What is a Stablecoin?

What is a Stablecoin?

Famous for their volatility, cryptoassets aspire to become world currencies. But, most are frequently dismissed as no more than speculative assets due to their wild price swings. Money is supposed to have three functions: a store of value, a unit of account, and a medium of exchange. Stability is key to all these functions; this allows people to be fairly and predictably compensated for goods and services without changes in value during the payment process. Stablecoins are a class of cryptoassets created to address this problem. As the name implies, they are designed to be price stable with respect to some reference point.

This article is intended to understand what Stablecoin is, why we need it and what its real-world applications are.

Stablecoin

Stablecoin is price-stable cryptocurrencies meaning the market price of stablecoin is pegged to another stable asset like the US dollar or to a commodity’s price such as gold. Stablecoins have gained traction as they attempt to offer the best of both worlds —the instant processing and security or privacy of payments of cryptocurrencies, and the volatility-free stable valuations of fiat currencies. 

Even though as global currencies, Bitcoin and Ether are volatile, this is certainly not sustainable for users and investors who prefer stability in the market.

Essentially, a currency should act as a medium of monetary exchange and a mode of storage of monetary value, and its value should remain relatively stable over longer time horizons. Ideally, a crypto coin should maintain its purchasing power and should have the lowest possible inflation, sufficient enough to encourage spending the tokens instead of saving them. Stablecoins provide a solution to achieve this ideal behavior.

Types of Stablecoin

Fiat-backed Stablecoin

This is the most common type supported by other fiat currencies with a 1:1 ratio. Fiat currency (fiat currency) is a commonly used currency such as Euro, Rupiah, or US Dollar. Example: USD Tether (USDT), USD Vexanium (USDV), Indonesian Rupiah Token (IDRT). Stablecoin issuers such as companies, banks, or even the government must have the same amount of money in their Bank account or Trust account. 

Other forms of collateral could include precious metals such as gold or silver, as well as commodities such as oil, but most fiat-insured stablecoins currently use the dollar supply.

Pros Cons  
– Simplest 
– 100% price stable
– Less vulnerable to hack since no collateral held on the blockchain 
– Centralized as a trusted custodian must store the fiat
– Need audits to ensure transparency
– Highly regulated
– Expensive and slow liquidation to fiat

Cryptocurrency-backed Stable Coins

Just like fiat, however, these stablecoins with crypto guarantees are supported by cryptocurrencies. This type of coin is also pegged to the US dollar where a $ 1 USD stablecoin is a lot of $ 1 USD cryptocurrency. The more volatile the cryptocurrency is, the higher the ratio to be sure even if there is a price drop there will still be $ 1 available. The process of issuing coins of this type is carried out through various protocols carried out on the blockchain.

For example, $ 2,000 worth of Ether could be held in reserve to issue $ 1,000 worth of crypto-backed stablecoins holding up to 50% in the reserve currency (Ether). And if the price of the underlying cryptocurrency drops low enough, the stablecoins will be automatically liquidated.

Frequent audits and monitoring add to price stability. Powered by Ethereum, DAI MakerDAO is pegged against the US dollar and makes it possible to use multiple crypto assets in reserve. 

Pros Cons  
– More decentralized
– Can liquidate cheaply and quickly into underlying crypto collateral
– Easy for everyone to inspect the collateralization ratio of the stablecoin
– Less price stable than fiat
– Can be auto-liquidated during the price crash
– Tied to the healthy of a particular cryptocurrency
– Inefficient use of capital
– Highest complexity

Non-collateralized Stable Coins

Unsecured stablecoins are based on the concept of the Seigniorage Shares system. Seigniorage is the difference between the value for money and the cost of printing it. The coin relies on a blockchain-based algorithm, which changes the volume of supply to control its price or to ensure the coin will always be trading for one US dollar. Examples are Basis and Carbon USD.

It is the most decentralized and independent form of stablecoins, as they are not pledged as collateral to any other asset. However, non-collateralized stablecoins need continuous growth to be successful. If a crash occurs, there is no guarantee to liquidate coins again, and everyone’s money will be lost.

Pros Cons
– No collateral required
– Most decentralized and independent
– Not tied to any cryptocurrency or fiat
– Most vulnerable to crypto decline or crash with no ability to liquidate
– Some complexity
– Difficult to analyze safety bounds or health
– Requires continual growth

Commodity-collateralized Stable Coins

Commodity-collateralized stablecoins are backed by other types of exchangeable assets such as real estate and precious metals. Gold is one of the most collateralized commodities. These commodities even have the potential to appreciate in value over time, which provides an increased incentive for people to hold and use these coins. 

These types of assets are generally reserved only for the rich, but stablecoins open up new investment possibilities for the average individual globally.

Classification Framework for Stablecoins Design

Application of Stablecoins

Protection from local currency destruction

In this case, the fiat currency is depreciated; Locals can exchange the drop in currency for EUR-backed, USD-backed, or asset-backed stablecoins before they lose their savings. In this way, the people could be protected from a further decline in the value of the local currency.

Stablecoins can provide an ideal solution for everyone by allowing them to exchange falling currencies for stable currencies.

Day-to-day currency

Stablecoins can be used for everyday transactions, such as buying coffee in the morning to send money to relatives, we can use digital wallets to pay with stablecoins.

This stable exchange rate is particularly beneficial for payments overseas, as there is no need to convert to a different fiat currency. A person in the Philippines can receive USD-backed stablecoins without having to convert them to Pesos and lose a large percentage of fees.

Simplify P2P and recurring payments

Stablecoins allow the use of smart financial contracts that are on the blockchain network and do not require a third party or centralized authority to execute them. As automated transactions are transparent, irreversible and traceable, they are also ideal for loan payments, salaries, subscriptions, and rent payments.

For example, employers can set up smart contracts to automatically transfer stablecoins to their employees at the end of each month. This is certainly very helpful for companies that have employees in all parts of the world. Reduces the high costs and lengthy process of exchanging fiat currencies from bank accounts in New York to Asian bank accounts.

With stablecoins, this process only takes a few minutes and costs a small amount of money.

Improved cryptocurrency exchange

There are only a few cryptocurrency exchanges that support fiat cryptocurrencies due to strict regulations. However, the use of stablecoins allows exchanges to solve this problem by offering crypto-fiat trading pairs. 

Users can use USD-backed stablecoins instead of using actual dollars. This will lead to increased adoption of cryptocurrency trading as the process of acquiring cryptocurrency becomes easier for newcomers. Additionally, they can think of trading in terms of dollars or stable assets rather than fluctuating the value of cryptocurrencies like Bitcoin.

Fast and affordable remittances for migrant workers

Today, immigrant workers send payments via platforms like Western Union to send money to loved ones and family. The whole process is quite expensive and slow as the family loses a large amount of funds due to high costs.

While cryptocurrencies are the best solution to this problem with low fees and fast transactions, cryptocurrencies like Bitcoin can drop in value by up to 20-30% in just a day or two.

Stablecoins can be a better alternative to this problem because workers and their families can use digital wallets around the world to transfer stablecoins instantly at low fees and without volatility.

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