Stablecoins are cryptocurrencies whose prices are linked to a real-world asset. In theory, they could be linked to anything, but the majority are linked to currencies such as the US dollar or euro. A stablecoin can also be pegged to real-world assets like gold or other precious metals and stones.
The reason behind stablecoin
The main reason behind the introduction of stablecoins is to deal with the volatility nature associated with cryptocurrencies. The most common crypto coins like Bitcoin and Ethereum are very volatile. It is not a wonder for crypto coins to have an increase or a decrease of about 10-20% in a day. This makes it hard to use most of the cryptocurrencies for daily transactions. For instance, if you are used to paying USD 5 for coffee and then one day you get the price has tripled to USD 15, it will affect your confidence with the currency.
Price changes shock consumers and affect their trust in cryptocurrencies. However, stablecoins are designed to minimize the effects of price volatility in the crypto space.
What are they used for?
The most common use case for stablecoins at the moment is as a liquidity tool for cryptocurrency exchanges. Many exchanges have been shut out of mainstream banking because banks are wary of dealing with anything crypto-related for compliance reasons.
As a result, many exchanges can’t accept dollar or euro deposits. Clients want to buy with dollars and to be able to trade out of cryptos into dollars at times of high volatility. Stablecoins offer an elegant solution to this problem.
However, proponents of stablecoins hold that the technology could allow for more complex financial products to be built on crypto — things like insurance, smart contract dividend payments, and loans.
Fiat-collateralized stablecoins maintain a fiat currency reserve, like the U.S. dollar, as collateral to issue a suitable number of crypto coins. Other forms of collateral can include precious metals like gold or silver, as well as commodities like oil, but most of the present-day fiat-collateralized stablecoins use dollar reserves. Such reserves are maintained by independent custodians and are regularly audited for adherence to the necessary compliance. Tether (USDT) and TrueUSD are popular crypto coins that have a value equivalent to that of a single U.S. dollar and are backed by dollar deposits.
Crypto-collateralized stablecoins are backed by other cryptocurrencies. Since the reserve cryptocurrency may also be prone to high volatility, such stablecoins are “over-collateralized” – that is, a larger number of cryptocurrency tokens is maintained as a reserve for issuing a lower number of stablecoins. For example, USD 2’000 worth of Ether may be held as reserves for issuing USD 1’000 worth of crypto-backed stablecoins which accommodates for up to 50 percent of swings in reserve currency (Ether). More frequent audits and monitoring add to price stability. Backed by Ethereum, MakerDAO’s DAI is pegged against the U.S. dollar and allows for using a basket of crypto-assets as the reserve.
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 bank notes 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.