Learn Cryptocurrency
3 Feb 2021

What are Stablecoins? Uses of Stablecoins

Farheen Shaikh

Stablecoins are a type of cryptocurrency. However, there is a vast distinction between regular crypto coins like Bitcoin and Ethereum and stablecoins crypto. Many investors don’t like the volatility that the crypto market comes with and hence, stablecoins become a much more attractive alternative to conservative investors. 

Stablecoins are cryptocurrencies, which means that they have all the advantages associated with them; for example, stablecoins are also processed instantly, they have the security and privacy associated with their payments and are also based on the blockchain.

The reason why stablecoins are, well… stable, is because they are backed by a reserve asset. This means that their value depends on the valuations of other fiat currencies which are backed by various governments.

For example, USDT is a crypto coin that has a price pegged to the US dollar. This means that while investors in India would be buying USDT as a crypto coin, they would be paying an amount equivalent to the USD to INR conversion rate. If you were to buy 5 USDT on the crypto market, the price you would pay would be very close to 5 USD in INR.

The reason why investors are attracted to holding their crypto in these stablecoins is that they’re more stable than other coins on the exchanges. The value of various stable crypto coins depends on the value of the underlying currency they represent; they do not show major fluctuations in prices like other coins like Bitcoin and Ethereum.

Use-cases of Stablecoins

Originally, stablecoins were used to buy other cryptocurrencies on the market, like Bitcoin. This was because most cryptocurrency exchanges did not have access and permission from traditional banks to carry out transactions. The reason why stable coins were used in this situation was that they were backed by central bank-issued currencies like USD and EUR and they could be used just like other crypto coins 

Many experts believe that stablecoins are a good investment for a host of reasons:

  • They can be used as an everyday currency – While traditional crypto coins are subject to volatility and frequent price changes, stablecoins don’t fluctuate very much since they are backed by national currencies. However, all these stable coins have the same advantages as the other crypto coins. All such coins come with the security of the blockchain, anonymity in transactions, fast transfers and the absence of intermediaries. Stablecoins can be used in everyday life to pay for groceries, fares or even electricity bills; they are, after all, cryptocurrencies with the same value as actual cash.
  • High potential for smart contracts – Smart contracts are blockchain-backed programs that can be automated by programmers to facilitate the transfer and implementation of large assets, like real estate, business contracts or legal documents. These smart contracts are often based on other crypto coins like Ethereum. Frequent price changes can affect the terms of the contract unpredictably. In this case, the usage of stable coins like Tether can give both parties the stability of the contract via less volatility in the market and more secure contracts that are enforced by the blockchain.
  • They are attractive for conservative investors – Since stablecoin prices are not very volatile, they can be an attractive investment vehicle for people looking to secure their money in cryptocurrencies but do not want to risk them. Buying and betting on cryptocurrencies like Bitcoin and Ethereum has its own risks, but buying stablecoins can cut them down significantly and bring stability.

Types of Stablecoins

There are four types of stablecoins:

  • Fiat-collateralized
  • Commodity-collateralized
  • Crypto-collateralized
  • Non-collateralized

Fiat-collateralized Stablecoins

This is the most common type of stablecoin in the cryptocurrency market. Fiat currencies are currencies that are backed by national governments and used as legal tender in that country. USD, INR, EUR and the Rouble are all fiat currencies used by different nations. The stablecoins that derive their value from any one of these fiat currencies are known as fiat-collateralized stablecoins. 

One example of a fiat-collateralized stablecoin is Tether, which is backed by the USD. These are the safest investments for people looking to make conservative bets on the crypto market because they don’t move up and down at a price like other coins. They stay locked to the value of the fiat currency they are backed by.

For example, Tether does not fluctuate in price as rapidly as, say… Bitcoin. That’s because Bitcoin’s value is not backed by a reserve currency. It moves up and down depending on simple demand and supply in the market. In the case of Tether, the prices will move up and down depending on the economy of the United States and the intrinsic value of the USD.

Commodity-collateralized Stablecoins

These types of stablecoins are also backed by reserved assets, but in this case, those assets are not fiat currencies. They are commodities like gold, silver, real estate and various precious metals. While people who hold real commodities like gold have tangible assets, commodity-collateralized stablecoins are just crypto coins that appreciate over time.

