A stablecoin is a kind of crypto whose value is linked to an outside asset like the U.S. dollar; in other words, stablecoins’ values are pegged to a different asset class, like a fiat currency, precious metals, or industrial metals, to stabilize their price.
Cryptocurrencies are unpredictable and contrast the generally stable prices of fiat money or other assets. Values of currencies like the dollar change steadily over time, but the day-to-day altercations are usually more drastic for cryptos, increasing and decreasing in value frequently.
These coins tie the value of cryptocurrencies to other more stable assets to tackle price fluctuations. Fiat is the government-issued currency we use daily, like dollars or euros.
Typically, the entity behind these kinds of coins will set up a “reserve” where it stores the assets supporting these coins, for instance, 1 million dollars in a bank (the type with branches, ATMs, and tellers in the lobby) to support one million units of a stablecoin.
This is a way digital stablecoins are linked to real-world assets—the money in the reserve functions as collateral for these coins. Every time a stablecoin holder wants to cash out their tokens, an equal amount of any asset supports it is taken from the reserve.
A more complicated kind of coin is collateralized by other cryptos rather than fiat, still engineered to track a mainstream asset such as the dollar.
How do These coins work? How can we make a profit off of them? Read the following article to get your answers.
What is Cryptocurrency?
Cryptocurrency, or crypto, is any digital currency that exists virtually and uses cryptography to secure transactions. Cryptos do not have a regulating authority, central issuing, or use a decentralized system to issue new units and record transactions.
Stablecoins are digital currencies where the price depends on a cryptocurrency, fiat money, or exchange-traded commodities.
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What are stablecoins?
A stablecoin is digital money whose value is connected to another asset. This type of crypto tracks the underlying asset, making its price stable over time. In effect, it is like if the underlying asset has gone online, for example, like a digital dollar.
Because they aim to track an asset, specific assets back these coins; for instance, the organization issuing a stablecoin sets up a reserve at a financial institution that keeps the underlying asset. Therefore, these coins can hold 100 million dollars in reserve and issue 100 million coins with a fixed value of $1 per coin. If a stablecoins’ owner wishes to cash out, the real money can eventually be taken from the reserve.
This structure contrasts most cryptocurrencies, like Ethereum and Bitcoin, which nothing supports. Dissimilar to stablecoins, these other cryptocurrencies fluctuate considerably, frequently changing the price. These types of cryptos work as speculators push their prices up and down as they trade for profits.
Not all stablecoins are supported by hard assets. Instead, these others use technical tools (like destroying some of the coin supply to create scarcity) to keep the crypto price at a fixed value. These are algorithmic stablecoins.
These algorithmic coins are not collateralized; instead, coins are either created or burned to keep the coin’s price in proportion to the target price. Let’s imagine these coins fall from the target price of 1dollar to 0.75dollar. The algorithm will automatically burn coins to introduce more scarcity, pushing up the cost of the stablecoin. This kind of coin protocol is hard to get right and has been tested and failed many times over recent years. However, entrepreneurs keep trying.
One of the few functioning examples using this model is known as UST made by blockchain project Terra. These coins aim to mimic traditional currencies.
These coins are not affected by the price volatility of many other cryptocurrencies.
In 2010, for example, a programmer bought a pizza for 10,000 Bitcoins — worth roughly 688 million dollars at Bitcoin’s peak in November 2021. On the other hand, any dealer that accepted those coins at that peak price would have lost more than 200 million by the end of the year.
Consequently, many businesses are cynical of crypto as a viable means of payment. Microsoft, for instance, first began accepting Bitcoin as a payment in 2014, only to put a temporary halt on it in 2018 because of volatility. Online gaming platform Steam had to do the same.
These coins aim to gain the potential benefits of cryptocurrencies. These benefits are transparency, immutability, security, and decentralized control without losing the stability and guarantees using fiat currency.
Primarily, early crypto holders used These coins as a safe shelter in a market crash or decline. If the price of BTC began to drop fast, a holder could convert their BTC to a stablecoin in a matter of minutes on a platform, avoiding massive losses.
Without this option, the holders would have to transition their assets back into a fiat currency. However, many cryptocurrency exchange platforms either do not allow fiat or take a hefty fee from the transfer into fiat currency.
Other applications of stablecoins
But These coins also have other emerging applications. For example, they can benefit individuals and industries that need to quickly make international payments, from migrant workers sending money to their families to significant businesses looking for a more affordable way to pay overseas suppliers.
For decentralized cross-border lending, for instance, These coins can provide a secure, online environment for P2P transactions to happen without needing to use a volatile cryptocurrency like BTC or pay fees to convert money into local currencies.
These coins solve one of the major problems with many mainstream cryptos, namely, that their severe fluctuations make it complex, if not impossible, to use them for actual transactions.
Digital currencies like BTC and ETH are incredibly volatile, which makes pricing things in their terms very problematic. These coins avoid this problem by locking their prices to a known currency.
