Stablecoins: What are They Good For? Understanding Their Purpose
You may already be aware that stablecoins are essentially digital money. Except that’s not quite accurate, because stablecoins may be algorithmically linked to any sort of fiat (government) money, including the euro, Australian dollars, and others, as well as other forms of tangible assets, such as gold.
Stablecoins, in whatever form, exist to make cryptocurrency more predictable. While predictable cryptocurrency may appear to be an oxymoron, stablecoins — as the name implies — were designed to counter crypto’s hallmark volatility and provide a convenient way for crypto traders to preserve their fiat value without having to cash out of the market, as well as to allow users to pay for everyday goods and services in crypto without all the budgeting drama.
Let’s look at how stablecoins function.
How do stablecoins work?
Stablecoins operate similarly to other cryptocurrencies in that they are cryptocurrencies produced on a blockchain that users may buy, sell, and trade on an exchange just like any other crypto currency. Stablecoins may be stored in hot wallets and/or cold storage devices much like bitcoin or any other cryptocurrency.
Most stablecoins are connected to a reserve of external assets of some type, whether it be a hoard of fiat money, commodities like gold, or debt instruments like commercial paper, in order to maintain their integrity. Most of the time, the corporation or entity that creates the stablecoin has reserves equivalent to the number of stablecoins in circulation. This means that at any moment, each stablecoin holder should be able to redeem one stablecoin token for one dollar.
The four types of stablecoins
There are four different types of stablecoins, each with its own way of fixing the value of the tokens to a stable figure.
Fiat-backed
Cryptocurrency-backed
Commodity-backed
Algorithmic
Fiat-backed stablecoins
Stablecoins backed by fiat currency are the most popular on the market. For example, the USD coin (USDC) is fiat-backed and tied to the US dollar (USD) at a 1:1 ratio. Other stablecoins are tied to the euro, British pound, Japanese yen, and Chinese RMB.
Cryptocurrency-backed stablecoins
Without getting too technical, crypto-backed stablecoins are cryptocurrencies that are tethered to the value of a more established cryptocurrency. MakerDAO, for example, is one of the most popular crypto-backed stablecoins. It pools enough ether (ETH) to serve as collateral for its stablecoin using a smart contract — a form of self-executing, code-based contract – alongside the Ethereum blockchain. Then, whenever the quantity of collateral in the smart contract reaches a particular level, users can manufacture DAI – the MakerDAO stablecoin.
Commodity-backed stablecoins
Commodity-backed stablecoins, as the name implies, are tethered to the value of commodities such as precious metals, industrial metals, oil, or real estate. Commodity investors appreciate the idea of commodity-backed stablecoins because it allows them to invest in gold without having to worry about sourcing and storing it. Tether gold (XAUT) is an example of a stablecoin backed by a commodity. The currency is backed by a gold reserve stored in a Swiss vault. One XAUT is equal to one ounce of gold.
Algorithmic stablecoins
This type of stablecoin is not backed by any "real-world" commodities and instead employs algorithms to adjust supply according on market demand. In a nutshell, these algorithms automatically burn (remove coins from circulation permanently) or manufacture new coins according on the fluctuating demand for the stablecoin at any particular time.
Consider an algorithmic stablecoin to be a pail of water with a water level marked on the inside. You put up a system that adds or removes water based on how much the water level has strayed from the mark to keep the water inside the bucket at exactly the same level. This is regulated by a computer program, which orders the mechanism to release water from the bottom of the bucket until it reaches the water level mark if it rains and the bucket begins to fill up. On the other hand, if it's a hot day and the water evaporates from the bucket, the computer algorithm will direct the mechanism to add additional water to the bucket until the right level is restored.
There’s been a lot of trial and error in the quest to successfully introduce algorithmic stablecoins to the crypto ecosystem, but one example is Terra’s UST coin.
Why use stablecoins?
Stablecoins, which are designed for our increasingly global economy, supposedly overcome a few major difficulties that impede the flow of money.
Stablecoin users just need one crypto wallet to send crypto to their pals in different countries; they do not require numerous foreign bank accounts.
