Cryptocurrencies have come a long way since Bitcoin was first launched in 2009, with around 1,600 cryptocurrencies in existence today.
If you pay attention to cryptocurrency news, you know that price volatility is always a major topic of conversation and a source of concern for cryptocurrency enthusiasts. Most cryptocurrencies were designed to be both a store of value and a medium of exchange, which is why price volatility is such an issue.
While volatility is worrisome, it’s not without explanation. When compared to the value of traditional currencies, the relatively small market caps of individual cryptocurrencies, including the dominant ones like Bitcoin, cause them to experience huge price fluctuations.
Such occurrences scare off many of those who would otherwise adopt cryptocurrencies as a solution to their everyday money transfer problems. The lack of adoption, thanks to the inherent price volatility, may lead to the death of the cryptocurrency market unless significant change comes along.
In this guide, we will take a closer look at stablecoins, the current solution to the price volatility problem. We’ll show you how they work, what their limitations are and how they can be used.
What Are Stablecoins?
In the simplest terms, stablecoins are a type of cryptocurrency created to minimize price volatility. They’re designed to mimic stable, traditional currencies.
Stablecoins usually minimize the volatility of their prices by pegging their value to another asset, usually a stable one, or a collection of assets.
These assets are usually exchange-traded commodities like industrial or precious metals, fiat money or another cryptocurrency. This leads to the formation of two categories of stablecoins: backed and non-backed stablecoins.
Backed stablecoins are redeemable in commodities, fiat money and cryptocurrency, while the coins tied to an algorithm are considered non-backed. These stablecoins are also sometimes called seigniorage-style stablecoins.
Since they’re often backed by assets, stablecoins are collateralized by nature, typically at a 1:1 ratio. This pattern refers to the number of circulating stablecoins being backed by assets that are held in reserve. For instance, if there are 100,000 USD-pegged stablecoins circulating, there should be at least $100,000 stored in an account that’s associated with the entity behind the stablecoin.
Cryptocurrency experts believe that stablecoins will help mitigate the doubt surrounding conversion rates, therefore making cryptocurrencies more practical for purchasing products and services.
How Do Stablecoins Work?
As the name suggests, stablecoins work in a way that provides stability and maintains a near-constant value or price over time. Different stablecoins use different methods to achieve this. They can be divided into four categories.
The first and most common type is the fiat-collateralized stablecoin. As their name would imply, fiat-collateralized stablecoins are cryptocurrencies that are backed by a regular fiat currency like USD, GBP or EUR. Fiat-collateralized stablecoins function in a very simple and straightforward way: for every existing stablecoin, there is an equivalent amount of fiat currency stored in a bank account to back the stablecoin. Unlike the other types, this type of stablecoin has the simplest and most advantageous structure. It functions in a way that’s easy to understand and is, therefore, more readily adopted by members of the general public.
The second category is comprised of stablecoins that are backed by various types of interchangeable assets. Commodities that are regularly used as collateral are gold, real estate, precious metals and oil. Essentially, the holders of commodity-collateralized stablecoins possess a tangible asset with a concrete, real value. Most of the commodities used to back up stablecoins have the potential to increase in value over time, which adds to the lure for people to use and hold these coins.
When it comes to commodity-collateralized stablecoins, every person has the chance to invest, which is not necessarily the case with the commodities that back them up. For example, gold and real estate are typically only purchased by wealthier individuals or groups, but stablecoins open up these investment possibilities for average people.
Next, there are stablecoins that are collateralized by other cryptocurrencies. This concept may be confusing, especially if you consider that the point of stablecoins is to get away from the price volatility of cryptocurrencies. However, the mechanism of this type of stablecoin can be explained fairly simply.
First, it’s important to understand that price fluctuations are still possible with crypto-collateralized stablecoins. As we’ve mentioned and as you probably already know, everything that involves cryptocurrencies also involves price volatility with it. Crypto-collateralized stablecoins are no exception.
