What are Stablecoins and how do they work?
After the introduction of Bitcoin 10 years ago, we started to see many altcoins in the market including Ethereum. The number of these coins is 2224, considering those currently registered with Coinmarketcap. Many of us, at some point, would have imagined how much money we would have if we had bought $ 1,000 worth Bitcoin at the right time. This is because Bitcoin, like Ethereum, fluctuates with the price of assets entirely left to market supply and demand.
These unstable coins may experience ups and downs in prices, as they are not governed by any central authority and because they are not official state money. So, is there a safe escape ramp to prevent this volatility, and how does it work?
Table of Contents
- What are Stablecoins?
- How do Stablecoins affect cryptocurrency prices?
- How do Stablecoins work?
- Three types of Stablecoins
- Non-Collateralized Stablecoins:
- Stablecoin Advantages
- Stablecoin Disadvantages
What are Stablecoins?
Stablecoins are cryptocurrencies that are often expressed in dollars. Thanks to these dollar-indexed coins, you have the opportunity to maximize your chances of protection from market fluctuations or risks.
Let’s quickly look at some popular Stablecoins:
Exchanges: Binance, OKex, Huobi and many more
Market Cap: $1,884,587,370
Exchange: Binance, DigiFinex, Bit-Z
Market Cap: $213,749,697
Exchange: HItBTC, KuCoin, OasisDEX
Market Cap: $56,801,526
Paxos Standard (PAX)
Exchange: DigiFinex, OKex, Binance
Market Cap: $167,241,364
Gemini Dollar (GUSD)
Exchange: HitBTC, BCEX, DigiFinex
Market Cap: $86,072,734
How do Stablecoins affect cryptocurrency prices?
Cryptocurrencies are not affiliated with any government or firm. They are also not bound by political, social and other economic indicators. These currencies, which depend entirely on supply and demand in the market, can therefore be quite volatile.
This volatility is both a driver and result of the lack of public (whether institutional or individual) trust in cryptocurrency as a reliable and balanced currency option. Poor and undefined regulation also play a role in adding to this distrust. People are disconcerted by the lack of a structured framework to guide adoption of crypto and therefore view it as a speculative investment.
Given high levels of distrust in cryptocurrencies, investors tend to resort to safer options like Stablecoins.
Sadly, half of the world’s wealth now in the hands of 1% of the population. The situation in the world of cryptocurrencies is not much different – 20% of all Bitcoins are owned by 448 people. These people, called Whales, play an active role in influencing the prices of cryptocurrencies. If these people want to convert their crypto assets into Stablecoins, the price of cryptocurrencies enters a downward trend, or vice versa. That is why the price of cryptocurrencies is highly dependent on whales, and therefore on Stablecoins.
How do Stablecoins work?
Stablecoin is a cryptocurrency with a fixed value. This means that the value of the cryptocurrency should not fluctuate frequently, as in normal crypto assets. Although this fixed price range is often tied to the US dollar, there are also currencies fixed to different price indices. Some Stablecoins, which are just getting ready to enter the market, aim to be fixed to the consumer price index or similar indices of some countries. Since Stablecoins can be fixed to almost anything in theory, there are Stablecoins fixed to multiple fiat coins and even to precious items like gold or silver.
The decisive factor for Stablecoins is how the latch is maintained and what the whole system is based on. In other words, how does the coin organizer maintain the value of the currency?
Some central Stablecoins, such as Tether, require a custodian to regulate the currency and then reserve a certain amount of collateral. Tether holds the US dollar in a bank account and the amount held must be equal to what they issue to maintain the order of the system. In this way, price fluctuations are prevented.
However, there are other stable decentralized cryptocurrencies, such as Dai that achieve this goal without a central authority figure. They use smart contracts on the Ethereum blockchain to manage the collateral and maintain order.
