What Is a Stablecoin? How Does It Affect the Cryptocurrency Ecosystem?

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What Is a Stablecoin?

A stablecoin is a type of cryptocurrency that is expected to maintain a fixed value over some time. Stablecoins bridge the worlds of cryptocurrency and fiat currency as their prices are pegged to a reserve asset like the USD or precious metals like gold. Ideally, one unit of this cryptocurrency equals one unit of the real currency.

The use of stablecoins reduces unpredictability compared to other volatile cryptocurrencies like Bitcoin. This results in a form of digital money that is suitable for daily commerce or making transfers between exchanges. The price of stablecoins is not likely to fluctuate.

How Do Stablecoins Work?

Stablecoins are cryptocurrencies tied to the price of another asset with the help of algorithms or reserves. A peg refers to the specific price that a token is aiming to stay at, relative to the asset it’s linked to. In the case of a USD stablecoin, the value would be 1 USD.

Because cryptocurrencies can experience large price swings in a short period, a stablecoin linked to one of these coins that are experiencing volatility may also experience value changes.

Stablecoins are backed by multiple sources, including fiat currency, other cryptocurrencies, precious metals, and algorithmic functions. Stablecoins can be classified into several categories based on the type of assets they’re pegged to. Let’s take a look at them.

Fiat-Backed Stablecoins

Fiat-backed stablecoins are cryptocurrencies that are supported with huge cash reserves. Fiat currencies are issued by central banks, such as the USD, Sterling Pound, and Euro.There is no consistency in how the information about reserves is demonstrated across different coins. It also lacks the clarity and standards for reporting the composition of those reserves.

Cryptocurrency-Backed Stablecoins

Cryptocurrency-backed stablecoins are coins backed by other cryptocurrencies. The most popular variant by market capitalization is Wrapped Bitcoin (WBTC), a token similar to  Bitcoin but issued on the Ethereum blockchain. Wrapped Bitcoin reserves are held in vaults operated by guardians. Other crypto-backed stablecoins, such as renBTC, are held in vaults managed by encrypted smart contracts.

Asset-Backed Stablecoins

Popularly also known as commodity-backed stablecoins. These are aided by other interchangeable assets, such as precious metals. The most common commodity to be collateralized is gold, but there are also stablecoins backed by oil, real estate, and other metals. Stablecoins endorsed by commodities are much less likely to see their value inflated compared to other fiat-backed coins.

Commodity-backed stablecoins bearers can redeem their stablecoins at the conversion rate to acquire real assets. The cost of maintaining the stability of the stablecoin is as close as the cost of storing the commodity supporting it.

Algorithmic Stablecoins

In algorithmic stablecoins, also known as non-collateralized stablecoins, the peg is determined by rules or software code linked to another cryptocurrency.  Algorithmic stablecoins make use of a Seigniorage Shares system. These stablecoins use algorithms to administrate the market value. Algorithms can alter the supply volume of coins to maintain their price.

Uses of Stablecoins

  • Minimize Volatility -The value of cryptocurrencies fluctuates rapidly, sometimes by the minute. An asset pegged to a more stable currency can assure buyers and sellers that the value of their tokens won’t rise or crash abruptly soon.
  • Trade or Save Assets – A bank account is not required to hold the stablecoins, and they’re easy to transfer. Stablecoins’ value can be sent easily across the globe, including to places where the USD may be hard to get or where the local currency is unstable.
  • Earn Interest -There are easy ways to earn interest on a stablecoin investment.
  • Transfer Money – People can send huge sums across the globe with transfer fees of less than 1 USD.
  • Send Funds Internationally – Fast processing and low transaction fees make stablecoins like USD coins a good choice for sending money anywhere in the world.

Examples of Stablecoins

There are abundant Stablecoins with each offering its benefits. Let’s look at some of the successful ones in the market.

  • Tether
  • USD Coin
  • bitCNY
  • TrueUSD
  • Dai

Stablecoin vs. Altcoin

DifferencesStablecoins is a cryptocurrency whose price is tethered to a cryptocurrency or fiat money or for trading commodities.All cryptocurrencies other than Bitcoin are known are Altcoins.
TypeAll stablecoins are altcoins.All altcoins are cryptocurrencies.
CategoriesFiat-backed stablecoins, cryptocurrency-backed stablecoins, asset-backed stablecoins, and algorithmic stablecoinsEthereum, Binance Coin, Thether, Uniswap, THETA, Litecoin, Ripple, Dogecoin, Cardano, Polkadot, XRP, Stellar Lumens, etc.
ProsThey make financial processes efficient. Transaction fees are lower. New features can be added with the changing requirements.  They primarily serve as an alternative to Bitcoin. Their function is unique. They offer several solutions. The transactional fees are less.    
ConsThey require a third party to function. Stablecoins also require external audits. The investment returns are low.   Altcoins give less exposure, have limited usage, and have volatile values.  

Risks Using Stablecoins

Although stablecoins may be less fickle than other types of cryptocurrencies, they are still using newer technology that may have bugs or uncertainties. There is always scope that you could lose the private keys that allow access to your cryptocurrency, either through a hack or user error.

Purchasing Stablecoins

To purchase stablecoins, you’ll need an account with a crypto exchange or a digital wallet where you can buy crypto directly. However, some services may not be available in all locations. Stablecoins may be available on exchanges like Coinbase, but they may only be listed in their fiat-backed forms. Using a decentralized exchange to exchange any existing tokens for additional stablecoins would give you access to more possibilities.

The Final Word

Stablecoins are useful assets, but they come with their own set of risks. Algorithmic stablecoins might not be able to maintain their peg in the event of a market crash. Stablecoins backed by fiat that has not been audited may not have the reserves that their issuers claim.

It is advised to research the stablecoin before investing. Investors should read whitepapers, examine audits and attestation reports, and determine the system by how a coin is backed. It is also recommended that one should check how the coin performed in times of market crashes and how it managed to hold the peg.

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