However, experts suggest that these stablecoins minimize the risk by having their value backed up at twice the value. In other words, for every $1 worth of crypto-collateralized stablecoin, there is $2 worth of the cryptocurrency by which the stablecoin is backed. These assets are deposited with a custodian and help to keep the decentralization of the stablecoin alive.
Reasonably, the underlying problem with this kind of stablecoin is that they’re directly connected to another cryptocurrency. However, as long as major changes to the backing crypto don’t occur, the stability of the stablecoin will be maintained, which can be quite tricky.
Non-collateralized stablecoins are last on the list. This type of stablecoin isn’t backed by anything, which may sound contradictory to the concept of stablecoins. That being said, the value of these stablecoins isn’t just decided upon by a single group that maintains control over the entirety of the supply. Instead, to control the supply, these coins use an algorithmically-governed approach. As mentioned earlier in this guide, these stablecoins are sometimes called seigniorage-style stablecoins and the shares are known as seigniorage shares.
The algorithms behind non-collateralized stablecoins constantly monitor the supply and demand of the coin, buying circulating coins at low prices and issuing new coins at higher prices. This practice effectively keeps the price at a constant level.
In order to be successful, non-collateralized stablecoins need constant growth. Since there’s no collateral for the coins to be liquidated back into, in the event of a crash, everyone’s money would be completely lost.
What Are the Limitations of Stablecoins?
While stablecoins do have many advantages, they’re also limited in a way.
The prevailing limitation that comes with stablecoins is transparency. For example, fiat-collateralized stablecoins, which are run by a single entity, should ensure transparency at all times to maintain confidence in the coin. Unfortunately, this is not the case with many stablecoins on the market today. Instead, the banks keep most of the information to themselves, initiating a loss of trust by the users. Increased transparency will be key to sparking adoption of this type of stablecoin.
The limitation related to commodity-collateralized stablecoins is that obtaining the commodities isn’t instant. The process of acquiring bars of gold or purchasing real estate takes time, which means it may take a while before these commodities can be used as assets for a particular stablecoin. This significant time delay may also affect the liquidity of the cryptocurrencies, which can be a serious issue in the event of a crash.
Crypto-collateralized stablecoins also come with their own set of problems. As we mentioned earlier, being pegged to another cryptocurrency, regardless of the dominance of said cryptocurrency, can make these stablecoins extremely unstable and vulnerable in comparison with commodity-backed and fiat-backed stablecoins. This issue has caused crypto-backed stablecoins to be the least adopted category of stablecoin.
Why Have Stablecoins Become so Popular?
The answer to this question is simple: stablecoins offer a solution to one of the most serious problems in the cryptocurrency world. Stablecoins can minimize and even eliminate the uncertainty associated with cryptocurrencies, especially when it comes to rate conversions.
When there’s some kind of risk in the crypto market, stablecoins give their owners a safe storage place for their assets. If consumers are worried about future movements of the market, they’re able to easily and quickly convert their stablecoins to unpegged cryptocurrencies, eliminating the need to use fiat currencies. These simple conversions take the banks and other payment processors out of the equation. At the same time, they also tend to be less expensive than traditional conversion methods.
Cryptocurrency exchanges can also be credited with the growing popularity of stablecoins. The majority of them are actively raising awareness about what stablecoins are, the way they work and the problems they solve. While Binance, the world’s largest cryptocurrency exchange, aggressively extends their trading pair offerings, OKEx, the sixth-largest exchange, plans to launch their own stablecoin. In addition to the efforts of these two exchanges, many other trusted cryptocurrency exchanges are also contributing to the increasing popularity of stablecoins.
Stablecoins, as a new form of digital currency, still have a long way to go before they become part of the cryptocurrency mainstream.
Right now, none of the four types of stablecoin is perfect as each of them comes with its own set of advantages and drawbacks. Yet, their design, stability and potential value for both businesses and individuals are beyond promising. In the long run, stablecoins have the potential to bring cryptocurrencies to a completely new level. However, due to the continual changes in the blockchain world, it’s almost impossible to predict what the future has in store for stablecoins.