Stablecoins have been receiving a lot of hype lately in the blockchain and cryptocurrency world, but what exactly is it and why should we pay attention to it?
CryptoMeNow to the rescue! We’re here to break down Stablecoins for you in an easy to understand way along with a few example tokens.
Alright, what the heck are stablecoins?
A stablecoin is a cryptocurrency with a fixed price. The price of most cryptocurrencies is determined by the marketplace, where buyers and sellers exchange coins and a price is discovered by supply and demand.
Most cryptocurrency tokens are like stocks where the price is usually controlled by buyers and sellers.
Stablecoins, on the other hand, seeks to achieve a fixed price, which happens through a variety of means that will be explored in this piece.
Why stablecoins play an important role
As mentioned above, current cryptocurrencies can be compared to stocks where investors invest in them with hopes of earning a profit.
Prices jump up and down on a daily basis, which can cause a lot of instability.
Because of this, it will be extremely difficult for a cryptocurrency like Bitcoin or Ethereum to be used like US dollars because the price changes too rapidly.
This is where stablecoins kick in because it could be one of the first type of cryptocurrency out there to become a true usable currency.
While volatility is fine for speculation, it’s not great for everyday payments. Due to the risk of price changes, small business aren’t open to accepting cryptocurrencies.
Imagine your salary is paid exclusively in crypto. If the price of said crypto drops overnight by 50%, everything will have effectively become 2x more expensive by the time you wake up the next morning.
That would suck wouldn’t it?
The main categories of stablecoins
There are three main categories of stablecoins out there that blockchain companies are trying to build.
All of those company fall under one of the following categories:
- Fiat collateralized
- Crypto collateralized
Let’s break down each individual one in an easy way that we could all understand.
This is probably the most common one. This one is also the most tangible. Each unit of the stablecoin is backed by a corresponding unit of fiat currency, like a US Dollar.
Holders of the stablecoin are guaranteed to redeem their token at any point for the stable value in fiat. An example would be like $1 = 1 stablecoin.
That way the price won’t jump and down out of nowhere because it is following the US dollar.
Tether is the most famous example out there at the moment. For every issued Tether token, an equal amount of US dollars is deposited with a custodian, meaning Tether should always trade 1:1 (1USDT = 1USD) regardless of what’s going on with the market and economy.
Ok, so fiat collateralized stablecoins might seem like the perfect solution right? Well, there’s downsides to it as well.
It’s unlikely to become an everyday token of choice for two main reasons.
- We would need something like a bank to be a central authority of the stablecoin or custodian will have to be trusted with keeping the coin valid. The banks would need to constantly audit to ensure that prices are kept up.
- It’s hard to scale because you will need fasts amounts of capital to serve as collateral if you want to mint enough tokens to have the ability of mass adoption.
Crypto collateralized coins
This is the second one on our list.
Crypto collateralized stable coins are backed by reserves of another cryptocurrency. This is done to address the centralization aspect of fiat collateralized tokens and achieve price stability in a completely decentralized ecosystem.
Instead of backing units of a stablecoin 1:1 with fiat, crypto-collateralized stablecoins hold a ratio greater than 1:1 of a cryptocurrency and issue units of a stablecoin supported by the cryptocurrency held.
Well, the problem with a crypto collateralized coin is pretty straight forward. It’s not actually “stable” since the coin that it’s following can change in price.
- Does not rely on third-party custody like fiat-collateralized
- Quite transparent since it lives on the blockchain. That means it won’t require banks and auditors.
- Quick and decentralized
- Super complex due to the selection of the cryptocurrency to follow
- Price changes
The first cryptocurrency to use this form of collateralization was BitShares, which uses their native network currency (bitshares) as collateral to create market different smaller assets such as BitUSD, BitCNY and BitGold.
This is the last category on the list. This one does not rely on being collateralized by either fiat or cryptocurrency holdings.
It is the most complex, but potentially the most impactful for the ecosystem.
To maintain the price level, a “central bank” is created that algorithmically maintains the supply of currency, increasing it when price goes up and decreasing it when price goes down.
So how does this central bank thing work?
In this situation, a smart contract would need to be developed in order to manage the price changes.
It will work with the supply and demand model. If the coin is trading too high, the smart contract will mint more tokens to increase supply and therefore reduce the value of the coin.
In the case that the price trades above $1 per unit, the smart contract central bank will issue additional units to increase supply until the price reaches $1, collecting profits in the process.
The same applies to if the price drops $1, then supply would decrease until it comes back up.
This can cause a lot of mess because random tokens could be generated.
The biggest problem here is that if the token platform does not continue growing with new users, it will be impossible to maintain its market price.
There are a number of stablecoins using this concept with the most noteworthy being Basis (formerly known as Basecoin) and Saga.
- Does not require collateral or a “real bank”
- Can be a mess
- Require always increasing future demand
There’s a bright future for stablecoins. Even though this concept is still in the early stages, it’s an excellent idea and solution to turn cryptocurrencies into an actual spendable currency that is decentralized and not managed by others.
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