Stablecoins have born from the popularity of cryptocurrencies in the last decade. Some of the things to discuss are – how does a stablecoin works? stablecoin benefits, stablecoin price fluctuations, stablecoin examples to name a few.

With the Bitcoin, there have been more researches on the tokenization and digital assets. Critics, enthusiasts, learners, hobbyists and business professionals alike have shown interest in the crypto and digital currencies.

Diving deep in the subject and trying to inculcate them in the current financial systems, the business professionals and financial community have found issues and tried to solve them in their own ways.

Solving one issue have sometimes created another. But then, this is the beauty of working, analyzing and brainstorming on any particular subject.

The story of Stablecoin also comes from the realms of these above experiments and analysis. Let’s discuss what is stablecoin and how stablecoin works. We shall also discuss stablecoin business model.

Cryptocurrency volatility and fluctuations

Despite the revolutionary concept taking the financial community by storm, the cryptocurrency market suffers from high volatility and unpredictable price fluctuations.

Many a times, the price fluctuations have been linked to the infancy of the industry. People predicted that crypto has a long way to go before it is widely accepted for use of day to day transactions.

The demand for cryptocurrency is fuelled more by speculation and trading. There is less adoption as a medium of financial transaction. This too has fuelled volatility and unpredictability. Ultimately, it is a spiral effect.

Last two years have seen the market capitalization of the crypto reaching almost 1 Trillion USD and then bouncing back to less than 200 billion USD.

Most of the coins are down 80% from their all-time highs. They are struggling to maintain a decent valuation against the fiat.

With all the above stories and instances, the retail merchants are sceptical of accepting the crypto for transactions.

To get rid of the volatility of the cryptocurrency market, different variations of stablecoins have been introduced.

What are Stablecoins? Stablecoin Benefits

Stablecoins are just any other cryptocurrency or digital token. The difference is that it is pegged to another asset of a stable value such as precious metal (which is generally gold) or fiat money (which is specifically USD).

Since the stablecoin is correlated to the gold or fiat, its valuation is fixed in relation to that underlying asset.

The best and most popular example of stablecoin is Tether (USDT) which is backed by USD and has a stable value of 1 USD for each token. Hence despite the volatility of other cryptocurrencies, this stablecoin has a stable value of 1 USD.

So in gist, the stablecoin is a cryptocurrency with all its intrinsic functionality but, does not suffer from the vulnerabilities of market fluctuations and price volatilities. This is because stablecoins has a fixed value in relation to the underlying asset.

Stablecoin basket consists of digix, erc20 stablecoin, idx stablecoin, basis, gemini stablecoin to name a few.

Importance of Stablecoin

Stablecoins economics come into play because of near non-volatility and price stability. Stablecoin benefits give it a better chance of mass adoption due to these factors. Other advantages which make the stablecoin important are:

Help against problems of fiat devaluation

High inflation rates in economically weak countries reduce the purchasing power of their citizens. Due to higher inflation, what I bought today for 10 units of X currency, tomorrow or next month, depending on the inflation, I will have to pay an amount more than 10 units of the same X currency.

The most recent example of hyperinflation in any country is the devaluation of the currency of Venezuela.

Currencies of such hyperinflationary economies are also not accepted by other countries. This ultimately results in economic and political hardship for their citizens.

Stablecoins development comes in the picture as a helping hand. If the money is converted into stablecoin, it will ensure that the value of money is preserved. Stablecoin in this way has the ability to help the general population from the fallout of economic and political uncertainties.

Hedging for Crypto Trader

Stablecoin help in reducing the risk of high price movements. They are used in the cryptocurrency market as a hedge against bitcoin and other top cryptocurrencies.

During high price variations, traders can sell their normal cryptocurrencies and transfer funds to stablecoin cryptocurrency tokens. Instead of selling and converting to fiat, the traders convert to stablecoins. Converting to stablecoin is beneficial because transaction costs would be low and change from one crypto to another is fast as compared to changing from any crypto to fiat or any other asset.

Converting the holding to stablecoin reduces the risk and protects the value.

The best example of this is Tether (USDT). USDT is used by short term crypto traders to reduce the investment risk without actually cashing out or moving the money back to the bank account. Money transfers to a bank account may take hours or days with some significant commissions.

Types of Stabecoins

Stablecoins have been categorized into four types.

Fiat backed Stablecoin

Commodity-backed Stablecoin

Crypto backed Stablecoin

Seignorage style Stablecoin

Fiat backed Stablecoin

Fiat backed stablecoin is the most popular form of stablecoin. These coins are fully backed by fiat money.

Fiat backed stablecoins are backed on a 1:1 ratio. This means 1USD of the stablecoin is equal to 1USD fiat money. The concept is that the stablecoin is backed by real fiat in real bank accounts.

Fiat backed stablecoins are the most simple but are also the most centralized.

Stablecoin working is quite simple. They are backed by a company or a central entity. This company or central entity manage the acceptance of new fiat and issues a corresponding amount of the fiat backed tokens. The company or the central entity is the custodian of the fiat reserves, and it backs all the tokens.

A degree of trust in the central entity is created by third-party audits – validating that fiat reserves are kept equal to the token supply. The central entity is the custodian of the fiat reserves that back all the tokens.

If the holder wishes to redeem cash with his tokens, the company or central entity will wire transfer the fiat money to the holder’s bank account and the equivalent coins will be destroyed or taken out of circulation.

