How do Stablecoins work? Here’s Everything You Need To Know!
What is a Stablecoin?
The cryptocurrency industry has been developed in recent years, and the stablecoin market has come to follow this growth. A stablecoin is a digital currency that attempts to offer price stability and backed to stable reserve assets like the U.S dollar or gold. They are designed to reduce volatility relative to unpegged cryptocurrencies like Bitcoin.
Stablecoins aim to bridge the gap between cryptocurrencies advantages and the stable nature of fiat currencies. In short, stablecoin is a crypto token with a value pegged to the price of a national currency to eliminate its volatility.
Why do we need it ?
A stablecoin is a cryptocurrency that provides low volatility against the world’s major national currencies, combining the benefits of cryptocurrencies — such as transparency, security, fast transactions, low fees, and privacy — and also trust and stability that come with using fiat currency.
Therefore, a stable decentralized currency could become a global currency by allowing trustless and cross-border transactions. Else, stablecoins emerge as a new option for investors who want to make a transaction via a global currency, providing access to all.
To summarise, stablecoins has many benefits, these are some :
- Stablecoins are secure to transmit.
- they are accessible to all people in the world.
- They allow people to cash out cheaply and fast.
- There are easy ways to earn interest on a stablecoin investment.
With stablecoins, inefficiencies can be removed from the cryptocurrencies by eliminating its volatility.
Types of Stablecoins
Not all stablecoins are fully backed by a fiat currency or a commodity like gold, some are even backed by other cryptocurrencies.
There are several types of stablecoins falling into Four main categories. They include:
This type of stablecoin is pegged to a national currency, keeps fiat currency reserves like the US dollar to be used as collateral in order to issue a number of tokens.
As it is named, fiat currency needs to be deposited as collateral for a fiat-collateralized stablecoin. The tokens are issued at the 1:1 ratio against the collateralized fiat currency.
However, most fiat-collateralized US Dollar stablecoins use dollar reserves.
Other forms of collateral could include precious metals such as gold, silver and other commodities like oil or Real Estate. These kinds of assets have generally only been reserved for the wealthy people, but stablecoins open up new possibilities of investments to average individuals globally.
In the same way that a fiat-collateralized stablecoin has fiat tender as collateral, a crypto-collateralized stablecoin has cryptocurrency locked up as collateral, such as Ethereum. Here are the advantages :
- High level of decentralization;
- Regulation and transactions are easy and quick because it is fully blockchain-based
- No custodian required for storage
- Higher liquidity than fiat-backed tokens;
- No external auditing is required
However, since the reserve cryptocurrency could be prone to high volatility, such stablecoins are “over-collateralized”. This means that a big portion of the issued supply is maintained as a reserve in order to distribute a lower number of stablecoins, which in turn allows the issuers to maintain price stability.
This stablecoin uses algorithmic mechanisms to maintain price stability and it is not backed by any assets, it makes use of a Seigniorage Shares system, which is the difference between the value of money and the cost of printing it.
Algorithmic stablecoins are based on smart contracts and mechanical algorithms which change the supply volume when needed in order to maintain their price.
Similar to other stablecoin competitors, the main objective is to retain price stability as close to $1 USD as possible. Yet, these are the least popular stablecoins, most notably due to their complexity and late entry into the market.
Stablecoin Use Cases
You might be wondering, what’s the point. Why not just own dollars, euros or pounds. Well, the fact that financial regulators across the world are putting stablecoins under the microscope, might give a few clues. A stablecoin has many applications in the real world, among them :
When it comes to saving in traditional markets, the average individual is commonly subject to rates that only go as high as 2% per year. Due to the sophisticated nature that stablecoins currently require, alternative savings on stablecoins have better returns than that of saving USD.
Stablecoins are an excellent option for trade. With their less volatility than traditional cryptocoins, they offer traders an environment more stable. Tether (USDT) is already dominating the trading market, it was used in almost 40% of the transactions on Binance.
Stablecoins are useful as a means of payment in stores and other services. With stablecoins businesses get to circumvent the transaction fees that come with intermediary services.
Stablecoins can also be used to pay workers. International workers can quickly get paid and send money without paying high foreign transaction fees.
By using blockchain and smart contracts, stablecoins eliminate the need for intermediaries in escrow services. From there, transactions are efficient, secure and faster, their fees go down, and speeds do higher.
How is a Stablecoin Price Determined?
A stablecoin’s price is determined by the market value of the currency or commodity it is pegged to. As a result, a large number of stablecoin prices are pegged to USD because it’s one of the most liquid and stable forms of money.
Stablecoins are connected to the price of fiat currencies and commodities,and to their monetary properties. Having a stablecoin pegged to USD provides easier access to economic stability for people in countries with economic instability.
In fact, most cryptocurrencies provide global economic opportunity cryptocurrencies are more accessible than traditional banking services. From there, Stablecoins offer a digital safe haven where people can securely store their money and earn interest.
Why choose stablecoin over cryptocurrencies?
Stablecoins are enormously popular and there are two main reasons that people choose stablecoins over cryptocurrencies:
They are relatively stable. Because they are backed by fiat currency, investors can be confident that their tokens will always sell for one dollar each.
They are a safe haven for investors. Many exchanges don’t allow traders to buy fiat currency, and only let them buy and sell cryptocurrencies. This is where stablecoins come in. Because they are cryptocurrencies, they live on most exchanges. So they act as a sort of temporary refuge for investors looking to secure their funds during a bear market.
Moreover, stablecoins have many other benefits, they provide:
- Faster transactional speeds
Stablecoins could make escrow services faster and more efficient, withou intermediaries.
- Lower fees
People working abroad can send money home without having to pay high international charges.
Backed to the blockchain stablecoins ensure any transaction is noticeable by all users in the network.
Stablecoins are tradeable anywhere in the globe and at any time. Unlike fiat currency limited by borderlines, stablecoins have no border restrictions.
- Secure transactions
Blockchain makes stablecoins safe and tamperproof. with stablecoins, you have direct transactions in play without the fear and worry of fraudulent activities.
Stablecoins are still an emergent technology. It is essential to do your due diligence before placing significant amounts of your net worth into a coin.
Stablecoins potentially support widespread cryptocurrency adoption, however stablecoins still have certain limitations. Fiat-collateralized variants are less decentralized than ordinary cryptocurrencies, as a central entity is needed to hold the supporting assets. As for crypto-collateralized and algorithmic coins, users must trust the wider community to ensure the longevity of the systems.
They are still new technologies, so they will need some time to mature.
Focus on (USDT) Stablecoin
Tether or USDT is a fiat backed stablecoin, it is arguably the most well-known stablecoin in today’s cryptocurrency market, which is currently the 9th largest cryptocurrency by market capitalization and has the highest daily trading volumes of any cryptocurrency, just after Bitcoin. Every unit of Tether is backed by a US dollar held in the Tether Limited Reserves. The company has even published their bank account and balance on the “transparency” page of their website.
One of Tether’s key benefits is that it maintains its $1 USD value and investors and traders can take advantage of this to avoid paying exchange fees and transaction costs.
Stablecoins seem to be the key to scalability when it comes to cryptocurrencies and blockchain. Their reliance on physical assets for value makes them highly reliable compared to traditional cryptocurrencies.
Companies like Tether have proven the need for stablecoins. After their introduction to the market, demand for Stablecoins continues to increase. Their advantages, and their less volatile nature makes them better alternatives than traditional cryptocurrencies. Simply put, stablecoins seem to be taking blockchain and other cryptocurrencies in the right direction.