A Stablecoin is a crypto with its value pegged to that of some other commodity, currency or financial instrument. This digital currency is an alternative to the highly volatile cryptocurrencies such as Bitcoin.
It won’t be wrong to say that stablecoins bridge the gap that exists between cryptocurrencies and fiat currencies.
In terms of decentralized cross-border lending, these coins offer a secure online environment for P2P transactions without utilizing volatile cryptocurrencies or paying for the conversion of money into local currencies.
The first Stablecoin: BitUSD
Issued on the BitShares blockchain, BitUSD was the first stablecoin and was introduced in 2014. It was invented by Charles Hoskinson and Dan Larimer. BitUSD was powered by BTS, the key token of BitShares, and was collateralized by several other cryptocurrencies with each of them locked in a smart contract so as to behave as a collateral.
Major types of stablecoins
Generally, there are four major types of stablecoins as mentioned below:
These stablecoins preserve a pool of fiat currencies as collateral to assure the value of stablecoin. Gold, silver and crude oil are some other types of collateral; however, the majority of fiat-collateralized stablecoins have supply of U.S. dollars.
Independent custodians maintain these supplies and are audited on a regular basis.
These stablecoins are supported by other cryptocurrencies. Since the reserve cryptocurrency has possibilities of extreme volatility, crypto-collateralized stablecoins are overcollateralized, which means the value of cryptocurrency in supply is more than the value of issued stablecoins.
These stablecoins can carry as well as not carry reserve assets. They keep the value of stablecoins stable by managing their supply via an algorithm, which is a computer program that runs a preset formula.
These are collateralized by interchangeable assets such as precious metals. Gold is the most common commodity that supports these stablecoins.
The underlying asset is usually stored in a third party’s vault. The buyer can redeem the coin with a commodity.
How do stablecoins work?
Being a cryptocurrency, a stablecoin is based on popular networks like Ethereum. Despite not being subjected to the control of the U.S. Federal Reserve, a stablecoin pegged to the U.S. dollar, is impacted by its action. On that note, if the rate of interest is increased by the Fed, it might strengthen the dollar’s value and stablecoins pegged to it.
Similarly, when the price of the dollar falls, the value of stablecoins is affected too. The value and reliability of a stablecoin is largely decided by the management of reserve assets.
Why makes stablecoins important?
There’s no doubt that Bitcoin is the most in-demand cryptocurrency; however, it suffers major volatility as far as its prices are concerned. Though the volatility benefits traders, usual transactions become risky for both buyers and sellers.
Also, merchants are not in a position to bear losses when a cryptocurrency’s price falls and they are paid in it. To behave like a medium of exchange, any currency that isn’t legal tender has to be stable to guarantee that those who accept it will hold buying power in the short term.
Such issues are resolved by stablecoins since they stabilize the cryptocurrency’s value in multiple ways.
Most popular stablecoins
Some of the popular stablecoins include:
Binance USD (BUSD)
When it comes to the market cap, BUSD is the third largest stablecoin. Not only it is pegged to the dollar on a direct basis but is claimed to be supported by an equal amount of U.S. dollars as well as treasury bills.
The stablecoin was introduced in 2018 together by Circle and Coinbase via the Centre Consortium. Prior to its shifting into a combination of collateral assets, USD coin is pegged into the U.S. dollar.
Common stablecoin collaterals
Stablecoins have different types of assets to support it such as:
The most usual collateral is fiat with the U.S. dollar being the most popular. However, companies are looking forward to various other currencies too.
Certain stablecoins utilize other cryptos with Ether being one of them.
There are a few stablecoins with values tied to the value of expensive metals like gold and silver.
At a time, USDT was supposed to be backed directly with dollars though its collateral mix shifted with time. In 2021, the firm disclosed that almost half of its reserves are in commercial paper.
Uses of stablecoins
Stablecoins can be used for a number of purposes and some of them are as follows:
Bitcoin and Ethereum are some of the cryptocurrencies with values that fluctuate like anything. However, assets like stablecoins are pegged to a stable and dependable currency; hence, let buyers and sellers rest assured that their values won’t neither increase nor decrease unexpectedly.
A bank account is not required to hold stablecoins and they can be transferred easily. Not only the value of stablecoins can be sent effortlessly worldwide but also at locations where the U.S. dollar can’t be acquired easily or at places with unstable local currency.
Investment in stablecoins is rewarding as the interest rate is way higher than the interest offered by any bank.
Popular financial institutions consider stablecoins to be a dependable alternative for international payments. Since stablecoins are processed quickly and have a low transaction fee, they are a good choice to send funds anywhere globally.
Risks of stablecoins
Even though they look risk-free, stablecoins do have certain risks. Take a look at some of them:
Stablecoins, similar to other cryptocurrencies, need to be stored somewhere, be it a digital wallet or exchange or with a broker. This leads to possibilities of risks, as the particular trading platform might have certain vulnerabilities and security issues.
Reserves that support a stablecoin are a major aspect of the stablecoin ecosystem. These reserves act as the support system of a stablecoin’s value. Having said that, it is not possible for the coin issuer to determine a stablecoin value without them.
Lack of confidence
A stablecoin that’s not supported by any hard asset has chances of losing the peg against its target currency. This is what became the fate of TerraUSD in May 2022, as it was not supported by cash. Its price fell since traders lost their confidence in it.
What does the future look like?
A stablecoin is administered algorithmically and not by any centralized body. Furthermore, its benefits are like the benefits of fiat currencies. Its stable nature can open doors for the adoption of digital assets on a regular basis. However, considering the drawbacks that come along, new forms of regulation are being explored.
Stablecoins hold immense potential to transform the payment system. By stabilizing consistently and winning the trust of masses, they will evolve the way digital assets are used in the financial sector. However, as they have a risky side too, how they will shape the destiny of finance is best left on time. All in all, investments related to stablecoins is the game of weighing the pros and cons carefully.