What are Stablecoins?: An Ultimate Beginner’s Guide

If you’re familiar with cryptocurrency in general, then you know how big of an issue price stability has been in the crypto industry from the very beginning. You’ve probably heard of the time when Florida man Laszlo Hanyecz infamously traded 10,000 BTC for two pizzas in 2010. Had Laszlo Hanyecz retained that Bitcoin today, it would have been worth over $340,000,000; this is quite a massive leap in value over a period of only 11 years. 

More than anything, this example highlights the sheer volatility in the price values of cryptocurrencies. Cryptocurrencies can go from being worth only a few cents to hundreds of millions of dollars in only a decade. This fact has not gone unnoticed by cryptocurrency developers and programmers, and in response to the problem of extreme volatility in value over short periods of time, stablecoins have been developed as a way to introduce some stability into the cryptocurrency market by pegging their value with other assets in the same manner as a non-fiat currency. 

What are Stablecoins? 

Stablecoins, as their name implies, have been designed to introduce some stability into the cryptocurrency market by limiting the volatility of value in regular cryptocurrency, which is not backed by anything and whose value depends entirely on market forces. Stablecoins, in contrast, are pegged in value to other assets, including national currency, other cryptocurrencies, and even real assets such as gold and silver; the most common stable coins are pegged to the US dollar, however. Stablecoins are meant to reduce the uncertainty in value associated with cryptocurrency purchases by as much as possible. 

Stablecoins achieve this by being pegged directly to other assets since depending on the price of another asset entails that their own value will neither rise nor fall drastically over relatively short periods of time, as Laszlo Hanyecz’s example shows that traditional cryptocurrency suffers from. So, the basic idea is that when you purchase a stablecoin, you should not have to worry about its value possibly increasing or decreasing by many magnitudes over a short period of time. In essence, you should not have to worry about spending 10,000 units of a stablecoin today, only for it to exponentially increase in the near future. 

How do Stablecoins Work? 

Stablecoins work largely in the same manner as regular cryptocurrency: you can mine, buy it, trade it for goods and services where it is accepted, invested in it, and depending on the specific currency, you may be able to use it for other purposes as well. There is no fundamental technological difference between a stablecoin and a regular cryptocurrency; the difference arises when we compare their market functionality. 

Since stablecoins are pegged to the value of another asset, the change in that asset’s value is the primary determiner in the value of the stablecoin. Take, for example, stablecoins that are backed by the United States dollar, the US dollar is a relatively stable currency given its importance to international trade and its status as the world’s reserve currency, its value does not change significantly very often, and so stablecoins backed by the US dollar also remain similarly stable in their value. If the value of the US dollar does change, however, then this change in value will be immediately reflected in all stablecoins that have been pegged to the US dollar. 

By having their values pegged to other assets, the value of stablecoins is not dictated by market forces of supply and demand in the same way that regular cryptocurrency, such as Bitcoin, is. It is a relatively simple economic principle that drives the rationale behind the existence of stablecoins. 

Types of Stablecoins 

Given that in order to constitute a ‘stablecoin’, a cryptocurrency need only be pegged in value to another asset, there are numerous kinds of assets that stablecoins can be attached to, which means that there are different type of stablecoins; there are essentially three types of stable coins: fiat-backed, commodity-backed and crypto-backed stablecoins. The difference among the three is entirely derived from the type of asset their value is pegged to. 

  • Fiat-Backed Stablecoins 

Fiat-backed stablecoins are attached to the value of fiat currencies. A fiat currency is a currency that is not backed by any real asset, such as the United States Dollar, which is the common fiat currency to which the value of a stablecoin is pegged. Fiat-backed stablecoins are considered an ‘off-chain’ asset since their value is determined by the central monetary authority that issues the fiat currency to which the value of their stablecoin is pegged. In the case of stablecoins backed by the US dollar, their value could be determined by the monetary institutions of the United States since they regulate or influence the value of the US dollar. Examples of stablecoins backed by the US dollar include Tether, USD Coin, and Dai. 

