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Crypto Explained

What Are Stablecoins?

December 14, 2021


What Are Stablecoins?
Stablecoins are a type of cryptocurrency that maintains a relatively stable value. Unlike regular cryptocurrencies that can be highly volatile, stablecoin value is pegged to an external asset, such as the U.S. dollar, euro, or gold, which stabilizes the price.

Stablecoins are extremely attractive for many different groups as they retain the core qualities of cryptocurrencies, such as peer-to-peer transactions, fast settlement, and low fees, but avoid the wild price fluctuations of their counterparts.

Stablecoins allow users to transact using cryptocurrency and make payments with a greater degree of confidence that the value will be retained over time. They are also vital for traders who wish to quickly convert their assets from BTC, ETH, or another cryptocurrency and hedge their positions during periods of high volatility. 

Stablecoins have increased in popularity lately, and the combined market capitalization of the largest stablecoin issuers exceeded $120 billion as of November 2021—almost a 500% increase from this time last year. This has also led to increased regulatory scrutiny and a push for stablecoin issuers to be more transparent about their reserves.

Stablecoins backed by fiat

There are more than 60 fiat-backed stablecoins on the market today with varying degrees of traction and use cases. The majority of stablecoins are backed by fiat (government-issued currency) and an entity that sets up a reserve where the assets backing the stablecoin are stored. For example, USD Coin (USDC), the second-largest stablecoin by market cap, is backed by 60% cash and 40% debt securities and bonds

Other prominent fiat-backed stablecoins are Tether (USDT), TrueUSD (TUSD), and Pax Dollar (USDP). There are also stablecoins backed by various different fiat currencies, including the euro, yen, and Swiss franc. However, the overwhelming volume of trading is carried out in USD-backed stablecoins. 

EQONEX uses USDC as our preferred stablecoin partner as it is much more transparent and universally trusted than Tether. Circle also maintains a regulation-first approach and is active in assisting with the adoption of clear regulatory standards for stablecoins. 

Stablecoins backed by other assets

Another way that stablecoins can be pegged to real-world assets to maintain their price is through commodities such as precious metals and even oil. The money in the reserve serves as collateral for the stablecoin so that whenever a holder wishes to retrieve their funds, an equal amount of the asset that backs the stablecoin is taken from the reserve. 

Thus far, these types of coins have received little traction, with a handful of gold-backed coins available, the most prominent being PAX Gold (PAXG). The Venezuelan government also launched its own stablecoin Petro, supposedly fully backed by Venezuelan crude oil. However, with opaque reporting and the need to trust in a centralized entity, Petro has been met with a lot of skepticism. Most Venezuelans prefer using actual U.S. dollars, Bitcoin (BTC), or Dash (DASH) over the local currency Bolivar.

Collateralized stablecoins

There are also more complex types of stablecoins on the market that are collateralized by other cryptocurrencies rather than fiat, yet, still designed in such a way that they track a mainstream asset like the U.S. dollar. The most popular of these is Maker, which establishes its stablecoin by using a service called a “Vault” (formerly known as a Collateralized Debt Position). The Vault essentially locks up a user’s cryptocurrency as collateral, and once the smart contract verifies the collateral as secure, users can borrow freshly minted DAI, Maker’s stablecoin. 

Algorithmic stablecoins

Algorithmic or synthetic stablecoins are not collateralized but are created or burned to maintain the coin’s value in line with the target price. So, for example, say the stablecoin was to drop from its target price of $1 down to $0.75. The algorithm would immediately trigger a command to burn a tranche of coins to introduce more scarcity, which raises the price of the stablecoin. 

However, the process is complicated, and many have tried and failed to maintain successful algorithmic stablecoins over the years. One such project achieving success is Terra with USDT TerraUSD.

What are the disadvantages of stablecoins?

While stablecoins have positively affected the growth of the cryptocurrency market and the industry in general, there are a few drawbacks to stablecoins to keep in mind. One of these is how the reserves backing the coins are stored, and they must be stored in a bank or another third party, introducing more risk.  

In addition, there is increased regulatory scrutiny surrounding stablecoins, with many governments concerned about them competing with fiat. The potential introduction of CBDCs into the market may also threaten the continued growth of stablecoins. The coming months and years should give a firmer indication of the future of stablecoins as regulation becomes clearer and stablecoin issuers step up to meet new requirements.

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