To understand the concept of stablecoins, you need some basic knowledge regarding the current state of the cryptocurrency market. Even if you are a die-hard blockchain enthusiast, you have to admit, although the major cryptocurrencies are pretty volatile. In fact, the volatility of Bitcoin and other established currencies are currently one of the main obstacles that are hindering their wider adoption.
With the value of cryptocurrencies fluctuating constantly - and often quite dramatically - it is difficult to use them for business transactions or paying out salaries. The purchasing power behind the crypto-assets changes rapidly and the changes are too great to make them a practical choice for storing your, or your company’s, assets. As a result, cryptocurrencies are currently used mostly as an investment and speculation tool, not as a regular currency to keep your savings in.
But what if a cryptocurrency had a stable value tied to the value of another asset, such as a fiat currency like USD? If that were the case, people might be more inclined to use it like they use traditional money.
Such a cryptocurrency with value pegged to another stable asset is called a stablecoin.
But how does a stablecoin work, exactly? How can you tie the value of a cryptocurrency to USD or another asset and make it less volatile than your typical cryptocurrency?
There are three main types of stablecoins:
Let’s take a closer look at these stablecoin types and the differences between them.
This kind of cryptocurrency is backed by actual reserves kept in the fiat currency - its value is pegged on. For example, if one coin is supposed to always have the same value as 1 USD, it should be backed by one dollar per coin. Such reserves are typically kept in a bank account owned by the company responsible for the coin’s development.
As a result of such solution, this type of stablecoin goes against some of the popular ideas behind cryptocurrencies - such as decentralisation and independence from third-party financial institutions. Since the transactions related to the bank account containing the reserves are not registered on the blockchain, certain amount of trust must be awarded to the company behind the coin. On top of that, potentially costly third-party audits might prove to be necessary, to make sure that the reserves are actually there. Those are exactly the problems that the blockchain technology was supposed to root out - which makes the fiat-collateralized currencies not an ideal solution for many blockchain enthusiasts.
It is also very difficult for this type of stablecoin to be scaled - there’s only so much fiat currency the company behind the currency can afford to keep as reserve.
A crypto-collateralized stablecoin is backed by another cryptocurrency, like Bitcoin or Ether. This might sound quite counter-intuitive - after all, how can tying the value of one cryptocurrency to another volatile cryptocurrency result in a stablecoin? Wouldn’t the newly-created cryptocurrency be exactly as volatile as the collateral?
This is where the concept of overcollateralization comes into play. You see, in order to protect the stablecoin from Bitcoin’s (or another crypto it’s tied to) value fluctuations, the rate at which the stablecoin is backed is artificially heightened. This means that you would have to pay 1,5 USD for 1 USD worth of the coin. Such ratio protects the coin from fluctuations - but it also means that you are essentially overpaying for it. As such, the crypto-collateralized coins are not exactly efficient.
That doesn’t mean that they are entirely devoid of advantages. Unlike fiat-collateralized coins, they are fully decentralised and transparent. All the data is stored in blockchain and there is no issue with being forced to trust a company or a bank in regards to the reserves.
We’ve talked about stablecoins that are backed by fiat currencies or cryptocurrencies. But here’s an idea - how about a stablecoin that is not backed by any other asset?
This sounds too good to be true - how can you stabilise the value of a currency without having 1:1 reserves of a stable asset? If that’s possible, why are all cryptos not stable?
Well, the idea behind this type of stablecoins involves some rather complicated mechanisms and algorithms related to manipulating supply and demand. To explain it in simple words - when a currency’s value drops, automated bots are supposed to buy it back and destroy some of the coins, to make the remaining ones more valuable. On the other hand, when the same currency starts rising in value due to large demand, the algorithm will release new coins to meet the demand and keep the price on the same level.
Similar mechanisms are in fact used in case of government-backed currencies. However, a government might have some (not necessarily ethical) reasons to artificially dump or raise the price of its currency. There is no such risk in case of an algorithm, which is written with the sole purpose of keeping the value of the currency stable and has no other potentially nefarious goals.
Of course, there are some drawbacks as well. The underlying technology behind this kind of stablecoin can be quite complicated, and even with full transparency of the data, it might be difficult for a layperson to understand it. This might scare some beginners off from purchasing this type of stablecoin - after all, it is good to understand what exactly you’re investing in and what makes the stablecoin stable.
As usual, there is no simple answer to that. If you’re an investor who wants to increase your wealth by investing into cryptocurrencies or ICOs, you might not care for stablecoins - the fluctuations of value are what makes the high returns of investments in the crypto-world possible. But if your dream is for humanity to adopt cryptocurrencies for everyday transactions and embrace the blockchain revolution - then stablecoins might just be what you’ve been wishing for. And since many blockchain enthusiast agree with this, stablecoins might very well be the next big thing in the crypto-world, so it’s definitely worth for savvy crypto-investors to stay up-to-date with them.