  • Commodity-Backed Stablecoins 

Commodity-backed stablecoins function like digital versions of non-fiat currency, a currency that is dependent on the value of some physical good or object such as gold or silver. Unsurprisingly, most commodity-backed stablecoins are also dependent on gold which is the single most common commodity to which stablecoins are pegged. Other commodities and real assets that have also been used to peg the value of stablecoins include solver, oil and some other minerals. Since they are dependent on the value of real-commodities, commodity-backed stablecoins are, by far, the least stable in terms of their value and the most likely of the three types to experience some volatility in their value. Examples of commodity-backed stablecoins include Tether Gold and Paxos Gold. 

  • Crypto-Backed Stablecoins

Crypto backed stablecoins are, as their name implied, pegged to the value of other cryptocurrencies. To purchase a crypto-backed stablecoin, you enter into a smart contract with the central issuers of the currency. You obtain tokens that are of equal representative value to the units of stablecoin that you have purchased. If you wish to withdraw your original collateral amount, you just have to return your stablecoin to the smart contract. Crypto-backed stable coins are also over-collateralized to preserve their value which means that if, for example, the collateral rate is 200%, then you will have to spend around $200 of the crypto-currency backing the stablecoin you wish to purchase to receive the stablecoin you wish to purchase. The most popular crypto-backed stablecoin is Dai, which is backed by Ethereum. 

The Most Popular Stablecoins

Given that they answer one of the biggest problems associated with traditional cryptocurrency, high volatility in prices, it’s not surprising that stablecoins have recently grown in popularity. Some stablecoins have actually grown exponentially in terms of value recently. The following are the four most popular stablecoins as of the year 2021. 

  • Tether 

As by far the largest stablecoin of all and the largest fiat-backed stable coin, Tether has a total market cap of over $50 billion. It was also one of the very first stablecoins in existence, and it maintains a direct one-to-one ratio of value with the US dollar. Since it was one of the very first stablecoins in existence, it has also become one of the most popular in the market. 

  • USD Coin

USD Coin was developed by a consortium of companies, including Circle, Coinbase, and Bitmain. It is also a fiat-backed stablecoin, much like Tether, and it also has a one-ratio-one relationship in terms of value with the US dollar. Unlike Tether, however, USD Coin has been developed on the Ethereum blockchain, which has the advantage of permitting rapid and secures transactions with minimal costs. 

  • Dai

Dia, as mentioned above, is the world’s most popular crypto-backed stable coin, and Dai has been developed on the Ethereum network, which makes it a very versatile cryptocurrency in terms of its use. Dai also makes use of the smart-contract system as we’ve described above, where users borrow Dai against the rate of another crypto-currency, usually Ethereum, that they deposit into smart contracts. 

  • Paxos Standard 

The Paxos Trust Company developed Paxos Standard as a way to improve digital transactions. It has been developed with the guiding philosophy of maintaining as close a relationship with the US dollar, in terms of value, as possible. Consequently, it is one of the most stable stablecoins in the market, and that has allowed it to also become one of the most popular in the world. Like both Tether and USD Coin, Paxos standard also has a direct one-to-one relationship with the US Dollar in terms of value. 

The Importance of Stablecoins

The importance of stablecoins is that they represent the most stable element within the crypto-currency world. They are the very closest thing to digital versions of existing fiat currencies. They have all of the advantages and benefits of traditional cryptocurrency with the additional advantage of increased price stability. 

The most profound aspect of stablecoins, especially those that are fiat-backed, is that since their value is pegged to real assets, they can be much more safely invested and used for commercial activities than regular cryptocurrency such as Bitcoin. If you use Bitcoin for commercial purposes, you suffer from the risk of your Bitcoin possibly losing its value rapidly in a short period of time, but if you were to make use of a stablecoin instead, you would not have to worry about this. 

Therefore, stablecoins have the most potential to become the most dominant type of cryptocurrency for commercial transactions in the near future, especially international transactions. 

The Advantages and Disadvantages of Stablecoins

Stablecoins definitely have a lot of potential in terms of their future growth and use, given that they fulfill demand from consumers, i.e., cryptocurrencies with relatively stable prices. However, as with any other commodity, there are a number of advantages and disadvantages associated with the use of stablecoins that you should be aware of before making any decisions regarding your own investments into stablecoins. 

We’ve highlighted some of the most important advantages and disadvantages of investing in stablecoins below so that you can obtain a better understanding of the overall nature of stablecoins. 

