What Are Stablecoins?

What Is the Purpose of Stablecoins? 

What are stablecoins? Digital currencies were conceived as an alternative means of payment, as well as a safe tool for accumulation and savings. Nowadays the promises of the first crypto enthusiasts and developers look like black sarcasm: “The crypto will be more reliable than ordinary money, because it does not depend on the state and is not subject to currency fluctuations.”

In fact, crypto assets have become the opposite of what was intended – it is very difficult (almost impossible) to buy something with them, and they are the worst tool for savings and accumulation. 

Today, crypto is just a high-risk speculative exchange asset. This is due primarily to the highest volatility – that is, exposure to sharp fluctuations in the exchange rate.

For stock speculators, volatility is a risky high-margin way to earn quickly and a lot. But for serious investment, accumulation, transactional activity and trading activity, it is categorically contraindicated. This became a prerequisite for the creation of a new form of crypto products – stablecoins, resistant to exchange rate fluctuations.

 

What Is the Point of Stablecoins?

Any money  that existed in human history is associated with two primary concepts – a social contract and security. The social contract in a simplified form sounds like this: "We’ve all agreed that this is money." Even among the natives of Rapa Nui, this worked great with shells, but cryptocurrencies are the quintessence of the idea of “contractual money”.

Security is a more complex concept. For a long time, money was a self-supporting asset: gold, silver, and sable skins have their own value.Then there was money “backed by gold” and representing IOUs for a physical (gold) asset. When currencies broke away from the “gold standard”, issuers (states and central banks) undertook to provide them with “public property”. That is, theoretically, they undertook to monitor the correspondence of money and commodity masses, so that each  dollar was backed by some kind of tangible asset – oil, grain, real estate, precious metals, and so on. This system does not work very well, frankly bad in some places, but the principle is exactly the same. 

But the cryptocurrency is not backed by anything other than confirmation of the fact that someone converted a bunch of electricity into heat, increasing the entropy of the Universe (PoW).  This is why crypto is so volatile, and we should invest in in stablecoins. 

The point of stablecoins is, so to speak, to adapt crypto technologies to real life, that is, to offer a stable digital currency that can be used as a universal medium of exchange, a unit of account for determining prices for goods and services, as well as simple money transfers, including number and abroad.

At the end of 2017, when the Bitcoin rate was breaking new records every day, many in the community began to lament that people did not consider Bitcoin as a currency, but perceived it as an investment asset and a means of capital preservation. Indeed, why buy pizza for BTC if tomorrow it will rise in price, and in a year it will be possible to buy a whole house for it?

What is the purpose of stablecoins? True, in practice, stablecoins are most often used to fix profits in trading and as a “safe haven” during a storm in the market. Moreover, on Binance you can find almost all the most popular stablecoins, including Tether, Paxos Standart, USDC, TrueUSD, StableUSD, etc.

Why Invest in Stablecoins? 

Why invest in stablecoins? They have certain advantages. 

A stable exchange rate with low volatility makes stablecoins convenient for paying for goods and commercial services in everyday life, using them for settlements, transactions between people and international transfers;

Simple transparent and fast p2p transfers;

the ability to earn on the growth of various assets without owning them, for example, on the gold rate;

simple profit taking in cryptocurrency trading and risk reduction during market correction;

the emergence of new services on the blockchain, for example, issuing loans and insurance, where fluctuations of 10-20% per day are very critical;

assistance to the population of countries with a weak own currency, high inflation and strong currency restrictions;

lack of dependence on the institutional players in the form of state and central banks, which physically cannot manipulate the exchange rate, freeze accounts and block transfers;

the absence of intermediaries when it comes to decentralized stablecoins, which are issued by a smart contract and are provided with the money of users who own coins;

all together, this contributes to a more massive use, distribution and acceptance of the crypt.

What Are the Flaws of Stablecoins? 

Most stablecoins are issued and backed by authorized entities, leading to problems with centralization and sometimes uncontrolled issuance, collateral issues, and high control over the blockchain (for example, some may freeze any wallet, make all tokens non-transferable, or refuse to exchange them back to fiat);

despite the convenience of stablecoins, they are rarely used in decentralized applications and stores that accept payment in cryptocurrency (most prefer to make payments in Bitcoin, Ethereum or TRON);

if we talk about the most popular stablecoins, whose exchange rate is pegged to the US dollar, then they are not suitable for saving money, because the bucks themselves are not very stable and subject to inflation,

pegging to a physical dollar effectively makes stablecoins a derivative, which means they are automatically subject to foreign exchange laws;

fiat currencies with a fixed rate are either too expensive or doomed to failure.