With the backing of such Commodity-collateralized stablecoins, people around the world can technically buy commodities like gold (DGX) and real estate in Switzerland (SRC) even if their countries don’t allow them to do so tangibly.

Tiberius Coin (TCX) is a crypto coin that is backed by seven precious metals that are commonly used in technological hardware. The price of this stablecoin, hence, will depend on the collective prices of all the precious metals that it is backed by.

Crypto-collateralized Stablecoins

Crypto-collateralized stablecoins are backed by other cryptocurrencies. Because cryptocurrencies are volatile, these stablecoins have to be overcompensated for them to be collateralized.

For example, to buy a crypto-collateralized stablecoin like DAI worth Rs. 10,000, you as an investor will have to buy and deposit a cryptocurrency like ETH worth Rs. 15,000. In this scenario, your stablecoin, DAI, is 150% collateralized and can withstand a drop in price by that amount. In simpler terms, your Rs. 10,000 worth of DAI is collateralized by Rs. 15,000 worth of ETH.

Non-collateralized Stablecoins

Non-collateralized stablecoins are not backed by any other reserve asset. While that might seem a little contradictory to what stablecoins are, there is a much more advanced concept at play here. These stablecoins are programmed in a way that they regulate their value by controlling their demand and supply in the market.

If the demand increases and the prices go up, new stablecoins are created automatically to reduce the price back to the normal level. If the trading goes too low, the coins in the market are bought up to reduce the supply and boost prices.

One example of a non-collateralized stablecoin is Ampleforth, AMPL, which is a stablecoin that works on the supply and demand model.

Stablecoins list

Here are some of the most popular stablecoins on the crypto exchanges as of August 2021:

  • Tether – backed by USD
  • DAI – decentralized
  • USD Coin – backed by USD
  • True USD – backed by USD
  • Digix Gold – backed by gold
  • Havven’s Nomin – backed by Ether
  • Binance USD – backed by USD
  • Palladium Coin – backed by Palladium
  • Gemini Dollar – backed by USD

Limitations of Stablecoins

While stablecoins have so many obvious advantages, there are several limitations to their use too. Libra, proposed by Facebook, is a currency-collateralized stablecoin backed by several fiat currencies around the world, which shows how stablecoins can go wrong. The value of fiat currencies is run by single entities (reserve banks and governments), there are a lot of regulations that are imposed on their trades.

For instance, Libra, when it went public with its coin, faced a huge amount of regulatory blowback from governments around the world. Due to so much resistance, Facebook had dropped their multi-currency claim and was rebranded.

While stablecoins are less volatile, they are also less liquid than other cryptos. This is especially the case with commodity-collateralized stablecoins. If gold prices crash around the world due to an unforeseen calamity, coins like DGX, which are backed by gold, also fall.

Crypto-collateralized coins are also faced with volatility issues because they are dependent on price instability. They are tied to the value of a particular cryptocurrency, and if that crypto takes a huge fall, stablecoins backed by it also take a nosedive.

Another limitation is that: they are really complex to understand. Beginners in the crypto market stand to take losses while trading in such stablecoins because of a lack of deep understanding of the market.

The Future With Stablecoins

The most popular shortcoming of the crypto market as an asset class is the short-term volatility that it has in terms of price fluctuations. With the advent of stablecoins, that problem is also solved. In the future, crypto holders can use such stablecoins as reliably as cash, but in a faster and safer manner. Their digital existence will make money transfers really easy and convenient, not to mention cheap.

These stablecoins give crypto holders all the advantages of using cryptocurrencies without the shortcoming of price volatilities. These coins have a great future because they focus more on the utility of cryptos in themselves, rather than treating them as an asset that appreciates in value rapidly.

How To Invest In Stablecoins?

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If you’re an investor who’s looking to invest in cryptos for their utility, safety and anonymity, buying stablecoins backed by various collaterals is a great place to start. However, if you want to learn more about this space and about cryptos in general, we recommend you visit our YouTube channel.

Disclaimer : Crypto products and NFTs are unregulated and can be highly risky. There may be no regulatory recourse for any loss from such transactions. The information provided in this post is not to be considered as investment/financial advice from CoinSwitch. Any action taken upon the information shall be at user's own risk.

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Farheen Shaikh

Content Writer

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