Cryptocurrencies are volatile assets, and compared to fiat, their values fluctuate a lot. But there are some cryptocurrencies built to have a price that is secure.
These are referred to as StableCoins.
Stablecoins are intended to be stable, by definition.
By pegging the price of the coin to another physical commodity, these coins help to retain a constant price. May it be:
A fiat currency
A barrel of fuel
Real Estate
It makes sense for developers of stablecoin to bind their coins to a traditionally stable physical asset, although this is not a necessity.
The fiat price also fluctuates with a stablecoin that is pegged to a fiat currency.
Some stablecoins provide the underlying assets with legal entitlement, and some do not. Ownership of the coin means holders are entitled to the asset that the coin is backed by as the coin reflects ownership of the asset for the coins that do include this.
This implies that if something goes wrong with the network, all owners of the coin are legally entitled to the assets their coins are funded by. The other form of stablecoin maintains a stable price with respect to a particular asset, but owning the stablecoin does not imply that the underlying asset is entitled to you.
Why do you want a stable coin?
Stablecoins have some of the same advantages as conventional cryptocurrencies - they are highly secure and can be easily transferred with minimal or no fees.
Their primary usage is as a store of value. Some crypto exchanges do not sell fiat pairs, but instead have pairs with secure currencies that are fiat-backed, which is the next best thing for many traders.
A stablecoin helps traders of cryptocurrencies to store value and escape market instability. They are seen as a perfect way to reach and exit markets quickly, to either escape or benefit from uncertainty. Traders also use secure coins to exit markets when they fear that the price of a coin they hold will fall.
If a trader keeps Bitcoin and expects a decline in price, they may sell their Bitcoin for a stable coin, wait for the decrease in price, and then buy back in. This preserves the value of their keeping of Bitcoin, but boosts the amount of Bitcoin they have.
Their percentage rise would be higher than before as Bitcoin rises. Of course, if they are available, this can be done by trading with actual fiat pairs. Liquid is a crypto exchange that provides USD, SGD and JPY fiat currencies.
How it works
Depending on how they are configured and what mechanism is used to sustain the price, Stablecoins actually function in a number of ways. Let's take a look at asset-backed stablecoins first.
Tether, which is supported by USD, is one of the most recognized asset-backed stablecoins. Theoretically, any person who owns Tether is legally entitled to the equal amount of their Tether in USD.
Therefore, all the USD that is pledged to the coin holders must be owned by the organization behind the coin, and the coin holders need to trust the team that they actually own all the assets needed.
Coins of this type work fairly easily. The company behind the coin should ensure that when a customer buys one of the coins, they own the asset needed to back the coin and keep it safe.
In this situation, the business is supposed to have USD1 for each Tether sold. It is exchanged for USD1 when one of the coins is sold back to the company, and the coin is burned.
The process is similar for other asset-backed stablecoins - the business behind the coin must ensure that they own enough of the asset for the amount of coins issued.
If coins are purchased, more coins must be produced and more assets must be purchased.
They must burn the sold coins and refund the customer if coins are sold. Users have to trust a third party with stablecoins like this, which is not always attractive.
Stablecoins that are collateralized with cryptocurrencies are also accessible.
This reduce the need to trust a third party because everything is carried out by smart contracts on the blockchain and executed. The problem with crypto collateralized stable coins is that to account for cryptocurrency instability, you have to provide much more collateral than the coin is worth.
Stablecoins, which are not backed by cash, are even more complicated. These coins are held to balance the price of a specific asset, but you are not entitled to the asset by owning the coin.
In order to sustain the price, these coins are regulated by algorithms that are constantly changing the total supply of coins. By using a seigniorage shares scheme, the price can be retained.
Simply put, the algorithm will increase the overall supply when the price increases, and the supply will be reduced when the price decreases. Let's take a look at this scheme in depth now.
A smart contract governs the seigniorage shares scheme. Let's say this coin works to maintain a steady USD1 price. If the price increases above USD1, the availability, selling off the tokens and drawing a profit would be increased by the smart contract. The gain is known as seigniorage.
The smart contract does the reverse if the price drops below USD1. The proceeds from the seigniorage are used to buy back some of the supply to lift the price.
When the smart contract runs out of seigniorage income, the tricky component emerges, but the price is still under USD1. In this situation, shares of seigniorage must be given, which are sold to buyers with the guarantee that future seigniorage will be reimbursed.
The smart contract would have ample funds to lift the price to USD1 until the seigniorage shares are sold. Issues begin to arise when the seigniorage shares do not have buyers. If this is the case, as the price can not be sustained and community sentiment will drop significantly, the project will fail. This model therefore relies on continuous group development, with an increase in demand for the coin.
The Downside of Stablecoin
Stablecoins serve an important function, but they have drawbacks that need to be acknowledged as well.
Trust from third parties is essential - stablecoins are inherently centralized in some way. This goes against the elimination of the necessity for third-party confidence when looking after your assets, one of the fundamental advantages of blockchain technology.
You have to assume that the stablecoin issuer either has the assets needed to back up the coin, or that their algorithms are rock solid. This is not a concern right away, but it is something that must be taken into account.
Stable coins collateralized by Fiat are not really stable because they are impacted by the price fluctuation of the currency to which they are related.
The sum it could buy would stay the same, rather than the arbitrary price, if a coin were actually stable. In addition, fiat-backed coins function as an iteration of an existing currency, so it is more likely that legislation will strike them hard.
You have to over collateralize to compensate for the instability of the crypto for cryptocurrency-collateralized stablecoins. In this situation, it is also possible for the collateral to become useless and therefore for the stablecoin scheme to fail.
At best, the past of stable coins is rocky. Nearly all of the previous attempts at stablecoins failed. BitShares was designed to be pegged to USD, for instance, but the device failed only a few days after launch. This does not imply that present stablecoins are doomed to fail, but it is necessary that they remain impartial.
Projects like these will fail. It is very likely for the price of a non-asset backed stablecoin to decline sharply. If the community loses confidence in the project, the token issuer will not be able to collect the funds needed to purchase units and reduce the coin supply to raise the price to the amount necessary.
Since the price can not be sustained, if this is known, it will fall sharply. This model therefore suffers if there is no continuous rise in demand for the coin. Unless there is a steady influx of new buyers, it is unsustainable to keep rates stable.
Stablecoins have their ups and downs, but they do provide the cryptocurrency world with a new dynamic.
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