For the last 10 years, cryptocurrency has been one of the hottest topics still being discussed by tech enthusiasts and entrepreneurs all over the world. Despite the fact that crypto is proving to be more applicable than traditional finance, and the number of its adopters is growing, there’s one thing it can’t really afford. It’s the stability. Here’s where stablecoins come into play.
In this article, we’re going to dive into stablecoins and their main types. Whether you’re just starting to explore them or already know something but are curious to get more – this article will definitely come into handy.
What’s The Problem with Cryptocurrency?
Cryptocurrencies are blockchain-based digital assets designed as a great alternative to fiat money, covering those aspects that traditional money can’t really allow for. They are decentralized (not controlled by any authority/government), can’t be spent twice, and can be used anywhere, by anyone, and at any time (as long as you have Internet). Besides, the transactions on them can’t be reversed/cancelled and do not need any 3rd party to be successfully executed. These advantages seem to make them a perfect solution, don’t they?
However, there is a backside to any coin, even the crypto one. 😉 The fact that it doesn’t depend on any central authority makes cryptocurrency vulnerable before the market supply and demand. This results in the crypto experiencing ups and downs in its prices every time the market supply and/or demand changes (the top reason why investors find crypto investments risky). To eliminate this volatility, stablecoins have been introduced.
What Are Stablecoins?
Stablecoins are cryptocurrencies with a fixed value, which means their value should not fluctuate the way it happens with cryptos. Seems enough to move your interest, right?
Before you make up your mind to deal with stablecoins, make sure you take into account the following features:
- Stablecoins have no restrictions. This is what unites stablecoins with cryptos.Thanks to blockchain they are based on, stablecoins can be sent from any location, to anywhere, by anyone, and with no intermediaries. For the same reason, the stablecoin transactions can’t be blocked or cancelled.
- They are low-cost.
Because of the fact stablecoins require no banks or other 3rd parties to be processed and managed by, they are much cheaper than the traditional financial transactions. Besides, they do not charge additional fees or commissions as bank or credit card payments do. All this makes them a really cost-effective payment option.
- Stablecoin transactions are fast.
Again, thanks to the blockchain technologies, stablecoin transactions are far faster than the traditional ones. As there are no 3rd parties and no long waiting periods to process your transaction, it takes minutes for the money to get to your account.
- Stablecoins provide transparency.
All stablecoin transactions are based on public blockchain. This means everyone conducting stablecoin transactions can see them. This provides a great level of transparency and trust to stablecoin holders.
- The value of stablecoins can be pegged to different assets – from fiat currency and commodities to other cryptocurrencies and even specific algorithms (keep on reading to find more on that. 😉)
- The price of crypto currencies may actually be influenced by stablecoins. If people who possess a big percentage of cryptos decide to convert them into stablecoins, the price of cryptocurrency goes down. And vice versa. That’s why you should understand that by investing in stablecoins, you may add to the crypto’s volatility.
- Not all stablecoins are decentralized.
The great advantage of both cryptocurrencies and stablecoins is that they are decentralized. However, this doesn’t go for all stablecoin types. The fiat-backed or commodity-backed ones, for example, do need to have a central authority that controls and manages their issuance and flow, like banks do.
- Some stablecoins depend on the traditional financial market.
This applies for the fiat-backed stablecoins. As their value is linked to traditional money – fiat currency – they immediately become dependent on the changes within the traditional financial market. This means, as traditional money, they are also subject to inflation and that’s why they are not that stable as you could expect.
- Stablecoins are poorly regulated.
One of the main concerns about stablecoins’ adoption is the lack of the defined regulation and well-structured framework to help you adopt and manage your assets. This not only creates challenges on your way to successfully understand their management, but could also discourage you from investing in stablecoins. Without clear regulation, such kind of investment seems to be speculative.
Now, that you know the important peculiarities of stablecoins, let’s get deep into their main types:
As the term suggests, the value of the fiat-collateralized stablecoins is backed by the fiat currency, with a 1:1 ratio. To support this ratio, a central body (for example, a bank) keeps an appropriate amount of fiat currency (for example, USD) in reserve and issues the same amount of tokens. Users can at any time redeem them for their fiat equivalents.