Three types of Stablecoins
Based on design, we can split Stablecoins into 3 major types:
This is the simplest version, with every Stablecoin currency produced in that currency. Production and liquidation of the coin is carried out by the issuer of the coin. This system is similar to the age-old practice of “used amount of gold that should be kept in the central bank’s safe for every dollar printed”. (You will recall that this understanding became a thing of the past with the 1973 Bretton Woods agreement.)
Price remains stable because if you can buy the coin for less than $1, you can go and exchange it with the issuer for $1 and vice versa. Only problem is that it relies on the issuing party being properly regulated and honoring deposits and withdrawal as they should.
Well-known Fiat-collateralized Stablecoins
- Tether — USDT
- TUSD Gemini
- GUSD Paxos
- PAX Circle
As the name suggests this version uses other cryptocurrencies (e.g. ETH) as collateral for the stable coins. However, because the crypto values themselves are not stable, these Stablecoins need to use a set of protocols to ensure that the price of the stablecoin issued remains at $1.
Let’s say we deposit $200 of ETH to receive $100 of a stablecoins in return. The stablecoins are now 200% collateralized. This means if the price of Ether drops by 25%, the stablecoins can still keep its price stable as there are still $150 worth in ETH collateral backing the value of the stablecoin.
Well-known Crypto-Collateralized Stablecoins
This is a very different design to stablecoins as it is not backed by any collateral. It operates in the way fiat currencies work, in that it is governed by a sovereign such as a country’s Central Bank.
If we talk about the USD, since the collapse of the Bretton Woods Agreement in 1973, the USD isn’t pegged to anything as well and is managed by the US Federal Reserve. It essentially creates a system that will mint more coins when the demand pushes it above $1 and buy it back when it falls below $1.
Well-known Non-Collateralized Stablecoins
Are Stablecoins worth considering?
If you don’t know much about blockchain technology and you don’t know what to do with changes in market conditions, you may need to keep your digital assets in Stablecoins since cryptocurrencies are often quite volatile. The volatility in cryptocurrencies is sometimes so high that if you don’t trade correctly, you may lose a lot. If you cannot keep a close eye on market conditions or changes, or if you are simply not familiar with all these, it may be wise to keep your digital assets in Stablecoins. In addition to this, cryptocurrencies can enter a recession period, called “bearish”, in which the value of all crypto coins falls considerably. During these periods, you can avoid potential risks by converting your digital assets into Stablecoins.
But at the same time, if you have been working as a trader in the market for a long time, then Stablecoins may not be for you at all. This is because traders follow daily fluctuations in cryptocurrencies, arbitrage, usage graphs and many other ancillary data to generate revenue from price increase or decrease of cryptocurrencies. Hence, traders usually stay away from Stablecoins.
In the following section, I have listed some advantages and disadvantages of Stablecoins:
- Benefits of Cryptoconomy. Low fees. Secure transactions. Somewhat or completely anonymous.
- Stable. Asset-backed.
- Aids in Adoption. Acceptable (or easier) bridge from fiat to cryptocurrency use.
- Regulations. Fiat-related regulatory processes involved.
- Requires Third Party. Requires trust from an entity.
- External Audits Needed. To ensure assets are accounted for.
- Less Return on Investment. Traders and investors typically desire higher returns and may resort to other means for financial gains.
- Regulations. Fiat-involving processes involved.
Although Stablecoins seem to be a safe escape point by many, the damage to cryptocurrencies also needs to be considered. This is because, especially when large whales move down the market, they can secure a significant blow to the price of cryptocurrencies while securing themselves to Stablecoin. Therefore, we cannot say that there is a definite consensus on the existence of Stablecoins.
While I respect both of these views, I am one of those who think that Stablecoins are an obstacle to rising prices of cryptocurrency. For small traders or investors, switching to Stablecoin does not affect the market price. But the escape of large whales to Stablecoin, or their escape from Stablecoin, has the power to drive the entire market bullish or bearish. While respecting both opinions, it will be interesting to closely monitor the future of Stablecoins.