Stablecoins enable real peer-to-peer digital transfers by eliminating the need for third-party middlemen.
Stablecoins, in principle, reduce the costs, transfer time, and possible privacy invasion that we’ve gotten accustomed to under the central banking model.
Assume you are a Chinese business owner who has to pay an invoice to a Japanese client who has subcontractors in Europe.
"You'd need a Chinese bank account, a Japanese bank account, and a European bank account," William Quigley, co-founder of the WAX blockchain and one of the inventors of USDT issuer Tether, says. "If someone wishes to transfer you euros, yen, or RMB, the intermediaries who can handle those accounts will exchange those currencies for the currency you can hold and send it to your bank." And they've taken a lot of money off the top for it along the way."
Quigley believes that we cannot all have 50 distinct bank accounts in 50 different countries. Stablecoins, on the other hand, do not require this.
Privacy advocates, in particular, value this aspect of stablecoins since it allows them to skip the KYC, or know your customer, procedure, which requires them to give picture ID and Social Security information in order to create a financial account. While KYC has become a standard element of interacting with money for most of us, crypto supporters claim that it is prohibitively expensive when applied to central banking institutions in other nations.
"This is why it amazes me that someone in New York, California, or Texas may have ten distinct tokenized currencies in their Ledger [wallet] that remain in their native form," added Quigley. "You do not require a Chinese bank account." You may maintain a token representing that Chinese cash and utilize it as if it were Chinese currency without ever having to convert."
Stablecoins' direct, peer-to-peer architecture saves money that would otherwise be spent on processing fees and administrative costs for third-party middlemen.
"This is why it amazes me that someone in New York, California, or Texas may have ten distinct tokenized currencies in their Ledger [wallet] that remain in their native form," added Quigley. "You do not require a Chinese bank account." You may maintain a token representing that Chinese cash and utilize it as if it were Chinese currency without ever having to convert."
Stablecoins' direct, peer-to-peer architecture saves money that would otherwise be spent on processing fees and administrative costs for third-party middlemen.
How do you pick the right stablecoin?
Even experts find it difficult to choose which stablecoins to buy, trade, or even utilize for everyday transactions among the larger ecosystem of 16,000+ cryptocurrencies already accessible.
As with anything crypto, there is a constant balance to be struck between centralization and decentralization, stability and freedom, regulation and permissionlessness.
For example, fiat-backed stablecoins are popular because they are as stable as the US dollar (USD) or other widely accepted currencies. However, by tying crypto to a federal currency, fiat-backed cryptos become more centralized and subject to government control — a trade-off as compared to algorithmic stablecoins, the most decentralized alternative.
There's also the question of what actually backs each currency. For example, not all USD-backed stablecoins (USDT and BUSD, to mention a few) are backed by an identical 1:1 dollar-to-crypto ratio. The contents of the reserves differ according on the entity behind the currency.
Tether (USDT), for example, used to be set up so that the dollar amount in reserves was the same as the number of USDT created. But that is no longer the case, according to Quigley, who adds, "What Tether [the issuing business] has done today is they have a certain number of the outstanding tether [USDT] kept in fiat and then a certain proportion held in liquid marketable securities."
Instead of dollar notes, liquid reserves might take the form of bonds, CDs, treasury bonds, and cash equivalents.
"They divulge the mix on a regular basis," Quigley says of Tether.
Another distinction is the platforms and exchanges where each stablecoin may be found. USDC, for example, may be purchased and traded on Coinbase, a well-known cryptocurrency exchange. USDT, on the other hand, is unable to.
When considering which stablecoins to add to your portfolio, consider the following questions:
Where can I buy and exchange the stablecoin?
On what platform is the stablecoin minted?
How often are the reserves audited and how transparent is the reporting?
What’s the market cap and circulating supply?
According to some commentators, 2022 might be a significant year for stablecoins as the Federal Reserve of the United States intends to tighten monetary policy, which will boost the dollar and drive up demand for any digital assets tethered to it. It’s tough to predict if this will happen or not, especially considering the number of US government organizations trying to tighten rules on stablecoins in the coming months.