Advantages 

  • Price Stability 

Since stablecoins are non-volatile assets, they are relatively safe investments that can be invested in with a minimal degree of risk. You do not have to worry about the chance that your cryptocurrency will rapidly lose its value in a short period of time, so there is a good degree of stability that you obtain from investing in stablecoins. 

  • Time Efficient

Stablecoins increase the speed of transactions since they often make use of smart contracts, such as in the case of Dai. The benefit of these smart contracts is that they allow transactions to be processed rapidly as no central authority regulating the use of stablecoins. So, when you invest in stablecoins, you know that it can complete transactions much faster than other cryptocurrencies. 

  • Minimal Transaction Fees

Given that stablecoins require far less processing time and power, another side advantage of this fact, in addition to greater time efficiency, is that stablecoins also require far fewer transaction fees. This means that transactions completed through stablecoins require much less money to actually complete when compared with traditional cryptocurrencies. 

  • International Transactions 

Stablecoins are specifically suited for international transactions since they are relatively stable and can be used for rapid commercial transactions. This makes them ideally suited for international relations since international transactions require fast processing times and low transaction costs. 

  • Similar to Physical Currency 

Since stablecoins depend upon the value of other assets the most, they are the most similar to actual physical currencies, which makes their use the most probable by average individuals. Stablecoins are the most likely cryptocurrencies to be used for ordinary people. So, the mass appeal of stablecoins is quite evident. 

Disadvantages 

  • Centralization 

Since stablecoin depends largely on individual organizations, their entire regulation and production depend on a single entity. The best example of this is Paxos Standard which is entirely produced by the Paxos Trust Company. The disadvantage of this centralization is that the continued distribution and maintenance of the currency depends on a single company that may or may not adequately perform such a function. 

  • Dependence of Traditional Financial Markets and Institutions 

As most stablecoins depend on the value of more traditional assets such as the US dollar or commodities such as gold or oil, their values depend on the fluctuations of traditional financial markets and institutions. This is especially the case with stablecoins that depend on the US dollar since changes in the value of the dollar will dictate changes in the value of the stablecoin. Hence, the stability of the stablecoin is further dependent on the stability of the currency or asset to which it is pegged to. 

  • Regulation 

All cryptocurrencies are unregulated, but with respect to stablecoins, the degree of regulation is far different. Stablecoins depend on traditional financial institutions and markets, which also means that changes in regulations in financial institutions and markets also directly and immediately affect the values of a stablecoin. This leaves them far more vulnerable to be influenced by government actions and policies than traditional cryptocurrencies. 

Should you Invest in Stablecoins? 

Given the above advantages and disadvantages that we have outlined, it naturally begs the question of whether or not you should consider investing in stablecoin. On the one hand, you can see that stablecoins have a lot of potentials since they fulfill an active demand from consumers, and their advantages in terms of improved speed of transactions and lower transaction fees mean that stablecoins can be effectively employed for commercial purposes. But you have also learned that stablecoins are relatively dependent on the conditions and policies of traditional financial institutions and markets, which leaves them vulnerable to market shocks as well as disruptive legislation. 

In spite of the several seeming vulnerabilities that stablecoins have, it can still be said that they are a relatively good and safe investment, far more so than traditional cryptocurrency. This can be largely attributed to the non-volatile nature of stablecoins which make them a comparatively safe investment. Additionally, although stablecoins are vulnerable to changes in financial markets and institutions, both financial markets and institutions have proven to be relatively stable in recent times, so there is little reason to believe that there could be any sudden shocks that can disrupt the use of stablecoins. Overall, this makes stablecoins a good investment opportunity. 

Conclusion

Stablecoins have been developed in response to the fact that traditional cryptocurrency is extremely vulnerable to changes in price as a result of market actions. Stablecoins avoid this issue entirely by being pegged to the value of real assets. Stablecoins can be backed by fiat currencies, real commodities, and other cryptocurrencies. The advantages of stablecoins are that they entail lower transaction costs, quicker transaction speeds, and are very stable in value, mimicking real-world fiat currency. The disadvantages are that they depend on traditional financial institutions, are often centralized, and are vulnerable to changes in traditional financial institutions and markets. Despite these disadvantages, stablecoins can still be regarded as a good investment opportunity in view of their potential for growth and the relatively stable nature of most financial institutions and markets. 

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