Advantage and Disadvantages of Fiat backed Stablecoins

Stablecoins are simple to understand. They have a fiat backed structure and their operations and working are simple to understand.

Since these are backed by a stable fiat currency, which is again backed by some government or economy of the country, there is not much fluctuation in the prices.

On the disadvantage side, these are too centralized with a company or central authority. This is very much against the concept of decentralized crypto. The central structure is prone to its vulnerabilities. All said the very concept of decentralized currency is lost.

Again coming on the concept of trustless, stablecoin central authority has to be trusted. This also goes against the principle of cryptocurrencies.

Since the stablecoin is backed by fiat which is regulated. Hence there are chances of compromising the efficiency and other operational processes related to the stablecoin.

Despite all the advantages and disadvantages, stablecoins are popular. Tether (USDT) and TrueUSD are the best examples of fiat backed stablecoins.

Tether is popular among investors. This is evident by the simple fact that the daily turnover of Tether is the second most popular crypto after the bitcoin. The popularity of Tether lies in its use for hedging by the cryptocurrency traders whenever they find some bad news which is likely to dither the market sentiment.

Commodity Backed Stablecoin

These types of stablecoins are backed by some type of tangible commodity. The most common commodity which is collateralized is gold.

Gold backed stablecoin represents a specific value of gold. The physical gold in itself is stored in a trusted third party’s vault.

Commodity-backed stablecoins are not as popular as fiat backed stablecoins.

Examples of commodity-backed stable coins are Digix gold and Petro coin. Petro coin is a coin backed by the oil reserves of Venezuela.

Advantages and Disadvantages of commodity-backed stables coins

On the advantage side, these are backed by real assets. They provide stability and liquidity.

The coin holder has the advantage of recoursing to the underlying asset. They can redeem these assets at the conversion rate to take possession of the real assets.

Since the price of the asset (gold) is stable, so is the stablecoin. In a way, the commodity has been tokenized. This brings greater liquidity and price discovery.

On the disadvantage side, as in fiat backed also, some of the very concepts of crypto and digital currencies are defeated in this type of stable coin.

The holder is dependent on the vendors and custodians. They are in a way central authority to the full functioning of the system. This can also result in a single point of failure at some time.

This system is also dependent on the audit and assessment by the third party. This also underscores the purpose of cryptocurrency.

The oldest example of commodity-backed stablecoin is Digix Gold Token. The physical gold is stored in a vault in Singapore. DGX is dependent on the market value of gold and is fully redeemable at any point in time.

DGX is based on the Proof of Provenance algorithm. Each gold bar is secured. The ownership/custodianship status is tracked on the Ethereum blockchain.

Cryptocurrency backed Stablecoin

These coins are backed by other digital currencies like bitcoin or Ethereum. Generally, crypto backed coins are backed by a mix of cryptocurrencies rather than backed by a single currency.

In this type of coins, the volatility risk of a single cryptocurrency is reduced and distributed in a group of cryptocurrencies. The stablecoins are over-collateralized to withstand the extreme price fluctuations.

Crypto backed stable coins require holders to stake a certain amount of cryptocurrencies into a smart contract which will then result in the creation of a fixed ration of stablecoins.

Advantages and Disadvantages of Crypto backed Stablecoin

Like other stable coins, crypto backed stable coins also have some advantages and disadvantages.

These are decentralized and adhere to the trustless, transparency and secure structure of the crypto world. They are efficient in the sense that conversion from one crypto to another is quick as it occurs on the blockchain.

Crypto backed coins are considered transparent because transactions are recorded on the public blockchain with full transparency and accountability.

If we talk of the disadvantages of the crypto backed stable coins, they are volatile and complex.

Since the underlying asset is a cryptocurrency itself, it is inherently much more volatile as compared to other types of stablecoins. Also, there are multiple complex elements which can obfuscate the minting process of these stable coins.

The most prominent example of crypto backed stablecoin is MakerDAO project with two separate coins MKR and DAI. DAI is crypto backed stablecoin. DAI does not rely on any central entity and lives on the blockchain.

DAI face value is pegged to the USD. It achieves stability by using an autonomous system of smart contracts.

Seignorage Style Stablecoin

Seignorage style stablecoins are not backed by any other currency. stablecoin money supply. We can take an analogous example of a central bank which prints and destroys the currency.

As the total demand for the coin increases, a new supply of stable coins are created to reduce price back to stable levels. The main objective is to keep the coin’s price as close as possible to USD 1.

Seignorage coins are not at all popular.

The advantages of these type stablecoin are that they are decentralized, they have an absence of collaterals and lastly, they are kept at stable prices.

As for the disadvantages, these are much more complex.

Basis is an example of this type of coins. Basis is pegged to the value of USD through algorithmic adjustments of the coin supply. Prices are monitored using the Oracle system.

If the Basis trading price increases above USD 1, more coins are created and distributed. If it is traded below USD 1, Base Bonds – another separate currency – is created and sold in an open auction to take the coins out of circulation.

To conclude, stablecoins are a crucial element in the world of cryptocurrencies. The apprehension of volatility and price fluctuation is controlled by these. In the future, they will definitely help in the mass adoption of the crypto.

Let us hope we get more stablecoins in the future as we have tether today.

Please also read about the JPM coin from J.P. Morgan and UPEUR from The Universal Protocol Alliance.

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