What are Stablecoins?
Stablecoins are cryptocurrencies designed to maintain a stable value and whose prices are pegged against a fiat currency, a collection of fiat currencies, or other digital currencies.
Most stablecoins on the market use the US Dollar as their reference point, and are supposed to keep their valuation as close as possible to $1 at all times. Although their price can theoretically be linked to anything, in practice they are most often pegged to major fiat currencies.
The approach different stablecoins undertake in order to reach their goal of maintaining a stable price varies depending on their type.
Different Types of Stablecoins
Different stablecoin classifications exist, but we are going to sort stablecoins in three categories, primarily based on the type of assets they use as collateral. All three types rely on differing degrees of centralization and use different stabilisation mechanisms in order to maintain their intended peg.
The biggest and most traded stablecoin on the market currently is Tether (Tether USDT, 0.20%), USDT falls in the category of fiat collateralized stablecoins since it follows a rather simple concept – the company behind USDT, Tether Ltd., can only issue as many coins as the size of their fiat reserves permits, which means that for every USDT in circulation, there needs to be an equal amount of US Dollars kept in reserve as a required collateral, at a 1:1 ratio.
Every fiat collateralized token must be audited regularly by independent agencies, to prevent companies from making more coins than there are dollars stashed away in their reserves. Although there was a cloud of controversy surrounding Tether, it remains the most dominant stablecoin by an enormous margin.
As the name implies, cryptocurrency collateralized stablecoins are backed by cryptocurrencies (primarily by Ethereum ETH, 9.75% and BTC) instead of fiat currencies. Since the expected market volatility of crypto assets is bigger than the volatility of fiat, the cryptocurrency backed stablecoins require a higher than 1:1 ratio of coins-to-reserves.
In other words, these type of stablecoins are over collateralized in order to avoid problems with liquidity in the event of a sudden drop in value of the cryptocurrency they are pegged to. The holders of cryptocurrency collateralized stablecoins are expected to pay daily, and sometimes hourly, interest rate on their coins, which is often aptly referred to as a “stability fee”.
Why Do We Need Stablecoins?
Fast transactions, low fees, strong security measures, and accessibility to anyone with an internet connection – cryptocurrencies have a lot going for them. However, a stable price is not one of their benefits, not yet at least.That is where stablecoins enter the picture.
Big price fluctuations are somewhat fine for those that perceive digital currencies only as speculative investments, but to those that want to use them as an alternative medium of exchange, the volatility of the market represents quite an obstacle.
Stablecoins offer a neat solution to the problem. Since their price is pegged to some other asset, their users get to enjoy all the advantages of blockchain technology, with an added benefit of constant prices. This greatly enhances trading on cryptocurrency exchanges as it is much easier and faster to convert Bitcoin or other digital currencies to stablecoins, than it is to fiat.
They act as a stabilizing force in an otherwise volatile cryptocurrency ecosystem and provide increased liquidity that is always welcome.
The Future of Stablecoins
Fiat-collateralized coins are the most centralized of the three stablecoin types and require constant oversight of their money reserves from the authorities and consequently trust from their users, crypto-collateralized stablecoins are more decentralized but more susceptible to market’s volatility, while uncollateralized coins rely on algorithm’s ability to keep their price stable and have no underlying asset guaranteeing their value.
It will be interesting to observe which stablecoin method will prevail in the end as all three models have their advantages as well as shortcomings.