Stablecoins are cryptocurrencies tied to external assets like fiat, a commodity, or any cryptocurrency, unlike other cryptocurrencies.
Mostly, stablecoins are linked to fiats like the U.S dollar or a commodity like gold, and since these pegged assets experience negligible volatility, Stablecoins also face minimal fluctuations.
In instances where stablecoins are tied to a highly volatile asset like cryptocurrency, it still doesn’t see huge price variance because of the conscious efforts made on the network to keep the stablecoin stable. *you will find out about this later in the blog*
And thus while cryptocurrencies are popular for their volatility, Stablecoins are cryptocurrencies with no volatility.
After knowing this, I am sure you are curious to know why such a cryptocurrency exists and how it works.
The concept of cryptocurrencies originated with the idea to replace the flawed paper money of today.
But acknowledging the fact that the cryptocurrency market and blockchain technology is still very new and isn’t yet a payment means rather an asset class, cryptocurrencies like Bitcoin, Ethereum, etc., are highly volatile. By the time a crypto transaction settles, the value of the transacted cryptocurrency may vary significantly based on market conditions.
Though these cryptocurrencies are unstable, they have proved to be an effective investment vehicle. But their utility as a payment means is yet to unravel. And only time can tell how and when we can see them replacing paper money.
But until then, shall we put away the idea of transacting in a decentralised and trustless financial ecosystem? Doesn’t look like a good idea to me.
And that is where Stablecoins come into the picture. It is the perfect getaway for anybody to leverage the superfast, secure blockchain network for transacting without being affected by volatility.
If you were to send someone some Ethereums for a service rendered, you would think twice.
Because let’s say you transfer 1 Ethereum valued at ₹ 30,000 at the time of making the transaction. By the time the transaction settles, there is a high chance of Ethereum’s value appreciating or depreciating.
In such a case, both the sender and the receiver are at risk of a loss.
Whereas when you do a similar transaction with stablecoins, there are almost no such risks involved. Because the value of stablecoin doesn’t drastically move, unlike the value of other cryptocurrencies.
Another factor where stablecoins come in handy is when the cryptocurrency market shows severe downturns and the cryptocurrency you hold is falling steeply in value. In that instance, you can quickly move your cryptocurrency investment to stablecoins without fully cashing out.
Stablecoins especially come in handy to traders to move in and out of the market swiftly. Learn more about the use cases of Stablecoins in detail here.
How Does It Work?
When I say external assets peg stablecoin, they literally do.
What usually happens when you buy a stablecoin is that the entity behind that cryptocurrency sets up a reserve where it actually stores the fiat or commodity equivalent to the value of the stablecoins issued.
The physical asset stored then acts as collateral against the issued stablecoins.
Types of Stablecoins
Speaking of collateral, there are around three types of collaterals for distinct stablecoins.
1. Fiat-backed Stablecoins
Fiat-backed stablecoins are the most widely used stablecoins; relevant fiats back these stablecoins on a 1:1 ratio. The issuer of these stablecoins holds a specific amount of cash and issues equivalent no. of stablecoins in return.
You can use these stablecoins like any other cryptocurrency and redeem them anytime in exchange for its equivalent fiat.
There are over 200 stablecoins backed by & pegged to different national currencies, including USD, EUR, JPY, etc.
Crypto-backed Stablecoins are backed by reserves of cryptocurrencies like Ethereum, Ripple, etc.
To acquire these stablecoins, you have to lock in your cryptocurrency on a network, which will issue you tokens in exchange. And even though volatile cryptocurrencies back these stablecoins, their prices are still stable because participants of the reserve are incentivized to keep the crypto stable.
Specific reserves are responsible for maintaining the price stability of that particular stablecoin.
You can later pay back the stablecoins on the network to get your collateral (cryptocurrencies) back.
3. Algorithmic Stablecoins
Unlike the above two types, algorithms and smart contracts back this type of stablecoin and maintain its stability.
Even though no fiat backs these stablecoins, Algorithmic stablecoins still closely follow a specific fiat’s price movements.
What happens here is whenever a stablecoin falls below the price of the corresponding fiat, the algorithm automatically places a buy order to push the price back and vice versa.
I hope that now the concept of stablecoins is crystal clear in your head. If you still have doubts, feel free to drop in your questions :‑)
KuberVerse is an educational initiative. Anything expressed here directly or indirectly is not investment advice. And we ask you to do your own research before investing.