What is a Stablecoin?

Probably the most hotly debated financial buzzword sweeping the globe at the moment, cryptocurrency is a form of digital or virtual money. Its biggest feature is the blockchain; a  decentralized network of computers that manage and record transactions, which is secured by cryptography, making counterfeiting and double-spending practically impossible. 

Given the unpredictable nature and price volatility of this new financial technology, there has been a renewed focus on developing a digital asset that combines the benefits of cryptocurrencies with the stability that makes them a reliable asset. 

Often used for hedging risk, stablecoins were created to maintain the digital nature of cryptocurrencies but with the added maturity of the traditional financial system.

What are Stablecoins?

Types of Stablecoins

Most Popular Stablecoins

Why use a Stablecoin?

Stablecoin Risks

Summary

The crypto assets known as stablecoins are a group of cryptocurrencies whose market value is pegged to an external source. Its value is usually linked to fiat money, but can also be pegged to other reserve assets like gold or even other cryptocurrencies. 

Stablecoins has gained momentum as it seeks to offer the best of both worlds — the fast, secure processing and privacy of cryptocurrency blockchains, married with  relatively more stable fiat currencies.

Most stablecoins claim to be pegged 1:1 to a fiat currency such as the Euro or the US dollar. 

There are two main types of stablecoins: backed stablecoins and algorithmic stablecoins. 

Backed stablecoins are divided into fiat-backed, commodity-backed, and cryptocurrency-backed. 

Algorithmic (non-collateralized) stablecoins are pegged to a fluctuating supply mechanism.

Fiat-backed

Fiat-backed stablecoins are backed entirely or partially by one or multiple government-issued fiat currency (such as the U.S Dollar) and held in a third-party regulated financial entity, usually a bank. 

Commodity-backed

Similar to fiat-backed stablecoins, instead backed by commodities such as precious metals, oil, or real estate. 

Crypto-backed

The value of crypto-backed stablecoins is derived from other cryptocurrencies.

Non-collateralized (Algorithmic)

These stablecoins have no backing in cash, commodities, or cryptocurrencies. Instead, they maintain value by changes in supply of the stablecoin. 

Some of the popular stablecoins are listed below.

Coinbase – USD Coin

Coinbase is one of the world largest and most recognised cryptocurrency exchanges with their own stablecoin known as USD Coin.

Binance USD

Another major cryptocurrency exchange, Binance, has released the Binance USD stablecoin, tied 1:1 to the US dollar.

Tether

It is often the most popular stable coin because of its seamless integration with various platforms and security mechanisms. Tether is a cryptocurrency that is “tethered” to the value of the US dollar and is backed by gold, cash equivalents, and fiat currencies. Although there is some controversy surrounding Tether, as we have noted previously.

True USD

True USD is one of the most liquid stablecoins and is linked to the US dollar. This stablecoin offers some of the higest interest rates when it comes to staking the coin.

Stablecoins enjoy all the advantages of a cryptocurrency like transparency, privacy, authenticity, digital wallets, rapid transactions, cheap fees, and confidentiality without the accompanying volatility and uncertainty previously associated with cryptocurrencies.  

Stablecoins present significant advantages across the financial services ecosystem as a whole.

Everything from cross-border borrowing to financial planning might benefit from a secure and stable decentralized system. Stablecoins could help create a reliable environment for peer-to-peer (P2P) transactions in decentralized lending, for example, without requiring the usage of a historically volatile cryptocurrency like bitcoin.

Hedging with Stablecoins

Most fiat currencies are vulnerable to inflation. Because governments and central banks can issue fiat money in unlimited quantities, its long-term value is threatened.

It’s essential to keep in mind that not all fiat currencies are equally stable in price. Because of their low inflation rates, “stronger” fiat currencies such as the US dollar (USD) or the Euro (EUR) are often preferred.

Hyperinflation, or monthly inflation of more than 50%, may make it hard to save money or accumulate wealth in specific conditions. Local currency inflation in some countries may make it harder for people to exchange their money for a stronger fiat currency, such as the US dollar.

Trading with Stablecoins

Stablecoins are generally used to make cryptocurrency trades easier. Instead of buying Bitcoin in fiat currency like the American dollar, traders often exchange fiat for stablecoins and trade stablecoins for other cryptocurrency like BTC or ETH.

Remittances, or the transmission of payments across international borders, is another application for stablecoins. Sol Digital, a stable coin linked to Peru’s national currency, was released on the Stellar network. It can be sent between people in different nations without the high costs of third companies for cross-border money transactions.

Stablecoins have numerous advantages. However, there are a few bottlenecks to be aware of.

For instance, many stablecoin issuers don’t disclose where or how their reserves are kept. For this reason, many investors and traders struggle to evaluate the level of risk involved.

Here are a few potential risks:

Reserve Risk

The reserves that underpin a stablecoin are an essential part of the ecosystem. Whether due to corruptive or external factors, a lack of reserves means a stablecoin’s value cannot be guaranteed. 

Security

Stablecoins, like other cryptocurrencies, require storage, whether it’s in a trader’s digital wallet or through a broker or exchange. This poses a danger in an ecosystem rife with malicious hacks.

Counter-party Risk

By relying on a third party to produce money and keep a cryptocurrency stable, the reserve asssets might be fractionally reserved rather than fully backed. In this instance, a traditional bank run could cause the coin’s valuation to plummet.

Centralization risk

The exact monetary challenges that fiat currencies confront when a central authority can produce money without monitoring are centralization hazards. Unauthorized third parties could potentially steal money from your account.  

Algorithmic Manipulations

As most decentralized stablecoins are based on smart contracts in Ethereum or Stellar, there’s a chance that the algorithm that keeps the money stable will fail. Under certain circumstances, malicious third party could even modify algorithms.

Stablecoins link fiat currencies such as the dollar to cryptocurrencies. Stablecoins, which are price-stable digital assets that operate like money while retaining the mobility and utility of cryptocurrency, are a creative response to speculative volatility. The four major categories are fiat-backed, commodity-backed, crypto-backed, and algorithmic stablecoins, each with their own unique underlying collateral structure.

Even though many people believe that stablecoins are a safe haven, they still come with their own risks. However, if understood correctly and used smartly, they can be a great addition to a cryptocurrency portfolio.

Our cutting-edge platform comes with connections to all major exchanges that include most stablecoin pairs. Viewing stablecoin order flow on our unique heatmap can give you an even better edge.

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