What are Stablecoins?
The cryptocurrency’s decentralized nature is the one of the best characteristics that helped skyrocket its popularity the past few years as it eliminated the intermediary institutions making transactions open to anyone around the world. However, even if cryptocurrencies have already existed for more than a decade, their prices are still unpredictable and have a tendency to fluctuate wildly, making it a major drawback.
Cryptocurrency’s unpredictability comes in contrast to the generally stable prices of fiat money, such as U.S. dollars, gold, and other real-world assets. The value of dollars or euros do change gradually over time, but not as drastic as cryptocurrencies do, which rise and fall in value regularly. Fiat currencies are under a central authority that steps in to manage the demand and supply of the currency to maintain price stability. Unfortunately, cryptocurrencies lack such key features — they don’t have a reserve backing their valuations, and they don’t have a central authority that controls prices when required.
This kind of short-term volatility makes cryptocurrencies unsuitable for everyday use by the general public — and this is where stablecoins solve all of these issues.
A stablecoin is a type of cryptocurrency whose value is pegged to another asset class, such as the U.S. dollar or gold, to stabilize its price and is backed by a reserve asset. It gained traction as it attempts to offer the instant processing and security or privacy of payments of cryptocurrencies, and the volatility-free stable valuations of fiat (real-world) currencies. Entities behind a stablecoin sets up a “reserve” where it securely stores the asset or basket of assets backing the stablecoin — for example, $1 million in a typical bank is used to back up one million units of a stablecoin.
Stablecoins attempt to bridge the gap between fiat currencies and cryptocurrencies, and this happens in three (3) categories based on their working mechanisms.
The stablecoins that maintain a fiat currency reserve, like dollars or euros, as collateral to issue a suitable number of crypto coins. Precious metals like gold or silver and even commodities like oil can also be a collateral, but the most common fiat-collateralized stablecoins today use USD reserves.
These reserves are maintained by independent custodians and are regularly audited for adherence to the necessary compliance. Tether (USDTUSD) and TrueUSD (TUSDUSD) are popular crypto coins that have a value equivalent to that of a single U.S. dollar and are backed by dollar deposits.
These stablecoins are backed by other cryptocurrencies. Since the reserve cryptocurrency is also prone to high volatility, such stablecoins are over-collateralized, which means a larger number of cryptocurrency tokens is stored as reserve for issuing a lesser number of stablecoins. More frequent audits and monitoring makes the price stable.
For example, $2,000 worth of ether may be held as reserves for issuing $1,000 worth of crypto-backed stablecoins, which accommodates up to 50% of swings in reserve currency (ether). Backed by Ethereum (ETHUSD), MakerDAO’s DAI (DAIUSD) is pegged against the U.S. dollar and allows for using a basket of crypto assets as a reserve.
Algorithmic, also called non-collateralized, stablecoins don’t use any reserve but include a working mechanism, like that of a central bank, to retain a stable price. For instance, the dollar-pegged basecoin uses a consensus mechanism to increase or decrease the supply of tokens on a need basis.
Such actions are similar to a central bank printing banknotes to maintain valuations of the fiat currency. It can be achieved by implementing a smart contract on a decentralized platform that can run in an autonomous manner.
Now, if you have stablecoins ready, your next question would be, “How do I use my stablecoins?” Well, you got two options:
1. Hold the funds
Holding the funds in a stablecoin limits your risk. It’s a bit like keeping cash in a brokerage account while waiting to make an investment — our funds may grow but not that much.
2. Participate in decentralized finance (DeFi) projects
This is the most popular way that people use stablecoins. Crypto lending, yield farming, and staking platforms are some of the popular DeFi projects today. Minimizing the volatility risk for users could make it easier to understand the cost (or profit) that can come from these transactions.
You should check out the newest DeFi project that lets you earn more money with your savings all in auto-pilot, The Rand Network. To know more about this exciting and groundbreaking project, head on to our whitepaper here.
What Is Stablecoin?
A stablecoin is a class of cryptocurrencies that attempt to offer price stability and are backed by a reserve asset…