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Stablecoins 101: What They Are & How They Work?

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For quite a while, volatility has been the Achilles heel of many forms of digital cash, including Bitcoin. Despite the many benefits cryptocurrencies offer, many people shy away from them because their value fluctuates almost daily.

Luckily, stablecoins are here to save the day. 

Stablecoins are a more stable type of crypto. They’re inherently cryptocurrencies whose value is pegged to less volatile collateral assets such as commodities, traditional currencies, and other cryptocurrencies. Stablecoins may also be backed by computer algorithms.

Read on for an eye-opener on what stablecoins are, how the various collateral assets affect coin volatility, and how they stack up against conventional cryptocurrencies.

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What Are Stablecoins?

Stablecoins are cryptocurrencies specially designed to be more stable than conventional crypto. Their extra stability is because they’re usually pegged to less volatile reserve assets that may include traditional currencies such as the USD.

Stablecoins can also be pegged to other digital currencies such as Bitcoin, precious metals like gold, and tangible assets such as real estate.

That’s unlike conventional cryptocurrencies like Bitcoin, whose value is pegged to software-driven cryptography and peer-to-peer technology.

While many investors see stablecoins as a risk-free alternative, they carry some level of volatility; it’s just lower. Think of it this way; the USD does fluctuate. However, it’s still less volatile than Bitcoin.

How Do Stablecoins Work?

Stablecoins work pretty much like conventional crypto; the only difference is that they’re less volatile. Stability aside, they come with pretty much the same features of conventional cryptocurrencies, including:

Added Privacy

When you transact through stablecoins, it’s virtually impossible to tie your financial activity to your identity. Companies can also transact with stablecoin anonymously.

That’s because instead of linking your personal/business transactions to your identity/business name (as is the case with conventional cash), stablecoins associate them to a random sequence of characters.

In doing so, they hide your paper trail, helping keep your transactions anonymous.

Security

Like other cryptocurrencies, stablecoins come with an additional layer of security, particularly when it comes to storage. You can store this type of crypto in a specialized virtual wallet and secure it with a private key that only you know.

What’s more, you can use encryption technology to further secure your coins against unauthorized access across various devices.

The fact that stablecoin transactions can’t be reversed also contributes to security, especially for individuals and companies selling online. Too often, dishonest individuals will receive a product that’s perfectly fine and request a chargeback without returning the product in question.

This is known as chargeback fraud, and stablecoins’ irreversibility eliminates it.

Decentralization

Stablecoin transactions are executed outside the conventional institutional model. They aren’t regulated by any government or intermediaries, helping eliminate limitations such as trading disruptions caused by hacking attempts and order processing delays.

Decentralization can be particularly helpful when sending money across countries. Since the value of stablecoins is independent of geographical location, you won’t have to do things like currency conversions.

Also, transactions are virtually instant.

While on the subject of how stablecoins work, it’s worth noting that the type of backing asset significantly affects the volatility of the coin in question. Digital currencies may be backed by various asset reserves, including traditional currencies, precious metals, algorithmic functions, and other cryptocurrencies.

Types of Stablecoins 

Generally, the more significant the link between a stablecoin and a centralized financial system, the more stable the coin. To clarify, let’s review the various types of stablecoins and how their backing asset affects their volatility.

Fiat-Backed Stablecoins

With this type of stablecoin, you use conventional fiat currency (such as USD) to acquire stablecoins. If need be, you can exchange these coins later for your original currency at a specified rate. 

Fiat-backed stablecoins are arguably the most stable type because their backing source is centralized, allowing authority figures to intervene and control prices in case of excessive volatility.

For instance, if a stablecoin is backed by the USD, it’ll be pretty much as stable as that currency because the federal reserve system always controls the monetary system to prevent drastic changes in the dollar’s value that might lead to financial crises.

The stability of fiat-backed stablecoins depends entirely on the economy of the backing fiat currency. As long as that particular country’s economy remains stable, this type of stablecoin won’t fluctuate even if the price of other cryptocurrencies drops to zero.

Simplicity is also part of fiat-backed stablecoins’ appeal. In most cases, you’ll find that fiat-collateralized stablecoins can be exchanged at a 1:1 ratio to the backing currency.

This makes it easy to understand how these coins work, especially for people new to crypto, allowing for widespread adoption of this new form of digital currency.

Some popular stablecoins are Tether (USDT) and USD Coin (USDC).

Cryptocurrency-Backed Stablecoins

As the name suggests, crypto-backed stablecoins are pegged to other crypto assets. Since crypto-assets are more volatile than most traditional currencies, this type of stablecoin is less stable than its fiat-backed counterpart discussed above.

To help reduce some of the volatility, crypto-backed stablecoins are often over-collateralized. For instance, a stablecoin worth $1 may be pegged to a $2 crypto asset instead of a $1 asset.

This way, the stablecoin gets a 1-dollar cushion (i.e., if the crypto asset loses half of its value, the stablecoin will still be worth $1). 

What’s more, crypto-collateralized stablecoins are automatically liquidated if the price of the backing crypto-assets drops too low. While this is often the last resort, it helps protect investors from extreme losses by ensuring that they recoup some of their money when cryptocurrency prices fluctuate too much. 

Additional volatility aside, crypto-collateralized coins are also the most complex type of stablecoins. As such, they haven’t gained as much popularity as other forms of stablecoins, mainly because new investors often struggle to understand the intricacies of blockchain technology.

On the bright side, crypto-backed digital currencies are fully decentralized because everything happens on the blockchain. The lack of intervention by regulatory bodies means investors and businesses can enjoy secure, transparent transactions without geographical limitations.

Lastly, this type of stablecoins is far more liquid than their fiat-backed counterparts, making it easier to convert them into their collateral asset.

