Cryptonomics: What are Stablecoins

Cryptocurrencies drive a financial revolution that provides the benefits of security, lower transaction costs, and borderless settlements, etc. Thus, stablecoins often are used as collaterals in crypto exchanges and decentralized finance applications.

By
Ahamdi Abarikwu
on
March 10, 2021
Category:
Cryptonomics

Introduction

The arrival of cryptocurrencies began with Bitcoin in 2008. Since then, crypto has witnessed a rapid surge in user adoption. The utility value of crypto was what made it so appealing to many. Crypto users can make financial settlements without the trouble of going through banks and without revealing their identity. Users can also make international payments at very low fees.

All that is required to send or receive crypto is a phone or computer. This means that that person can trade, albeit peer-to-peer, without access to traditional banks anywhere in the world. These are just the basic features that cryptocurrency possesses. Its features helped crypto quickly gain widespread adoption. Since then, the high instability associated with cryptos' market value attracted many criticisms, and it is the single most potent hindrance to it being institutionally endorsed as a store of value.

For cryptocurrencies to make a case for use as a replacement for fiat, they need to have much less volatility than what is expected with crypto. Imagine a scenario where particular crypto was worth $8 yesterday, and one unit was used to purchase an item. If by today the value relative to the Dollar drops to $0.5, the item initially purchased can only be sold at a loss now. The prices of cryptos must have to be relatively stable for users to have the confidence to use them for daily transactions.

The need to have cryptocurrencies that are not prone to price volatility while still maintaining benefits such as privacy, security and low transaction fees etc, eventually gave rise to Stablecoins.

Stablecoins Defined

The base description is in the name. The coin is practically stable in value. A Stablecoin is a cryptocurrency whose market value is pegged to another asset that has a stable value. It solves the problem of crypto volatility. Thus users don't have to worry about price fluctuations. The price of a stable coin tracks that of the asset it is pegged to, such that if any large market movement causes any deviation, the price quickly readjusts to that of the peg.

Do We Need Stablecoins?

Definitely, without a doubt, we do. If they don't exist, we could end up with a world where purchasing power will swing erratically with every market speculation. Where users on a loan or mortgage taken in crypto could see their repayments multiply exponentially etc. If crypto must be a replacement for fiat in day-to-day transactions, it must be a reliable store of value. People will not want to use it if they are not sure of its purchasing power tomorrow.

How do They Maintain Their Stability?

Different stablecoins employ different pegging mechanisms to keep their values stable. Depending on the mechanism, stablecoins generally fall into the following groups,

  1. Algorithmic

The stability of stablecoins in this category is controlled by codes and smart contracts rather than any physical asset. It starts out by pegging 1 unit of the coin to say, $1. If the value of 1 coin goes above or below $1, the smart contract respectively either mints more coins or withdraws more coins from circulation until demand and supply are balanced at the point that will restore 1 coin to $1 value.

  1. Fiat-Backed

This class of stablecoins is backed by fiat held in a treasury/bank account, usually in a 1:1 ratio. Ideally, for every single coin in circulation, a unit of the fiat backing it as collateral.

  1. Crypto-Backed.

The stablecoins that fall under this group are backed by fellow cryptocurrencies that are not stablecoins but which have high collateral value, likely Ethereum, Bitcoin etc. Since the cryptos backing this set of stablecoins are themselves susceptible to volatility, the backing ratio is usually 1:2 or more. This ensures that even if the stable coin's value goes below its peg, the higher backing will protect from defaulting.

  1. Commodity-Backed

Here we have stablecoins that are pegged to non-fiat valuable assets such as crude oil and gold etc. In this case, one token of the coin is pegged to a reference value of the asset, say 1 ounce of gold or 1 barrel of Crude oil. Since the asset's reference value has its own worth in fiat, which can vary, it means that the value of the stablecoin can also vary with respect to fiat valuation while it maintains its underlying asset-peg.

Common Applications of Stablecoins

As volatility is no longer an issue, they are used as alternatives to fiat currencies. Therefore, the settlement is done on the blockchain and is faster and cheaper to transact than using fiat. Several retail giants such as Visa and Walmart have begun to accept stablecoins for payments and remittances.

For the crypto trader, stablecoins act as a hedge during times of high market volatility. If a trader has some Ethereum and the markets are so volatile that he expects ETH to drop in value, he can quickly swap his ETH into a stablecoin. He was simultaneously keeping the worth of his holdings intact in doing so. Similarly, if a local fiat currency is losing value, people can change the fiat into a stable coin and protect their wealth from depreciation.

Since they are stable and pegged to reliable assets, stablecoins often are used as collaterals in crypto exchanges and decentralized finance applications. Further reading on other use-cases of stablecoins is illustrated here.

Some popular stablecoins in current use are Tether (USDT), Binance USD (BUSD), True USD (TUSD), Paxos Standard (PAX), USD Coin (USDC), Dai etc


Conclusion

Cryptocurrencies drive a financial revolution that provides the benefits of security, lower transaction costs, fast remittances, and borderless settlements, etc. But for all the promise cryptocurrencies hold, they have been heavily criticized as not being a reliable store of value for day-to-day transactions. This is mainly due to their highly unstable price swings. However, stablecoins are a more practical alternative to replace fiat currency. Stablecoins are cryptocurrencies quite alright, but they have their value tied to commonly accepted stable assets, which ensure that their value is practically stable. With the world moving towards full-scale cashless digital money economies, it is expected that stablecoins will become more and more integrated as day-to-day alternatives to fiat.

For further reading, check out the following sources!

1. Everything You Need To Know About Stablecoins And How They Work

2. What Are Stablecoins?

3. Stablecoin



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Ahamdi Abarikwu

Ahamdi Abarikwu is an Electrical Engineer and a lover of anything crypto. He is also an avid writer, proofreader and editor. He loves to play Scrabble in his spare time.

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