One of the disadvantages of this type of stablecoins is that since it is pegged to fiat money, it automatically grows dependent on the economic changes within the traditional financial system (e.g. can get inflated)- something all cryptos have been designed against.
Besides, since there is one central issuer, this means fiat-backed stablecoins are not decentralized. Everything you can do about it is simply trust the issuing company and hope that it is as much transparent as possible and does hold enough funds in reserve.
This type of stablecoins presupposes commodities, like precious metals (gold, silver, etc.) or raw materials (oil, gas, etc.), as collaterals. Such stablecoins offer more price stability than the fiat-backed ones could try to, are supported by great market liquidity, and can be pegged to more than one commodity, which lets them be a trusted and long-term investment option.
However, commodity-backed stablecoins are also not decentralized. You’ll have to deal with many third parties to keep your assets and (again) rely on their audits and reports being honest and transparent. Besides, although aspiring to guarantee more stability, these stablecoins also depend on their collateral – precious metals/raw materials’ prices.
Crypto-backed stablecoins use cryptocurrency as a collateral. The great thing about them is that they are totally decentralized. There is no need for a central body to govern them since smart contracts manage their issuance. This also means a high level of security and transparency since here the whole network of participants check that your transaction has been conducted properly, and you actually can track any transaction too, as it’s based on public blockchain.
Besides, such stablecoins offer much liquidity as they can be converted fast and presuppose low transaction costs.
However, as crypto-backed stablecoins rely on crypto, they also become vulnerable to the price volatility – by the time your transaction settles, cryptocoins can be worth more or less than the time they were sent at.
Moreover, if the price of the reserve cryptocurrency increases, overcollateralization takes place. This is an expensive process since a large amount of reserve cryptocurrencies is needed to issue such tokens.
The best-known crypto-collateralized stablecoin is DAI, introduced by MakerDao. The project aims at production and support of the DAI stablecoins, by utilising their Maker tokens and this way decreasing DAI’s price instability.
The most impressive type of stablecoins is the algorithmic one. It covers non-collateralized stablecoins (like ZigZag or Carbon) that are linked to neither fiat, commodity, nor cryptocurrency. To maintain their stability, special algorithms and smart contracts that issue and govern tokens are used.
Supply and demand are at the core of algorithmic stablecoins’ prices. If the price of such stablecoins falls below the price of fiat currency, the algorithmic system which uses automated supply techniques will reduce the token supply. And vice versa – if their value becomes higher, new tokens are issued.
Algorithmic stablecoins are considered the most decentralized type of stablecoins as they are not pegged to any collateral and do not need a central body to be supplied and managed. Besides, being built on smart contracts, they provide the same transparency as crypto-backed stablecoins.
However, there are doubts about the possibility to build a sustainable algorithmic stablecoin. In addition, the integration of the algorithmic system is very complex both in terms of its logic and investors’ understanding. Being new, it seems to be very futuristic, experimental and not economically proven (doesn’t it?).
Despite the fact that stablecoins are still an experimental industry with their regulatory and centralization issues, nowadays they are experiencing a significant rise which lets us be quite optimistic about their future.
If in 2017 more than a half of stablecoin projects were in the process of development or closed, 2020 has proven to be a year of stablecoins – the overall stablecoin market increased from $5.3 billion to more than $13 billion.
Moreover, 2020 has demonstrated an increase in stablecoins not denominated in U.S. dollars which is more than likely to continue in the next couple of years.
However, the regulatory framework of stablecoins still remains one of their top pressing issues. Thus, it would be reasonable to expect more solutions on the improvement of the stablecoin regulation system as well as the development of new regulatory frameworks in the nearest future.
At FutureBlock, we organize regular online meetups devoted to sharing DeFi knowledge among our network members. If you are willing to join our DeFi Evenings (as an attendee or a speaker) too, feel free to contact us.