12. Stablecoins – What they are?
We have over 100 different stablecoins. There is no denying that they serve a very important function in the crypto ecosystem. What are they? How do you use them? What advantages and disadvantages do they have? During today’s lesson we will try to answer all these questions.
Stablecoin – definition
The literal translation is “stable coin”. Stablecoin is a digital asset that is linked to another asset with a fixed market value such as FIAT currencies, gold, the US dollar or bitcoin. By design, they are supposed to have low exchange rate volatility. As you know, the cryptocurrency market fluctuates a lot. That is why it is so hard for digital assets to become full-fledged means of payment. Stablecoins are their opposite. They are meant to improve the security associated with investing in other cryptocurrencies. We can convert all cryptocurrencies into stablecoins. They provide users with more stability than traditional crypto because their price is linked to the price of another currency.
The assets we are discussing today are often compared to a digital deposit, where many users of cryptocurrency exchanges keep their funds. We will not exaggerate if we say that they were created to minimize the uncertainty of many people who were afraid to take risks in investing in crypto. Their supply and demand is regulated by a central bank-like entity that minimizes price volatility.
Of course, they serve us as a means of payment, but not only. Stablecoins provide us with price stability, especially during increased price volatility in the cryptocurrency market. They are also used as a quick transfer between crypto and FIAT currencies. So you can see the important role they play in the ecosystem.
You have noticed that they have many of them. Stable coins:
∙ This is an important currency, especially in countries with high inflation.
∙ They are used in countries where access to banking services is limited.
∙ They offset price changes in other digital assets, thanks to their low volatility.
∙ They are mobile and very easy to exchange.
∙ Stablecoin transactions are fast, simple and transparent.
∙ They allow you to keep your profits.
Linking to other assets
As we mentioned earlier, stablecoins are backed by various assets to maintain their stability. This group includes:
∙ FIAT currencies such as the US dollar or the euro.
∙ Cryptocurrencies such as bitcoin, ethereum.
∙ Physical commodities like gold, oil or even real estate.
∙ Smart contracts that reduce the supply of a coin as soon as its price falls below $1. And the other way – if the price of stablecoin is higher than $1, then the algorithm increases its supply to lower the price.
Examples of stablecoins
∙ Tether (USDT)
∙ Dai (DAI)
∙ USD Coin (USDC)
∙ Paxos Standard (PAX)
∙ Binance USD (BUSD)
Division of stablecoins:
1. Centralized stablecoins: USDT, BUSD, USDC – They operate centrally as a fiat currency (USD or Euro). This means that a central organization manages and controls its issuance. This entity guarantees the issuance of these stablecoins through its cash reserves, which it usually keeps in a bank account. For every dollar of stablecoin issued, it is supposed to have one dollar in its accounts.
2. Decentralized stablecoins: DAI jEuro, jCHF – They operate in a decentralized manner, like Bitcoin and Ethereum. This means that no central entity interacts with the process. The protocol is managed by algorithms and blockchain. These stablecoins are backed by a reserve of cryptocurrencies such as Ether. To create this we secure (put as back-up) an amount of Ether that allows us to create stablecoins. In reality, the amount of cryptocurrency pledged is always greater than the amount of stablecoins created. For example, to create $100 Stablecoins, we place $150 Ether as collateral. This ratio keeps the balance . Otherwise, the protocol provides for the liquidation of reserves to guarantee stability.
3. Algorithmic stablecoin: Frax, UST*– As we have seen, the creation of decentralized stablecoins is possible by reserving a large number of tokens. However, these reserves are blocked and can no longer be used. These stablecoins offer a solution to these blockades. Indeed, through a complex algorithm-based mechanism, the protocol will act as a central bank. It will increase or decrease the number of tokens in circulation to maintain price stability. Specifically, when the price of stablecoin falls relative to the traditional asset it represents, the protocol will reduce supply through a combustion mechanism. Conversely, when the price of stablecoin increases relative to the traditional asset it represents, the protocol increases supply through a minting mechanism.
History of UST
UST is a stablecoin representing the dollar, developed by the Terra blockchain. The value of UST is maintained by an arbitrage mechanism that destroys or creates tokens to maintain stability. Its architecture is therefore based on two tokens: UST, which represents the dollar, and Luna, which allows volatility to be absorbed.
UST was the third most stablecoin on the market, ahead of DAI and BUSD.
Nevertheless, Luna’s minutes were under pressure. On May 7, the price of the then $18 billion algorithmic stablecoin terraUSD (UST), which is supposed to hold steady at $1, began to wobble and fell to 35 cents on May 9. Its companion token, LUNA, which was designed to stabilize the price of UST, fell from $80 to a few cents by 12 May. Stablecoin UST collapsed and people lost their savings. As we can see, it is important to choose stablecoins carefully and, as in any case, diversify the stablecoins you own.
It is uncomplicated. Using this asset, we earn interest, loans or staking. Here are some examples:
∙ Interest – by depositing our money in stablecoins on the exchange, we earn money from the interest earned.
∙ Borrowing – cryptocurrency exchanges pay high interest rates for borrowing and even owning stablecoins. All because they are an important reserve of capital and provide high liquidity.
∙ Investing – for example, in stablecoin backed by gold. If the value of gold increases, the value of stablecoin based on this commodity will also increase.
∙ Staking – you hold your stablecoin and in return you receive income from the network. We can compare this process to holding savings in an account.
The future of stablecoin
It looks very promising. Many notable people from the crypto world claim that they are the link between traditional banking and the crypto world. Therefore, they will be a kind of innovation in the financial sector. They are growing with the rise of DeFi, NFT and Web3. Nevertheless, it is still an under-regulated market. However, given the increased interest surrounding them, I think we can expect them to be regulated soon.
As you can see, this is a very interesting solution. With them you can invest in the crypto market even if you are afraid of risk. You already know from our lesson that stablecoins are immune to market fluctuations, so you don’t lose sleep like with fluctuating cryptocurrencies.
Test your knowledge on Kanga Exchange