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Stablecoins: Everything You Need to Know

What Are Stablecoins?

Stablecoins are digital cryptocurrencies whose value is pegged to an underlying asset. Coins such as Tether and PAX are pegged 1:1 to the US Dollar. Regardless of any market volatility, the value of those stablecoins will be mostly immune.

What Are Stablecoins Used For?

Stablecoins serve a variety of functions across the world. They are increasingly becoming an integral part of the cryptocurrency digital asset class and act as a haven for many investors, traders and those without access to traditional banking services. Today, stablecoins are primarily used for:

Investing & Trading

Stablecoins originally came about as a solution for anyone trading cryptocurrency coins or tokens other than Bitcoin or Ethereum with fiat. At the time, major cryptocurrency exchanges where altcoins such as Cardano, EOS, and NEO were traded only had Bitcoin or Ethereum trading pairs. Therefore, in order to buy and sell these altcoins, you would have to hold Bitcoin or Ethereum. Exiting your position meant you would need to make two transactions:

  1. Sell back into Bitcoin or Ethereum

  2. Exchange Bitcoin or Ethereum for fiat

Not only was such a system complicated, but it left traders and investors vulnerable to the high volatility in the prices of Bitcoin and Ethereum. Ultimately, this left a big need in the market for a stable cryptocurrency that would protect portfolios from the rollercoaster of price fluctuations.

Helping the UnBanked

The size and sheer reach of banking institutions in the world sometimes make us forget about the billions of people that do not have access to such services. Economic turmoil, such as the devaluation of the Venezuelan currency last year, has led to people hoarding Bitcoin in developing countries. However, holding a volatile asset when one needs money to pay bills and buy food is far from ideal.

How Do Stablecoins Work?

The companies behind a stablecoins maintain a certain amount collateralized balance of the underlying asset to which their stablecoin is pegged. While many stablecoin companies claim to be backed by fiat currency others, such as Dai, are backed by other crypto assets. Companies that issue stablecoins also control the supply and manage whatever mechanisms are necessary to ensure the stability in the price of the coin. There are various types of stablecoins that all hold unique benefits and risks for holders and investors.

Fiat Collateralized Stablecoins

Currently, these types of stablecoins are market leaders. The most famous is Tether (USDT), which ranks in the top 10 cryptocurrency list. It not only has the largest market capitalization of all stablecoins but has the highest daily trading volume as well. Companies that issue such coins claim to have $1 in reserve per every coin that they release. In theory, during a doomsday scenario, stablecoin holders could redeem them for fiat. While Tether has been the most popular stablecoin, other coins like Jcash (JUSD), TrueUSD, USD Coin (USDC) and Paxos (PAX) have managed to steal some market share.

Cryptocurrency Collateralized Stablecoins

Certain stablecoins, like Dai, are backed by crypto assets like Ethereum versus fiat. This method allows for a far more decentralized alternative to fiat-backed coins like Tether. Crypto backed stablecoins can usually be converted to their underlying asset for a small fee or are backed by various cryptocurrencies to mitigate risk. However, due to the volatile nature of the underlying cryptocurrency used as collateral, this type of collateralization usually requires a higher amount of coins to be put up against any amount of stablecoins issued.

Commodity Collateralized Stablecoins

These are stablecoins that utilize assets such as gold, oil and other real-world assets to collateralize their value. Perhaps the biggest benefit of these coins is that they do not have to be backed by just one commodity. Instead, they can be pegged to a basket of assets to diversify risk. Tiberius Coin (TCX), for example, is backed by seven precious metals. Such coins tend to be viewed as safer alternatives by some as they are collateralized by assets that tend to increase in value as time goes on.

What Are the Risks of Stablecoins?

While stablecoins regularly act as safe havens for many traders and investors, there are several risks that one should be aware of before engaging with them.

Insolvency Risks

While stablecoin giants, such as Tether and Dai, have grown to become market leaders, other stablecoins, like Nubits, have crashed and burned. Even Tether's value temporarily dropped to around .90 cents during suspicions around whether or not it held fiat reserves to back up its coin. A ten-cent or 10% difference is massive and defeats the whole purpose of a stablecoin in the first place.

Increased Volatility

In a space largely absent of regulation, stablecoins add fuel to the fire of cryptocurrency volatility as they allow for greater speculation. While this provides more liquidity to the market, it also opens the doors for market destabilization.

Centralized Trust

The ethos of cryptocurrency and blockchain is to replace centralized human trust with decentralized automated consensus. Arguably, stablecoins go against this. Since a single centralized company creates a coin like Tether, the fate of the stablecoin is inevitably tied to the successes and failures of its parent company.

Ultimately, stablecoins are safe havens against the volatility in the cryptocurrency space. While stablecoins are quite new and have not withstood the test of time, institutional players such as JP Morgan have solidified the concept in the future of digital assets. Although stablecoins are built to protect against other currency fluctuations, it is essential to always keep up to date with whichever one you may be holding.

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