What are Stablecoins?

Fredrick Awino
23.07.2022
315 Views

Since the advent of the first cryptocurrency, bitcoin in 2009, a lot of questions keep emerging. One critical question in the minds of many is about what is the basis of cryptocurrency value. Simply put, where does a cryptocurrency such as bitcoin or Ethereum get its value from? This is a legitimate question especially from people who have keenly read the history of currencies.

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A little history will tell you that people relied first on barter trade which basically involved exchange of goods for goods, then came the money system in which metals and precious minerals such as gold were used as a measure of value. fast forward, the fiat currency, which simply means the paper or silver money as we know them gained prominence and derive their value basically based on how much importance people place on them. Importance in this case is often threefold; a medium of exchange, a unit of measurement, and a storehouse for wealth.

The era of virtual currencies, in other words cryptocurrency has yet again presented new questions about where their value is anchored. A simple and straightforward answer is that the value of  most cryptocurrencies is not attached to any specific asset. Instead, the cryptocurrencies derive their respective value from a restricted supply and increasing demand. An example of restricted supply is halving in bitcoin. However, there is a breed of crypto that are actually attached to assets and they are called stable coins.

Stable Coins in Brief

A stablecoin refers to a digital currency, which is pegged to a reserve asset that is stable such as gold or the United States dollar. Stablecoins aim is to reduce the volatility that is relative to cryptos that are not pegged such as Bitcoins.  They are a bridge between the daily fiat currency and the world of cryptocurrency.

This digital currency was developed with the goal of addressing unbacked crypto assets’ price fluctuations. In addition, they have reserve assets that make them have a direct link with the traditional financial sector. Stable coins rely on tools stabilization in maintaining a stable value.

The Way Stable coins Work

Stable coins can easily be traded or redeemed for the value of an asset on which they are pegged. Cryptos are prone to price fluctuations and that is the reason we are currently experiencing crypto winter. This means that a stable coin, which is pegged on certain crypto that faces volatility may experience changes in value. However, most of the stable coins are pegged to fiat currencies.

Popular cryptos like Ether and Bitcoin suffer from high volatility. However, for an asset to be used as a medium of exchange, it has to maintain its value. Therefore, a stablecoin can be used as a medium of exchange and this bridges the gap between cryptos and fiat. Also, they are a good store of value.

The Main Ways of Getting Stablecoins

  1. Earning through working on the projects that are in the Ethereum ecosystem
  2. Picking most of the stable coins on the decentralized exchanges and then swapping the tokens you have for stablecoins.
  3. Directly buying the coins through exchanges and wallets
  4. Borrowing by using cryptocurrencies as collateral.

The Main Types of the Coins

Stablecoins are classified into different categories including Fiat-Backed Stablecoins, Algorithmic Stablecoins, Asset-Backed Stablecoins, and Cryptocurrency-Backed Stablecoins.

Cryptocurrency-Backed

Cryptocurrency-Backed Stablecoins refer to the stablecoins that are backed by other cryptos. An example is the Wrapped Bitcoin. It is a token, which mirrors Bitcoin even though it is Ethereum blockchain that issues it. Also, the Wrapped Bitcoin reserves are held in the vaults that custodians operate. On the other hand, renBTC, another example is held in vaults that smart contracts manage. A hacker can exploit the smart contracts’ fault and steal cryptos. An example is what happened to Wormhole where 120, 000 Wrapped Ethereum (wETH) were stolen.

Algorithmic

Although other cryptos back Algorithmic Stablecoins, the backing is not in relation to a crypto’s reserve. It means that the rules or even software code linked to another crypto determines the peg instead of the underlying crypto in a vault. An example is Dai. It maintains its peg to the United States Dollar via collateralized loans of coins including fiat stablecoins, Bitcoin, and Ether.

Fiat-Backed

Fiat-Backed Stablecoins refers to stablecoins backed with huge cash equivalents or cash reserves. Fiat currencies refer to the currencies provided by the central bank including the euro, the British pound, and the U.S dollar. Currently, the main fiat-backed stablecoins include USD Coin, Binance USD Coin, and Tether.

Asset-Backed

Asset-Backed Stablecoins are the stablecoins backed by reserves of a tangible asset. These may include stock-based tokens or gold.

Advantages of Stablecoins

The first benefit of stablecoins is that it has low fees. The transfers are inexpensive. The cost that you will incur in transferring funds is affordable. This is highly applicable in a case where you transfer money in large accounts. Also, in it, the transactions are secure and they are completely anonymous. It means that other people will not know the people who are transacting. With Stablecoins, you are convinced that your asset is well backed.

Furthermore, Stablecoins help in the adoption. It is acceptable in bridging from fiat to crypto use. Stablecoins is a good place of parking funds between the cryptocurrency’s investments. In case you make a big score in running up cryptos or in case you want to exit crypto because of market instability. In case of such situations, you may sell the cryptos that you have and then opt to invest in Stablecoins.

Investing in stablecoins is an indication that you are diversifying your investments. It is highly recommended that one has other assets apart from the cryptos. Diversifying about 20% of your cryptos to stablecoins. This helps in improving long-term performance and lowering volatility.

The coins are advantageous as it gives you the opportunity of moving money back to US dollar assets. Because the value of stablecoins is linked to US dollar assets, it is easy to transfer money from the crypto exchange to a bank account. Also, the coins may be utilized in making international payments.

When choosing this type of coin, you should choose the ones that pay interest. Through this, you will earn some amount of money on top. The interest rates differ from one stablecoin to the other. However, in most cases, they range between 8 to 9%.

The Disadvantages of Stablecoins

As compared to other cryptocurrencies, Stable coins have less return on investment. Investors and traders have the need for higher returns as well as resort to other forms of financial gains. Thus, they are not a good option.

The issue of centralization in stable coins is a disadvantage of a stable coin. As much as cryptocurrencies and blockchain technology celebrate decentralization, stable coins tend to be centralized. They are mainly centralized in assets backing. The reason is that to ensure that every coin which is in circulation is backed with equal reserve value, a team must be in place. Because of this, it seems to be centralized.

Most of the stable coins have been criticized for not being transparent with reserves. For instance, in tether, most of the investors have been asking the firm if it has the right number of reserves resulting in regulations and fines put in place by the federal government. Since then, the firm has released reports showing its holdings.

The main Stablecoins

  • Pax Dollar
  • Tether
  • TrueUSD
  • USD coin
  • Binance USD
  • Frax
  • Dai

 

Author Fredrick Awino