What Are Stablecoins? A Deep Dive Into It’s Mechanics & Functionality

Introduction

Bitcoin’s launch in 2008 lightened a new way for users to make payment transfers and trading. It gave decentralized and secure methods to do peer-to-peer transactions without getting involved with third parties like government authorities and financial institutions. 

Today, there are thousands of cryptos in the market, but it’s still uncommon to use them to pay for day-to-day actions like when buying groceries or paying for the child’s education.

Why? You ask- cause cryptos like Bitcoin, Ethereum, etc., are highly volatile, which makes them unsuitable for daily use, and that’s what led to the creation of stablecoins. 

In this article, we will explore about stablecoins, their importance, how these assets work on core, their types, and more. 

What is a stablecoin?

By definition, stablecoins are crypto assets that are pegged or backed by low-risk assets such as gold or fiat currencies (US Dollar, Yuan, etc.). 

Stablecoins were introduced back in 2014, and BitUSD is known to be the very first stablecoin in the crypto space. These assets were made to strike a balance between decentralization, speed, and security of cryptos and stability of the real-world fiats. Stablecoins enable a safe and secure monetary system for users and investors to perform everyday purchases and also protect them from inflation and financial eviction.

There are a variety of stablecoins- each having a unique working based on the mechanism used to create them. Stablecoins usually drive their value from fiat, like the US Dollar, and sustain prices close to $1. They are issued by centralized authorities responsible for maintaining an asset reserve equivalent to the number of coins circulating in the market.

For instance, USDT- the world’s largest stablecoin by market cap, is issued by Tether Ltd, which holds enough US dollar asset reserve to back each USDT stablecoin issued. 

Why are stablecoins important?

Looking at the reason for stablecoins, here are some of the important reasons why stablecoins are needed in the space.

• Volatility Mitigation for Traders: Stablecoins offer a solution for traders to navigate the high volatility of the crypto market. Their consistent value helps traders protect their gains and reduce the risk of losses due to crypto price fluctuations by moving into stablecoins.
• Fiat to Crypto conversion: Stablecoins provide an easy gateway for newcomers to enter the crypto space- as they’ll need funds. New investors can convert their fiat currency into stablecoins like the US Dollar, which doesn’t expose them to the immediate volatility of other cryptos.
• Lending and Borrowing Tools: They serve as a stable unit of account in the DeFi space. Lenders can provide loans in the form of stablecoins to borrowers through DeFi platforms like Aave and Compound in the form of stablecoin. This will ensure the value of collateral remains consistent throughout the loan duration.

Types of Stablecoins

Let’s see different types of stablecoins based on their backing mechanism:

• Fiat-backed: As we discussed, these stablecoins, such as Tether, are pegged to the fiat US dollar, which stabilizes its value. The issuers of fiat-backed stablecoin are needed to hold sufficient reserves to keep the value of the stablecoin. The peg does not always match and can sometimes fluctuate from the actual fiat price. However, that is by decimal points only.
• Crypto-backed: These stablecoins derive their peg from other cryptos like Bitcoin and Ethereum and are backed by overcollateralized crypto reserves. For example, the DAI stablecoin of Maker DAO is collateralized by a set ratio of Ethereum ETH and ERC-20 assets. 
• Algorithmic: Stablecoins that rely on automated mechanisms to maintain consistent peg value that burns and mints new coins according to the demand of the coin. For example, FRAX is a fractional algorithm-based stablecoin backed by a bucket of other stablecoins. 
• Commodity-backed: These assets maintain peg value from commodities like gold, precious metals, oil, or real estate. They are usually issued by centralized authorities who back coins by maintaining enough commodity reserves. For example, PAXG Paxos gold is a commodity stablecoin backed by gold reserves.

Read More: Top Algorithmic Stablecoin

Advantages & Disadvantages

Here are a few advantages of stablecoins:

• These assets have lower risk as compared to highly volatile cryptos like Bitcoin.
• Collateral-backed and algorithmic stablecoins enable transparent, decentralized, and censorship resistance payment options for users.
• Provide users freedom to financial services and protect them against fiat inflation. 
• They serve as a go-to option for cross-border payments at high speed and stable value.

Disadvantages of stablecoins:

• Fiat and commodity-backed stablecoins are bound to centralized operation and issuance.
• They can suffer from a lack of transparency, regulation, geopolitical and counterparty risks.
• Collateral-backed stablecoins like DAI face fluctuation risk of volatility in underlying assets. 
• Circumstances like faults in automated mechanisms, liquidation risk, change in collateral ratio, etc., might have an effect in undermining the value of the stablecoin.

How are stablecoins used?

• Remittances: Firstly, they help offer a quick and easy solution to send money across the world without needing to pass through government regulations and hefty changes in banking systems.
• Trading: Traders and investors can instantly enter and exit their positions and use stablecoins to park their money safely. This way, stablecoins act as a hedging instrument against market fluctuations.
• E-com payments: They serve as a more reliable and secure method for online purchases and business payments than volatile cryptos and inflation susceptible fiats. 
• DeFi applications: Stablecoins are one of the key components of the DeFi ecosystem. They provide an easy and secure portal for newcomers to enter and participate in lending, borrowing, yield farming, staking, and other decentralized financial services. 

List of Top Stablecoins

We have already discussed the majority of important aspects of stablecoin. Now, let’s see the top 5 stablecoins (based on market cap) that you should know to diversify your portfolio:

To invest in these stablecoins, you can download the Cryptocurrency app, register yourself, add funds, and buy cryptos of your choice.

Future of stablecoin

Stablecoins give users the best of both worlds- crypto and fiat currencies. They have already gained lots of attraction, offering reliable, secure, and stable assets in this erratic crypto market. However, these assets hold a bright future, opening new phases for financial systems, but it’s also important to grasp the risk associated with them. 

As the crypto space is rapidly developing at the speed of light, there are risks like de-pegging, liquidation, and regulatory changes. So, investors are advised always to conduct their own research, understand drawbacks, and diversify their portfolios accordingly.