Moreover, their stability allows many of These coins to become a functional currency in a crypto brokerage. For instance, traders might convert Bitcoin into a stablecoin like Tether rather than into dollars. These coins are available all the time, making them more available than cash achieved through the banking system, closed overnight and on weekends.
These coins can similarly be within smart contracts, a type of electronic contract automatically executed when one fulfils its terms. The stability of the crypto also helps circumvent disagreements that can arise when it comes to more volatile cryptos.
These coins do not often get the same press as other cryptos, in part because they do not provide the same kind of “get rich quick” opportunity. However, a few are among the most popular cryptocurrencies by market cap, as of February 2022:
- Tether (USDT): 79 billion dollars.
- USD Coin (USDC): 52 billion dollars.
- Dai: 10 billion dollars.
- TerraUSD (UST): 7 billiondollars.
Of course, the size of these market caps is not that much in comparison to the largest cryptocurrencies, like BTC, with a market cap of nearly 1.1 trillion dollars, and ETH, valued at more than 400 billion dollars.
Types of stablecoin collateral
These coins use a variety of types of assets as backing. They are as follows:
- Fiat: This is the most common collateral for stablecoins.
- Precious metals: such as gold or silver.
- Cryptocurrencies: such as ETH, the native token of the Ethereum, as collateral.
- Other investments are unspecified “approved investments” along with accounts at federally insured banks.
These coins might appear to be low risk. Compared to popular cryptos (backed by nothing), they are. But These coins offer some usual crypto risks and at least one of their type of risk, too:
- Security: Like other cryptos, These coins must be somewhere in your digital wallet or with a broker or exchange platform. And that presents risks because a given trading platform might not be secure enough or might have some vulnerabilities.
- Counterparty risk: Though it may seem like cryptocurrency is decentralized, in reality, you’re dealing with many parties in a transaction, including the organization issuing the stablecoin and the bank holding the reserves. They must be doing well (security, properly reserving, etc.) for the currency to keep its value.
- Reserve risk: A critical element of the stablecoin network are the reserves backing a coin. Those reserves are the last backstop on a stablecoins’ price. Without them, the coin issuer cannot guarantee the price of these coins with complete confidence.
How safe are stablecoins?
So how can we know if these coins are safe? You have to read the fine print on its issuer’s statements.
And even then, stablecoin owners should pay attention to what is backing their coin. Tether has lately come under fire for its disclosures on reserves. And those who think crypto is fully reserved should be cautious. In its March 31, 2021, reserve report, the company reported more reserves than its liabilities. That looks good, but it is not:
- About 76 per cent of its reserves are cash or cash equivalents (the majority is short-term corporate debt).
- Almost 13 per cent is for secured loans.
- Nearly 10 per cent is for corporate bonds, precious metals, and funds.
These other assets might act like real cash much of the time, but they are not.
If you pay attention, less than 4 per cent is real cash, while most are short-term corporate debt. And actual money is not the same as this commercial paper, especially in an emergency. If markets fall, those assets (and the other non-cash assets) could decrease in value quickly, making the Tether crypto less than fully reserved when it may most need to be.
Unless a coin holds100 per cent (or more) of its reserves in cash, there is no assurance that the cash will redeem coins. The value of These coins might prove to be a lot less than stable. Stablecoins holders might end up on the losing end of a classic bank run, a surprising destiny for a technology that claims to be highly modern.
In conclusion, the best guarantee of a currency’s safety is that people will accept it in exchange for services and goods. And the only commonly accepted currency in the U.S. is dollars.
Is Bitcoin a stablecoin?
Cryptocurrencies like BTC and ETH offer many benefits. One of the most fundamental does not require trust in an intermediary institution to conduct payments, which opens up their use to anyone anywhere. But one major drawback is that cryptos’ prices are volatile and have a tendency to fluctuate; this makes them problematic for ordinary people to use. People expect to know how much their money will be worth in a week, both for their livelihood and security. These coins are different from cryptocurrencies like Bitcoin or Ethereum, tied to mining.
Do stablecoins have any disadvantages?
There are a few disadvantages to stablecoins. Because these coins are usually set up, they have altered pain points than other cryptos.
If the reserves are in a bank or some other third party, another disadvantage is counterparty risk. This brings the question: Does the entity own the collateral it claims to have?
In the worst-case scenario, the reserves backing a coin could become inadequate to redeem every unit, shaking confidence in the coin.
Digital currencies wish to replace intermediary companies that are usually trusted with users’ money. Naturally, intermediaries have control over that money; they can generally stop a transaction from happening. Some of these coins add the ability to prevent transactions back in the mix.
Stablecoins offer the stability that other cryptocurrencies lack, making them impracticable as actual currency. But the users who choose to have These coins should know the risks they are taking when they own them. While it may seem like These coins have limited risks, they may become the riskiest in a crisis.