Stablecoins are cryptocurrencies that are pegged to real-world assets. They provide many of the advantages of digital currencies, while offering higher price stability.
Bitcoin has lost nearly 80% in value since December 2017. Many other cryptocurrencies didn’t fare any better. That’s why stablecoins have come on the radar.
On the contrary to cryptocurrencies like Bitcoin, stablecoins are not floating freely on the market. They are pegged to a “real-world” asset, for example a fiat currency or a commodity. Thus, the main goal is to combine the advantages of a digital currency and the stability of a real world asset.
There are three major types of stablecoins.
Fiat-collateralized stablecoins are the most common type. They are backed by a fiat currency like USD, EUR, or GBP.
Usually they are backed at a 1:1 ratio, meaning that for each coin in circulation, there is one unit of real fiat currency held in the bank account of the issuing entity.
In a way, the company that issues the coins acts like a central bank. Whenever someone wants to redeem cash, the company will send cash from its reserve to that person’s bank account, and destroy the equivalent amount of stablecoins.
These coins are backed by a commodity, most commonly precious metals such as gold, but also oil, or even a basket of different assets.
If the value of the underlying asset changes, the price of the stablecoin will change as well. Thus, these kind of coins are not only a means of payment, but also an investment in the underlying commodity.
These coins are not backed by any real value and are quite similar to most fiat currencies. The USD for example is not backed by any real asset either. The reason why the USD is stable, is because people believe in its value. Non-collateralized stablecoins are based on the same idea.
Their value is determined by supply and demand and their circulation is managed by an algorithm. As demand increases, new stablecoins are created to reduce the price back to its normal level. Likewise, if the price is going too low, coins will be taken out of circulation to increase prices back to normal.
Besides those three major types of stablecoins, developers are also working on other concepts, for example crypto-backed stablecoins. But none of these ideas have gained much traction yet.
Providing the benefits of digital currencies while reducing volatility
As the name indicates, the main advantage of stablecoins is price stability. Bitcoin and other cryptocurrencies have somewhat failed as a means of payment, mostly due to their high volatility.
Stablecoins enjoy the same benefits as other cryptocurrencies. They are transparent, secure and private. They can be used for fast international payments, are available to anyone with an internet connection and users do not need to go through the traditional banking system.
But they also provide the same level of stability as their underlying assets, which makes them much more useful as a means of payment compared to free-floating cryptocurrencies.
Moreover, they can provide crypto-holders with a safe haven in case of a market crash.
Currently, it’s not that simple to move a large amount of crypto-coins back into fiat, because many exchanges do not allow fiat on the platform or will charge large fees for the transfer. But traders could move into stablecoins in just a matter of minutes in case their crypto-holdings get beaten up.
Stablecoins are centralized
Fiat- or asset-backed stablecoins are centralized, meaning their circulation is managed by a single entity. They are not trustless, and can be manipulated more easily compared to other cryptocurrencies.
Take for example the USD-backed stablecoin Tether. The currency lost more than $1B in market cap in October 2018, after rumors that the issuing company is only holding a fraction of the USD it claimed to have.
Stablecoins are also subject to constrains that come with their underlying assets. That could be increased regulatory oversight, or a more difficult conversion process. Converting a gold-backed stablecoin into gold bars, for example, would require a long and expensive trip to the issuing entity’s vault.
Stablecoins come with their benefits and drawbacks. The concept is still in its infancy, so it’s too early to make a reliable prediction for the future. However, the value and stability they provide to businesses and individuals could eventually make them a widely used means of payment.