A Beginner’s Guide to Stablecoins

A Beginner’s Guide to Stablecoins

May 1, 2018.
Learn all about stablecoin basics, their benefits, how they work, and their limitations

Cryptocurrencies have recently and undeniably changed our financial landscape today. The potential of decentralization, transparency, and immutability brought about by blockchain technology are among the many things that make cryptocurrencies like Bitcoin and Ethereum the ideal currency people have been waiting for.

However, cryptocurrencies have their own set of limitations, with the most glaring one being its high volatility. On a normal day, the value of a cryptocurrency may fluctuate by a whopping 10% to 20%, depending on supply and demand. This erratic fluctuation has led many cryptocurrency enthusiasts to speculate on a volatile market, but this characteristic of cryptocurrencies greatly hindered its worldwide adoption.

With high volatility, investors and cryptocurrency holders are exposed to unnecessary risks when they negotiate transactions that require price stability, such as longer-term smart contracts and blockchain-based loans.

This is where stablecoins, or stable cryptocurrencies, fit into the picture. Recently, a number of blockchain enthusiasts have started to develop cryptocurrencies that are less volatile and have a more stable value. Here, we’ll talk about what stablecoins are, what makes them stable, and more.

What are stablecoins?

Stablecoins, as its name suggests, are price-stable and low-volatile cryptocurrencies. Because they are not easily subjected to erratic market fluctuations, they are a more ideal cryptocurrency option for exchange and as a store of value.

All stablecoins imply a pegged value or backed by collateral. They are usually pegged to another stable asset to affix its value, such as fiat money, much like how some fiat currencies peg their exchange rates to the value of another national currency.

How do stablecoins work?

Many stablecoins are pegged to the US dollar, such as Tether. On the otherhand, some stablecoins are pegged to currency baskets, on other major currencies, or to the consumer price index. This type of implementation where a fiat value is collateralized is more straightforward, where a centralized entity, such as Tether, deposits US dollars in a bank and issues stablecoins with a 1:1 ratio. Here, 1 USDT (the stablecoin) is redeemable for $1 USD—much like an IOU. This makes sure that the value of your cryptocurrency remains almost always stable at a value of one dollar, as all of the collateral is held in fiat dollar reserves.

Fiat is not the only collateral you can use. Stablecoins like DigixDAO and TrueUSD, are backed by gold, while some use silver and other precious metals. In this model, a stablecoin is issued which represents the value of that metal; for instance, 1 stablecoin is equivalent to 1 gram of gold. The gold is then stored by a trusted custodian as collateral.

Another way is to back your stablecoins with cryptocurrency. In this model, some stablecoins, such as Havven, are pegged to other cryptocurrencies. This implementation works by over-collaterizing the stablecoin in order for it to absorb any drastic price fluctuations in the collateral cryptocurrency. In this scheme, all transactions can be managed within the blockchain.

And in some schemes, stablecoins such as Basecoin aren’t backed by any collateral at all. In this implementation, an algorithm is in place that expands and contracts the supply of the stablecoin depending on the price of the coin. This model is based on a scheme termed as seigniorage shares, where stablecoin holders can buy bonds when the trading value of the coin is less than $1.

Following the idea of seigniorage, the smart contract who issues the digital currency will always act like a central bank in order to maintain its coin value equal to its fiat equivalent, usually a dollar. That said, when the price becomes too high, or conversely, the supply is too low, the smart contract can mint and auction new coins into the market until the price returns to its normal rate. These newly minted coins were termed seignorages. And when the price becomes too low (or the supply is too much), the smart contract needs to lessen the circulating supplies. But how do you retrieve currency that is already circulating? This is where seigniorage shares are released to buy back coins that promises holders to future seigniorage, giving shareholders priority to receive seignorages in the future.

What are the limitations of stablecoins?

Stablecoins, with its promise of price stability, aren’t as perfect as what was envisioned by cryptocurrency enthusiasts. Just like other mainstream cryptocurrencies, it also has its own set of challenges.

Fiat-backed stablecoins, as the most ideal model, may require some form of centralization. You need to be able to trust the central entity regulating and keeping your collateral to maintain the USD peg. And because the collateral is reserved in a traditional bank, liquidation of the stablecoin into fiat is subject to government controls, which are slow and costly. This centralization and high regulation defeats the entire purpose of the blockchain being a decentralized technology.

For crypto-backed stablecoins, the over-collateralization would also mean investing a lot of capital. Furthermore, the value of the stablecoin is directly tied to the health of the pegged cryptocurrency, which makes it less price-stable than fiat-backed stablecoins.

Other variants of stablecoins, such as those that are not collateralized, are still highly experimental and are based entirely on faith in the system and its smart contract that the price of the stablecoin will perpetually retain a certain value.

Final notes

The inception and evolution of stablecoins is truly a game-changing possibility that could greatly disrupt the landscape of the blockchain community and lead to changes in cryptocurrencies for the better. While the current frameworks for stablecoins are not without compromise, the future of stablecoins remains optimistic as new and emerging models are being developed.

– Article written by Tinny

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Categories: Cryptocurrency