Unscrambling the Significance of Stablecoins
People are always saying that cryptocurrency is the currency of the future. While that is definitely the case, it is a big subject matter to get our heads wrapped around before it is something that we use every day. Also, the value of some cryptocurrencies, like bitcoin or ether, are extremely volatile. This means that the price of these coins can vary extremely day to day, thus it is not feasible to be our main currency. One way that we can work around this and slowly bring cryptocurrency into our daily lives is by using stablecoins.
What are Stablecoins?
A stablecoin is a type of cryptocurrency that offers stability by being backed by some sort of reserve asset. Reserve assets are any kind of financial asset such as the U.S. dollar or gold. Instead of being mined by a network of computers like other cryptocurrencies, these coins derive its value from the price of another asset. This asset reserve serves as collateral, so if they ever needed to “cash out” and transfer it to the reserve asset, they are able to. If the value of the asset is stable, the price of the stablecoin remains stable as well.
These have become more popular because they offer the security and speed of cryptocurrency, while also being volatility-free. A coin like this is important because users will refrain from using digital currencies if they are unsure of its purchasing power. If there is one that is fully backed by something non-volatile, they are much more likely to begin using digital currencies.
Currently, the primary use for a stablecoin is aiding trades on cryptocurrency exchanges. Instead of buying a cryptocurrency like bitcoin directly with a fiat currency like the U.S. dollar, people often exchange the fiat for a stablecoin. They then use that stablecoin in a trade for whatever cryptocurrency they are wanting.
Different Kinds of Stablecoins
Fiat-Collateralized Stablecoins
Fiat-collateralized stablecoins are backed by a fiat currency reserve, like the U.S. dollar. This reserve is used as collateral to issue a sufficient amount of coins. This does take away one of the advantages of cryptocurrency because they would now be centralized, meaning they are run by a single entity. If the fiat it is backed with is the U.S. dollar, that means the U.S. government would be that entity.
These are maintained by custodians that are regularly audited to make sure that the stablecoin is being correctly priced. The fiat-backed stablecoins are backed at a 1:1 ratio. This means that one coin is equal to one unit of whatever currency is being used. Theoretically, there should be a real fiat currency being held in a back account for every stablecoin that exists to back it up. If someone wanted to redeem cash for their coins, they would be able to. The custodian of the fiat reserve would take out the money from the reserve and send it to the person’s bank account. The stablecoins that they are trading would then be “burned” or removed from circulation. As long as the currency the stablecoin is pegged to stays relatively stable, the value of the stablecoin should not fluctuate much either.
This is probably the easiest kind of cryptocurrency for someone new to start using. It is much easier to understand a currency if it is priced similarly to what they have always been using. This in turn can get people used to using cryptocurrency and allow for more widespread adoption.
While this would be a great first step for our world to take on cryptocurrency, it takes away one the main points of cryptocurrency. The fiat-backed stablecoins are constrained by all of the regulations that come with the fiat currency it is using, such as having a central authority or different weak spots. If a disastrous event happens to the fiat that a stablecoin is backed with, it would be disastrous for the stablecoin as well.
Commodity-Collateralized Stablecoins
Commodity-collateralized stablecoins are backed by different kinds of interchangeable assets. The most common commodity used is gold, but they can back backed by oil, real estate, and different precious metals.
These stablecoins can be a little more risky since they are the value of a real-world asset. These assets have the potential to increase or decrease in value over time, which can lower the incentives for using this kind of stablecoin. These would also create a longer process of liquidating these assets. The user would have to acquire the gold or whatever commodity is in the reserve. This could be an issue if the commodity is in a different country or hard to get to. Another option would be transferring the stablecoins into a different kind of coin where they could eventually receive physical currency like the U.S. dollar.
Crypto-Collateralized Stablecoins
It is baffling, but stablecoins are actually able to be backed by other kinds of cryptocurrency. This is called crypto-collateralized stablecoins. As we know, most cryptocurrencies are prone to high volatility. Because of this, if a stable coin is backed by another cryptocurrency, the stablecoin is over-collateralized. A larger number of coins are taken and maintained as a reserve for issuing a smaller number to stablecoins. For example, they could take $2,000 worth of bitcoin and hold it as a reserve to $1,000 worth of a crypto-backed stablecoin. This happens so that the stablecoin can absorb price fluctuations in the reserve cryptocurrency. In the event of a price drop, the stablecoin’s worth could remain the same, even though the reserve value changed. If the price of the reserve cryptocurrency drops low enough, the stablecoins would automatically be liquidated.
This kind of stablecoin follows the goal of cryptocurrency more than other kinds of stablecoins because it is decentralized. Everything is conducting in the blockchain without using a reserve from a real-world asset. Although, crypto-backed stablecoins are much more complex to understand and because of this, they have not gained as much traction as other coins.
Non-Collateralized (Algorithmic) Stablecoins
It is possible to have a stablecoin that does not have any kind of reserve. Non-collateralized stablecoins have a working mechanism that retains a stable price for the coins. These mechanisms are able to increase or decrease the supply of coins in a needed basis. This is like a central bank and the current U.S. dollar. The dollar use to be backed by gold, but it no longer is. It still has value because users believe in their value. The same idea can be applied to this kind of stablecoin.
This stablecoin can be achieved by using a smart contract that runs in an self-governing manner. As demand for the coin increases, new coins are created to reduce the price back to the original level. If trading of the coins is too low, the the coins currently in the market are bought to reduce the amount in the circulating supply. The goal would be to keep the prices of the stablecoins as stable as possible, driven by supply and demand.
This is the most decentralized version of the stablecoin since it is not collateralized to any other asset. This is a big incentive for someone who is a cryptocurrency expert looking to buy into stablecoins, because the lack of centralized authority is often desired. These coins require continual growth to be successful, so that may be difficult to achieve. Also, in the event of a big crash, there is no collateral to liquidate the coin back into.
Conclusion
There are pros and cons to each type of stablecoin, but the hope is that these could be used to gradually bring cryptocurrency into our lives. Stablecoins are much easier to understand if you are not an expert on cryptocurrency, and it would be a smoother transition if it is backed with a countries original currency. These coins could also give relief to populations that could benefit from a stable currency, because their local currency has rapid inflation. Stablecoins could be the first step for us, and the currency of the future.
