Every cryptocurrency investor must have heard about stablecoins time and again. Stablecoins are a type of cryptocurrency that is not volatile and retain a fixed value.
There are certain benefits and risks attached to stablecoin that every cryptocurrency investor should know about. In this article, the reader is going to take a deep dive into what a stablecoin is and how they can improve their crypto trading experience.
What is a Stablecoin?
A stablecoin is a cryptocurrency that has a fixed price at all times. It means that the price of a stablecoin does not increase or decrease over a specified value. For example, the Tether stablecoin, also known as USDT, has a stable value of $1 at all times.
This stable price of the stablecoin reminds the users of the fiat currencies such as USD or Euro. Just like a one-dollar note does not change its value based on market speculations, in the same manner, stablecoin prices do not change.
It is important to understand that there are some important distinctions between stablecoins and fiat currencies. Stablecoins are typically available in liquidity pools and custodial accounts of cryptocurrency investors.
Stablecoins are a type of cryptocurrency just like its other variants, such as NFTs, tokens, coins, utility tokens, governance tokens, and others. Stablecoins can also be used for staking in decentralized exchanges to earn yields.
How does Stablecoin Work?
There are two main focal qualities that stablecoin must ensure to remain intact. The first one is to ensure price stability, and the second one is to keep the volatility as low as possible. There are different types of mechanisms that different stablecoin projects adopt to keep their value stable.
Some stablecoins are pegged to the value of other cryptocurrencies, fiat currencies, or other asset reserves that holds value. The assets that stablecoins are pegged mustn’t exhibit massive volatility surges.
However, just about every asset class in the world is subject to constant appreciation and depreciation by the forces of economic changes. As and when the price stability of these pegged reserves fluctuates, so does the price of the stablecoin could change.
However, stablecoins can incorporate such as mechanisms that ensure that their prices remain the same despite the price fluctuations happening in the reserved assets.
At the same time, a stablecoin needs to have significant goodwill in the market to make sure that the investors hold their positions and pegged reserves remain intact.
Origin of Stablecoins
The first ever stablecoin was called BitUSD, and it was issued in 2014. BitUSD was native to a blockchain named BitShare. It was created by two well-known blockchain developers, Charles Hoskinson (Co-founder of Ethereum and Cardano) and Dan Larimer (Founder of EOS). The BitUSD stablecoin was backed by BitShare or BTS, which was the main coin of the BitShare blockchain.
Furthermore, it was also pegged to a mixture of other cryptocurrencies. The diversified crypto reserve of BitUSD was locked in a smart contract for security. This amalgam acted as the collective collateral for the BitUSD stablecoin.
It is important to understand that when the price of the stablecoin reserve decreases, extra stablecoins are burned, while when the value of stablecoin collateral increases, more stablecoins are printed.
In this manner, stablecoins can retain their constant assigned value. The BitUSD stablecoin also acts as collateral for a host of other stablecoin projects. After the announcement of Libra coins by Facebook, there was another surge in discussion about stablecoins.
There have been several organizations that have shown plans to issue stablecoins, such as Walmart, while some Central Banks, such as Unionbank of Philippines, etc.
At the same time, there are some notable stablecoin events such as TerraUSD coin, Acala USD, flexUSD, Deus Finance, and others that have incited reservations among cryptocurrency investors to proceed with caution before investing in a stablecoin. Investors should always weigh both pros and cons depending on individual stablecoin projects.
What to Look for in a Stablecoin?
Since the introduction of BitUSD, there have been several new stablecoins. Therefore, the most important question to ask an investor is how to know that a stablecoin is reliable. Investors can use the following factors to check what features to look for in a viable stablecoin project:
A good stablecoin should have the ability to have wide acceptance as a payment method. One of the main objectives of inventing stablecoins was to have an instrument as a medium of exchange for purchasing goods or services.
The prices of cryptocurrencies are heavily speculative; therefore, investors prefer to keep them reserved for a longer duration. However, stablecoins are more suitable for making payments.
The stablecoin can also serve as a value of measure for cryptocurrency investors. If they have purchased a new cryptocurrency with five stablecoins and sold it for ten stablecoins, it means that they have amassed a 50% profit and vice versa.
The price volatility of stablecoins should be as diminished as possible. The stablecoin should have a solid mechanism to ensure its price stability. Ideally, a stablecoin project should have backup reserves and other preventive measures to ensure its survival as long as possible.
