According to English Philosopher; John Locke, everything is in a state of flux. This statement is ever true for the payments and global financial systems where things have changed significantly in the last ten years. Humans have increasingly discovered convenient, secure, and instantaneous payment options with extensive innovation.
Due to these innovations, the traditional banking system has faced many disruptions from startups and big tech companies. These “disruptions” have led to widespread and efficient cross-border retail payment solutions. One of the many disruptions is the advent of stablecoins.
In the last two years, stablecoins have significantly gained popularity, and curious investors have gotten into the world of stablecoins. Most traders admit that it is a great way to stay balanced in an ever-volatile cryptocurrency market.
We will run through everything you need to know about stablecoins. We will also tell you why stablecoins matter and how you can leverage them in your investment portfolio and make gains.
What is a Stablecoin?
In cryptocurrency, the value of a coin is based on its overall market value. The market value is influenced by the forces of demand and supply. These forces are affected mainly by the level of trust that traders have in a particular cryptocurrency.
Unlike cryptocurrencies, Stablecoins are oftentimes backed by tangible assets verifiable either on the Blockchain or by the appropriate organization’s disclosures.
Also, with the stability that stablecoins offer and the instant processing and security that the blockchain provides, it looks like there will be a lot of stablecoins going around in the future.
With stablecoins, the world of finance can blur the lines between fiat currencies, like the U.S. dollar and cryptocurrencies.
Types of Stablecoins
Although that is not the main focus of this article, we will briefly touch on the major kinds of stablecoins. This will give us a better understanding of how stablecoins operate.
The first kinds of stablecoins are backed by fiat currencies issued by a central bank. In this case, the stablecoin is simply a representation of the same collateral structure of this currency. For instance, you can own part of a real-world currency like the USD by holding the stablecoin that is backed by a one-on-one ratio to the dollar.
To liquidate a fiat-backed stablecoin, you simply need to destroy the stablecoin and withdraw your USD equivalent. This is great because you can be rest assured that the value is the digital representation of the U.S. dollar.
At times there are doubts raised about the existence of reserves (I am looking at you, Tether…) but over the recent months, disclosures about assets used for backing have increased for some of the major fiat-backed stablecoins like USDC.
As the name implies, Crypto-backed stablecoins operate similarly to fiat-backed ones. However, the difference is that these stablecoins are backed with another cryptocurrency.
Another difference is the ratio between the collateral and the stablecoin. This is a result of the instability of crypto when compared to fiat currencies.
With fiat currencies like the dollar, you can be sure of a one-to-one ratio. However, crypto-backed stablecoins have a higher collateralization ratio.
Hence, the value of a crypto-backed stablecoin depends on the value of the cryptocurrency in question. This way, the entire system exists on the blockchain and could have many use cases.
Prominent examples are coins like DAI and RAI.
Non or partially collateralized stablecoins
Unlike both kinds of stablecoins listed above, these kinds of stablecoins perform the functions of a central bank using smart contracts. These contracts are monitored using AI-powered algorithms that monitor the prices of these stablecoins.
In cases where currencies like the US dollar or Ether collapse, non-collateralized stablecoins would, in theory, survive as a way to store value.
FRAX is a good example for a partially collateralized stablecoin.
Most Popular Stablecoins in the Crypto Market
Now that we know the types of stablecoins let’s look at a few of the most popular stablecoins on the market:
Also known as Tether, this stablecoin is pegged against the U.S. dollar and it maintains a 1-to-1 ratio with the U.S. dollar. It is a blockchain-based cryptocurrency whose tokens are always equivalent to USD$1.00.
Tether is also a major source of liquidity for the crypto market. According to CryptoCompare, 57% of bitcoin trading in February 2021 was done against USDT. The USDT has been designed as both a storage medium and a mode of storing value.
Based on its market value of more than $78 billion in February 2022, Tether is the third-biggest cryptocurrency in the world.
Although it is worth mentioning that there are some worries with Tether, as investors are worried that Tether may not have enough dollar reserves to back up its dollar peg of about $78 billion.
USDC (a regulated stable coin)
The USD coin (USDC) is also pegged with the U.S. dollar, and is an Ethereum based stablecoin with representations on other chains as well. It was created to tokenize the US dollar.
It was launched via a collaboration between crypto exchange Coinbase and financial service provider, Circle in 2018.
Although this coin is designed to be stable, it also goes through mild price changes. This is often a result of changes to supply and demand. USDC was at an all-time high of $1.19 and an all-time low of $0.89.
There is less worrying with USDC because new tokens are only issued on demand. To create a new token, you need to send the USD equivalent to the token issuer’s bank account.
DAI (collateralized and decentralized coin)
DAI is another popular stablecoin that is linked to the value of the U.S. dollar. DAI maintains a 1:1 ratio with the US dollar by locking other crypto assets in contracts. DAI is run by MakerDAO using an open-source software called the Maker protocol platform. It is a decentralized application that runs on the Ethereum blockchain.
It operates with DeFi (decentralized finance) features that enable borrowing, lending and trading. It can be bought directly from crypto exchanges using fiat currencies like the U.S. dollar or the Canadian dollar.
Unlike other stablecoins that get their value from other assets, DAI maintains its value by using collateralized debt in ETH.
DAI is designed in a way that the supply of DAI cannot be altered by any party. With the use of smart contracts on the Ethereum blockchain, the system can respond to changes in the market prices of the assets.
Risks for the market from stable coins
While stablecoins present a ray of hope, there are also concerns from economists and financial analysts. Some have pointed to the possibility of a market collapse as a result of a cascade of events.
The whole essence of the blockchain is decentralization: The fact that the system is decentralized and power does not lie with a single party. It is the reason why blockchain technology is edging away from traditional finance.
However, with stablecoins, that layer of transparency and immutability is questioned. This is because a single entity controls a large supply of stablecoins. For instance, USDT is controlled by a company called Tether. This company controls the supply and distribution rate of the USDT and will operate primarily with its interest at heart.
Other stablecoins, like USDC face significant US regulator risks whilst others, like DAI, are partially collateralized using other stablecoins like USDC. All this together creates stability risks to the entire DeFi economy.
Also, with stablecoins being pegged to fiat currencies, there is a risk of inflation. This is why you need to spread your assets in various stablecoins and avoid greed.
Today, Bitcoin remains the most popular cryptocurrency. However, there have been many price fluctuations over the last years.
Starting from about $3,000 at the height of the pandemic in 2020; to $69,000 in 2021, and then plunging by more than 50% to about $35,000.
Although these fluctuations may seem normal to crypto traders, they often concern outsiders. That’s why the advent of stablecoins (if they can maintain stability) is a welcome development.
Stablecoins continue to grow as part of the financial market structure. However, it is expected that there will be more scrutiny and set rules to govern the way these stablecoins (and cryptocurrency at large) operate.