Combining the stability of conventional assets with the flexibility of digital assets has proved to be a phenomenally appealing concept. Stablecoins have developed into a critical component of a growing class of products known as DeFi, or decentralized finance, in which transactions may be conducted without a third party’s intervention like a bank or broker. Let’s dive in and see what is a stablecoin and what are the different types of stablecoins.
What is a Stablecoin?
Stablecoins are a subset of cryptocurrencies that are backed by a reserve asset and try to maintain price stability. Stablecoins have gained increasing attention as they aim to combine the benefits of cryptocurrencies—instant payment processing and security or privacy—with the volatility-free steady prices of fiat currencies.
The unpredictable nature of cryptocurrency values contrasts with the relatively steady pricing of fiat money, such as US dollars, or other assets, such as gold. While the values of fiat currencies fluctuate over time, the daily fluctuations are often more dramatic for cryptocurrencies, which fluctuate in value regularly.
Overall, stablecoins attempt to mitigate price volatility by peg cryptocurrency values to more stable assets — often fiat currencies. Fiat is the term used to refer to the government-issued money that we are all used to utilizing on a daily basis, such as dollars or euros. Without a doubt, the demand for stablecoins is surging: it is estimated that the entire value of stable assets increased by nearly 495 % between October 2020 and October 2021.
Types of Stablecoins
Stablecoins come in four types, each with its unique method of tying the tokens’ value to a steady value.
This constitutes the most prevalent sort of stablecoin. They are tied to fiat currencies such as the US dollar or the Euro and are often backed 1:1, which means that for every stablecoin in circulation, there is one unit of fiat money in a bank account.
Stablecoins backed by fiat are analogous to IOUs – you spend your dollars (or another fiat currency) to purchase stablecoins that you can later redeem for your original currency. Unlike other cryptocurrencies, which may experience huge price volatility, fiat-backed stablecoins strive for very low price variations. Tether was the first stablecoin tied to the US dollar, and it was launched in 2014, subsequently becoming the blueprint for many future stablecoins. For each dollar deposited, users earn one token. The tokens may then be exchanged for the original currency at any time, again on a one-to-one basis. Other stablecoins are pegged to the euro, the pound sterling, the yen, and the Chinese renminbi.
These stablecoins are backed by other crypto assets. Due to the underlying asset’s volatility, crypto-backed stablecoins are overcollateralized to guarantee the stablecoin’s value. For example, MakerDAO is one of the most popular stablecoins backed by cryptocurrency. It pools enough ether (ETH) to serve as collateral for its stablecoin using a smart contract — a form of self-executing, code-based contract – in conjunction with the Ethereum network. Then, when the quantity of collateral in the smart contract reaches a certain threshold, users may manufacture DAI – the MakerDAO stablecoin.
Precious metal-backed stablecoins
Stablecoins backed by precious metals rely on gold and other precious metals to preserve their value. These stablecoins are centralized, which may be seen negatively by certain crypto community members, but it also protects them against crypto volatility. Gold has long been perceived as a hedge against stock market volatility and inflation, making it an appealing addition to portfolios during periods of market turbulence. Digix is a gold-backed stablecoin that enables investors to invest in precious metals without the hassles of moving and keeping them. For instance, Tether gold (XAUT) is backed by a gold reserve held in a Swiss vault, and a gram of gold is equivalent to one XAUT.
Algorithmic stablecoins are not backed by any asset, which makes them the most difficult stablecoin typology to comprehend. These stablecoins rely on a computer program (Smart Contracts) to keep the coin’s value stable. If the algorithmic stablecoin’s price is tied to $1 USD, but the price of the stablecoin increases, the algorithm will automatically increase the supply of tokens to bring the price down. If it goes below $1, the supply will be reduced, bringing the price back up. While the number of tokens you possess will fluctuate, they will always represent your share. AMPL (Ampleforth) is one algorithmic stablecoin that its developers claim is better prepared to absorb demand shocks.
Why are stablecoins needed?
In the first instance, stablecoins were utilized to purchase other cryptocurrencies, such as bitcoin, since many cryptocurrency exchanges lacked access to regular banks.
Nonetheless, stablecoins have the potential to replace conventional currency in a variety of applications, from migrant workers sending money home to corporations paying abroad suppliers or staff. They have the potential to make cross-border payments quicker, more secure, simpler, and cheaper.
Furthermore, stablecoins do not need a bank account to retain funds, and they are very straightforward to transfer. Stablecoins’ value may be readily transferred worldwide, especially to locations where the US dollar is scarce, or the local currency is unstable. Stablecoins such as USDC or Tether represent an excellent alternative for transferring money anywhere globally due to their rapid processing and cheap transaction fees. Stablecoins are accessible 24 hours a day, 7 days a week, unlike currency earned via the banking system, which is closed overnight and on weekends.
Stablecoins may be used in conjunction with smart contracts on blockchains, which, unlike traditional contracts, do not require legal permission to be implemented. The software’s programming automatically determines the parameters of the agreement, as well as how and when funds will be distributed. Hence, stablecoins are programmable in ways that dollars or euros are not.
In simple words, Smart Contract platforms understand crypto tokens. Smart contracts are used to automate many processes and contractual agreements on public blockchain networks. In order to use Fiat currency in smart contracts, you need a tokenized version of Fiat. Stablecoins serve exactly this purpose. Then the applications of stablecoins are limitless.
Stablecoins offer some of the stability that other cryptocurrencies lack, therefore rendering them worthless as money. However, users who use stablecoins should be aware of the hazards associated with their ownership. While stablecoins may seem to have reduced dangers during most periods, they may become the riskiest at times of crisis, when they should be the safest to hold.
Stablecoins backed by Fiat, Precious Metals or other types of assets can be considered the first use-cases of real asset tokenization.
Worthy of mention, there were concerns around some stablecoins and whether they were truly backed by Fiat. Despite your background and the purpose you want to use stablecoins, make sure you do proper research before deciding which stablecoin to use and which ones to avoid.