If the mechanism that runs a stablecoin is exorbitantly expensive, it means that it has a higher risk of going bust. Therefore, investors must look for stablecoins with a sustainable operational mechanism.
Scalability is the ability of a stablecoin to process transactions as soon as possible without compromising security. If a stablecoin does not have sufficient scalability, it can create a massive backlog of transactions, and users can sustain losses on account of delays in the processing of transactions.
Financial privacy is an important requirement for stablecoin users. The investors must investigate the security setup and technical integrity of a stablecoin project. This is the main reason that decentralized stablecoins are the most popular.
If a user has converted all their crypto investment portfolio into a stablecoin and it is banned by their local government, they can sustain massive losses. Furthermore, such as step can also threaten the de-pegging of a stablecoin on account of FUD. Therefore, stablecoins should be adaptable enough to accommodate the changing regulatory requirements.
Stablecoins are pegged to a collateral reserve. The stablecoin users should demand transparency when it comes to the particular and updated status of these stablecoin collaterals.
A stablecoin should maintain sufficient liquidity to ensure that its investors do not face issues with purchasing or selling them as and when needed.
Types of Stablecoins
Now that it has been established what stablecoins are and how they work, it is best to understand their various types. Classification of stablecoin with pros and cons for every type has been mentioned as under:
As visible by their name, fiat-backed stablecoins are pegged to the value of a dedicated fiat currency reserve such as USD, Euro, or Yen, etc. In most cases, the stablecoins are backed by the fiat in a 1:1 ratio.
It means that one stablecoin unit represents one unit of the fiat currency peg. Fiat-backed stablecoins are centralized and regulated. When a person purchases a stablecoin, their fiat currency is sent to the reserve of the stablecoin, and they are issued one unit of a stablecoin in exchange.
Pros of Fiat-Backed Stablecoins
- They are easy to understand, and it is easy to keep track of all the tradeoffs.
- Fiat currencies are considerably stable on account of their massive national adoption as a legal tender; therefore, fiat-backed stablecoins are low-risk.
- Fiat-backed stablecoins are considered ideal for payments and exchanges between traditional and blockchain ecosystems.
- Some of the biggest financial enterprises, such as JP Morgan, have invested heavily in fiat-backed stablecoins. JP Morgan introduced a fiat-backed stablecoin project in 2019.
Cons of Fiat-Backed Stablecoins
- Since fiat-backed stablecoins are centralized by design, it means that there is a massive lack of transparency and control for individual investors.
- If the fiat currency collateral undergoes exponential devaluation or crashes, the whole stablecoin project can collapse.
Commodities are defined as basic goods that are interchangeable with other goods hailing from a similar class. One of the most popular commodities in the world is gold. On the other hand, there are also other others, such as copper, oil, real estate, cotton, etc.
Since commodities are regulated, therefore, commodity-backed stablecoins are also centralized. There is a strong clash between commodities and cryptocurrency proponents. However, commodity-backed stablecoins combine both options into one product.
Pros of Commodity-backed Stablecoins
- Commodities are based on physical entities such as wheat, coffee, land, and precious metals. Therefore, they are always in demand and have considerable traction among investors. Therefore, commodity-backed stablecoins are also less risky.
- The value of commodities can increase over time, which means that the stablecoin reserves of the investors can also keep increasing.
Cons of Commodity-backed Stablecoins
- Some commodities are heavily regulated, such as real estate. Therefore, the users are at risk of wasting considerable time to redeem them.
- There is a vast array of commodities, and they are subject to price changes on account of various factors. Therefore, there is always the danger of loss of commodity value due to a lack of trust among investors and regulators.
Smart contracts are an integral part of the blockchain that are used to perform different tasks on the blockchain automatically. Algorithmic stablecoins are trading products that are based on smart contracts and depend on these automated protocols to maintain their pegs. If the price of an algorithmic stablecoin increase, the smart contract prints extra tokens.
On the other hand, if the accumulated value of the algorithmic stablecoin declines, the smart contract burns extra tokens. In this manner, the smart contract can maintain the stablecoin prices balanced.
Pros of Algorithmic Stablecoins
- Algorithmic stablecoins are not centralized. They are almost wholly decentralized, which means that they offer better transparency.
