide the necessary bridge required by cryptocurrency traders to bypass funding restrictions placed by banks on fiat transactions with crypto exchanges.
  • Furthermore, stablecoins provide a basis to trade fiat-crypto pairs on exchanges that ordinarily do not provide such facilities. For instance, a trader could trade the BTC/USDT pair as a substitute for the BTC/USD pair.
  • Stablecoins are the closest that cryptos have been able to get to in terms of creating a crypto that can serve as a medium of exchange. Any asset which fluctuates too much in price is not a suitable candidate to be a medium of exchange, as transactions and settlement of these transactions demand that price is stable.

Different Types of Stablecoins

A commonly used classification of stablecoins groups them according to the form of collateralization on which they depend. Therefore, we have the following categories:

  • Fiat-Backed stablecoins
  • Crypto-backed stablecoins
  • Asset-backed stablecoins
  • Non-collateralized stablecoins

Here is a description of the different types of stablecoins.

Fiat-Backed Stablecoins

The fiat-backed stablecoins are usually collateralized with an equivalent amount of fiat currency so as to maintain a peg of 1:1. The most common example is Tether. Created by Tether Ltd, Tether is the most traded stablecoin and is pegged to the US Dollar, in a ratio that is supposed to be at parity (i.e. 1:1). However, an April 2019 announcement that it was only pegged to the US Dollar by 74% only (as opposed to 100%) caused great volatility that nearly threatened Tether’s status. Its market dominance has now been challenged by other USD-backed stablecoins such as the True USD (TUSD), Gemini Dollar (GUSD) and USD Coin (USDC).

The essence of a fiat-based stablecoin is for the coin issuers to only hold the number of coins that can be backed by their fiat currency holdings. In other words, if a company has access to $100 million, they should only produce 100 million units of their stablecoin. Printing more than the fiat reserves, or creating a peg that is not at parity creates the kind of problems Tether had earlier in 2019.

Lately, stablecoins that are pegged to other currencies have started to emerge. There are now stablecoins for the Canadian Dollar and the Swiss Franc. A German bank, Bankhaus von der Heydt, has also announced its plans to issue a stablecoin for the Euro.

Commodity-Backed Stablecoins

Also known as asset-backed stablecoins, these are stablecoins that are pegged to commodities that are capable of storing value. For obvious reasons, the common examples here are gold-backed stablecoins. An example is the Digix Gold Token (DGX). CannDollar is a silver-backed stablecoin. According to an online news & education portal Invezz, DGX is pegged to one gram of gold and the backing gold is held in vaults located in Singapore. CannDollar’s backing silver is kept in the custody of the Royal Canadian Mint.

The advantage of these commodity-backed stablecoins is that they allow the holder to invest in the backing assets in a tokenized manner. This is because backing commodities can be traded as individual entities. Such a facility does not exist for fiat-backed tokens as they underlying fiat currencies have to be traded in pairs.

Cryptocurrency-Backed Stablecoins

These are stablecoins which are backed by crypto assets. Crypto assets have a higher degree of volatility than currencies. This means that the required peg cannot be at parity. There must be more of the backing asset to collateralize the stablecoin in question, so the ratio is always fractionated. A stability fee is usually charged as a form of interest to defray the cost of maintaining these high levels of collateral. The best known example of a crypto-backed stablecoin is DAI (owned by MakerDAO).

Non-Collateralized Stablecoins

Also known as algorithmic stablecoins, non-collateralized stablecoins use algorithms to automatically adjust the supply of the coin so as to maintain price stability on the coin. So when the coin price is too high, the algorithm increases supply. When price is too low, the algorithm cuts down the supply.

These stablecoins typically are less stable than the other three types because there is no physical quantifiable asset on which their value depends. Trust is therefore an integral part of the equation. If an event occurs to shake this trust, the stablecoin project will be in trouble. A good example of a stablecoin project is SagaCoin.

Conclusion on Stablecoins

As more and more stablecoins are launched, the question is this: will they come to be accepted as a means of exchange, or will they become another tool for speculative activity in the markets. However, they have a lot of trading potential as far as the cryptocurrency market is contained and will enable traders explore the world of crypto-stablecoin pairing.

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