Commodity-Backed Stablecoins

Even though real estate, oil, and other precious metals may be used as collateral assets, gold is arguably the most used backing mechanism for this type of stablecoins.

Gold-backed stablecoins are typically centralized because gold is regulated at both global and national levels.  

Sure, some in the crypto community might feel that pegging digital currency to a regulated asset comprises one of its main appeals: decentralization. However, the other side of the coin is that it reduces its volatility.

In doing so, it mitigates one of the primary concerns about crypto.

Speaking of volatility, gold-backed stablecoins are some of the most stable digital currencies. Gold has historically been used as a hedge against inflation and volatility in stock markets, and rightly so.

Research has found that despite being a weaker hedge than the Volatility Index (VIX), gold is a better hedge than other precious metals. Thus, using it to back stablecoins adds protection against inflation and volatility, making such coins more stable than their crypto-backed counterparts.

The added benefit of commodity-backed stablecoins is that you hold a tangible asset with real value when you own these. Sometimes, the underlying asset may appreciate over time (especially in the case of real estate), boosting the value of your stablecoins.

What’s more, owning stablecoins can be a great way to invest in commodities that would otherwise be out of your reach due to geographical restrictions.

For instance, you can own stablecoins pegged to overseas real estate that would be difficult or too expensive to invest in through conventional investment avenues.

Similarly, you can invest in precious metals such as gold without dealing with the challenges of transporting and storing them.

Algorithmic Stablecoins

These fall outside the conventional definition of stablecoins in that they’re not pegged to any asset. Instead, they leverage a computer algorithm to regulate volatility.

The way algorithmic stablecoins work is quite similar to the USD. First off, neither form of currency is pegged to a tangible asset. The USD was once backed by gold, but that came to an end several decades ago, and yet the currency remains fairly stable because businesses and individuals still believe in its value.

Secondly, the demand and supply of both forms of currency are controlled similarly. With the USD, the central bank prints and destroys currency to regulate demand and supply, subsequently stabilizing the currency’s value.

Similarly, computer algorithms regulate the demand and supply of non-collateralized stablecoins to stabilize their value. 

The governing mechanism of algorithmic stablecoins is based on a model known as seigniorage. When the demand increases, the algorithm automatically creates more tokens to lower the price back to the norm.

On the other hand, a decline in the value of this type of stablecoin prompts the algorithm to limit the circulating supply, effectively bringing the price back up.

Like their crypto-backed counterparts, algorithmic stablecoins are decentralized. However, they’re slightly more independent than crypto-collateralized coins because they’re not pegged to any other asset.

They’re also less volatile than crypto-backed coins because their volatility depends on supply and demand instead of other cryptocurrencies.

On the flip side, you stand to lose more with algorithmic stablecoins in case of a crash. Since there’s no backing asset to redeem your coins back into, you’d lose all your money in a crash.

That’s especially true given that you’d struggle to find a buyer for such coins during a crash.

Stablecoins vs. Other Cryptocurrencies: How Do They Compare?

Having understood what stablecoins are and how the various collateral assets affect their volatility, the next bit of information you need to get familiar with is how they stack up to conventional crypto.

This way, you can make an informed decision whether you’re looking to invest in stablecoins or use them to transact.

For purposes of this comparison, our areas of interest will be how stablecoins compare to conventional as:

  • A medium of exchange.
  • A store of value.
  • An investment.

Why only these merits?

Because stablecoins are pretty much the same as conventional crypto in terms of privacy and security. We could talk about volatility, but that would be unnecessary given that we’ve already established that stablecoins are less volatile.

Now that’s out of the way, let’s make the comparison.

A Medium of Exchange

The most critical requirement for a medium of exchange is that it should have steady purchasing power. In other words, it should have consistent intrinsic value.

Generally, the value of conventional non-collateralized digital currencies fluctuates more than that of stablecoins. As such, conventional crypto doesn’t maintain its purchasing power as consistently as stablecoins, making the latter a better medium of exchange.

A Store of Value

The defining trait of any good store of value is that it can be held for extended periods and converted into money without losing its value. Gold sets the bar in this regard because while it may fluctuate short term, it either maintains its value or appreciates in the long run.

Stablecoins share some of the traits of gold as a store of value; some are even pegged to gold. And even when they’re not backed by gold, they’re built to maintain their value better than conventional crypto in the long run, making them a better store of value.

An Investment

This is probably the only key area where conventional cryptocurrencies outperform stablecoins. Since the latter type of digital currency is typically designed with stability in mind, it rarely soars in value.

On the other hand, conventional cryptocurrencies are inherently volatile.

While volatility may have a bad rep when we talk about mediums of exchange and stores of value, that’s not necessarily the case for investments. 

Sure, volatility does increase risk in investments. However, it also increases potential returns.

So while you want to minimize risk by investing in moderately volatile assets (including cryptocurrencies), you don’t want to do that to the extent that you stand a next-to-zero chance of growing your investment; you need to shoulder a bit of risk and volatility to realize returns.

That’s why conventional cryptocurrencies are a better way to grow your money than stablecoins. With the right strategy, you can leverage crypto’s price fluctuations to generate some impressive returns.

Beware, though, because volatility is a double-edged sword: you can end up losing your money in a short period.

Should You Buy Stablecoins?

Stablecoins seem to have addressed a long-standing barrier to cryptocurrency adoption (volatility), which is bound to increase their adoption. If current trends are anything to go by, the future is already shaping up nicely for these digital currencies. 

From key players in the financial sector like JPMorgan Chase & Co. to payments networks such as Visa, various stakeholders are giving stablecoins the nod.

Regulatory organizations have also joined the bandwagon.

The US Office of the Comptroller of the Currency (OCC) recently published a guide to help financial institutions incorporate stablecoins and blockchain technology in their functions.

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