- There is no risk of the collapse of algorithmic stablecoins on account of a crash in their pegged reserves because they do not require any collateral.
Cons of Algorithmic Stablecoins
- Despite depending on supply and demand, it is not very easy for the smart contract to burn or print tokens at the required pace, which can suddenly crash.
- Algorithmic stablecoin needs to maintain constant traction in the market to ensure that its peg remains intact.
This type of stablecoin is backed by other cryptocurrencies. Cryptocurrencies are notoriously volatile; therefore, most crypto-backed stablecoins are pegged to a combination of different cryptocurrencies to reduce volatility. In some cases, a crypto-backed stablecoin can use a mechanism called over-collateralization.
Over-collateralized stablecoins’ pegged reserves are greater in value than the value of the token. For example, each crypto-backed stablecoin may be backed by 2 part pegging reserves maintaining 1:2 ratios.
Pros of Crypto-backed Stablecoins
- These stablecoins are also decentralized for the most part. Therefore, they may offer greater transparency and security for investors.
- The liquidity of crypto-backed stablecoins is better than its other counterparts.
- The transaction costs for crypto-backed stablecoins are lower on account of their greater liquidity, and they also offer better transaction speed.
Cons of Crypto-backed Stablecoins
- Crypto-backed stablecoins can incorporate a complex collateralization mechanism. Therefore, most investors can take their time to use them, resulting in smaller traction.
- If the value of the reserve currency for the stablecoin keeps increasing, it can result in making the stablecoin more expensive.
What are the Uses of Stablecoins?
One of the most important questions an investor can ask about stablecoin is why they are needed. There are some important utilities of stablecoins that can be beneficial for investors. Some of the proposed use cases for stablecoins are given as under:
Medium of Exchange
The most touted feature of stablecoins is their usage as a medium of exchange. There are cryptocurrencies like Bitcoin that have been introduced as an alternative to fiat currencies.
However, events like Bitcoin Pizza day are proof that it is better to reserve Bitcoin for a longer duration than to use them for making payments.
Under such circumstances, stablecoins are an ideal way for cryptocurrency investors to make payments and purchase goods or services rather than core digital assets.
Imagine an investor who purchased Bitcoin in 2021 and earned massive profits in 2022. However, the investor now fears that if they leave their Bitcoin reserves, the bull run will end, and their profits could disappear into thin air.
In this situation, the investor can convert their Bitcoin profits into stablecoin such as USDT to prevent loss of their revenues.
All cryptocurrency sales are subject to taxes as per IRS. Furthermore, the short-term taxes are greater than the long-term crypto trading sales.
Therefore, investors can save taxes by converting their crypto profits into stablecoins rather than cashing them out in fiat currencies. However, the investors must get familiar with the local regulations before adopting this method.
Stablecoins add several new utilities to the DeFi blockchains. Therefore, they add value to the entire DeFi network and add another layer of legitimacy to it.
Risks and Advantages Associated with Stablecoins
Investors can dedicate their capital to crypto investing in stablecoins without the pressure of creating a cryptocurrency portfolio instantly. They can keep purchasing or selling a host of cryptocurrencies freely using stablecoin swaps to strengthen, upgrade, and improve their cryptocurrency reserves.
Stablecoins are low-risk in comparison to cryptocurrencies, given that they are reliable projects. They can also be used as a store of value and have the potential to increase in value on account of probable traction in the future.
Stablecoins can help investors manage their taxes in a productive manner and decrease the accumulated costs of trading cryptocurrencies. However, investors must ensure that they are aware of all the regulatory implications in their native jurisdiction.
Just as there is a chance for appreciation of stablecoin reserves, there is always the looming threat of its sudden crash. In some instances, stablecoins can diminish consistently over time.
The fiat-backed cryptocurrencies may prove to be a losing deal by default. Historically speaking, fiat currencies constantly devaluate, and their value can drastically change on account of unpredictable events such as regulatory shifts or a global pandemic, etc.
Stablecoins are a mixture of pros and cons. In the best-case scenario, investors accumulate more knowledge about their technical and fundamental infrastructures to make sure that they can utilize them to their advantage.
At the same time, a better understanding of stablecoins can help investors take preventive measures to avoid associated risks. It is best to deal with each stablecoin project on a case-to-case basis to ensure the best results.