What Are the Types of Stablecoins?

Fiat-collateralized 

These are stablecoins backed by fiat currency (deposits in banks, user deposits). They are pegged to fiat currencies 1:1. The issuer keeps a certain amount in the reserve currency, issues a number of tokens in proportion to it. At the same time, the counterparty may not know whether the issuer has reserve funds. Therefore, it is important to look at the results of the audit, if any, before purchasing a fiat-backed stablecoin. An example of a fiat-backed stablecoin is BUSD, which is pegged to the US dollar.

This scheme seems flawless at first glance – simple, stable, resistant to hacking. However, everything is not so simple. First of all, because the issuer must have a profit – otherwise why would he freeze a huge amount of money on deposits? As a rule, the issuer's profit as a percentage for depositing money – that is, when buying 100 tokens, you can give back not $100, but, for example, $101. The question immediately arises: why not just store the amount in dollars?

The second point is centralized emission, which means that it is completely controlled by the regulator, there is no “crypto-freedom”.

And third, you can never be sure that the issuer is playing by the rules and actually has all those dollars. So in 2017, the very first stablecoin Tether sank – the audit could not establish whether the project has the declared amount of USD.

Backed by Other Cryptocurrencies

It is essentially the same, but instead of fiat, a conditional Bitcoin or Ethereum + some reserve is used, which, in theory, should level the jumps in rates. True, if the same cue ball or ether falls heavily, then the coin will depreciate even more, since it was provided with a margin;

Commodity-backed Stablecoins 

A rarer type of asset. Commodity-backed stablecoins have a rate that is pegged not to the dollar or euro, but to the value of a certain commodity asset on international exchanges. Usually it is gold, but it can be, for example, oil, gas, grain, and so on. It works in the same way as a fiat pledge – the issuer receives collateral: oil, gold, etc. in the form of an exchange asset – and deposits it with a trusted depository or a bank. 

Tokens are issued for the amount received. When assets are disposed of, they are destroyed. Theoretically, they can be exchanged with the issuer for real gold/oil/grain, but in fact it does not work that way.

As a long-term investment, a commodity-backed stablecoin works as a protection of capital from inflation. However, it is subject to all exchange fluctuations in the price of a collateral asset.

CBDC

This is the so-called "state crypto" – "digital dollar", "digital yuan'' and so on. Central Bank Digital Currencies are stablecoins issued by the state and being a digital form of fiat currency. They have the status of legal tender and do not fully relate to the crypto market, but it would be wrong not to mention them. Their advantages and disadvantages are fully consistent with those of conventional currencies. Institutional cryptos in different countries are at different stages of testing, but, apparently, they are already on the way.

Non-collateralized 

A stablecoin with no collateral at all. It is not directly tied to fiat currencies and cryptocurrencies. Collateralization is provided by a smart contract, an algorithm. They also issue the token. Its course maintenance is algorithmic, based on the seigniorage shares mechanism. Issuers control the volume of supply using smart contracts – when the exchange rate falls, a part of the asset is “burned”, and when the rate rises, an additional issue is made. At the same time, coin holders receive shares for a share in future seigniorage (revenue from issue).

If suddenly the value of the token falls below the price of the tracked fiat, then the algorithm system reduces the supply of the token. If suddenly the price of the token exceeds the price of fiat, then new coins are issued, which will reduce the price of the stablecoin.

The advantages of this mechanism is that there is no need for real collateral, the disadvantages are everything else. The seigniorage mechanism can only maintain stability in a narrow corridor, and the stablecoin itself works only as long as there is a stable growing demand for it.

Is Stablecoin Stable? 

In general, the answer is “no”. Whatever the form of a certain stablecoin collateralization is, it will always be inferior in stability to fiat itself, because it is secondary and has a “gasket'' in the form of an issuer. This is perfectly shown by recent events on crypto exchanges, when a sharp drop in major cryptocurrencies caused the “decoupling” of several stablecoins.

As far as the stablecoin vs cryptocurrency dilemma is concerned, fiat-backed stablecoins do not make sense from the point of view of cryptocurrencies, as they remove the advantages of the blockchain and add a level of risk.

What Are Stablecoins' Functions? 

So why are stablecoins needed? In the cryptocurrency market today, a stablecoin acts as a buffer. Large investment funds enter it through stablecoins. Due to this, they can conduct a large number of trade transactions, invest and participate in cryptocurrencies.

Another function is to reduce overall volatility. Due to the volatility of the cryptocurrency exchange rate, it is difficult to use the asset every day. Stablecoins are almost not affected by it, which allows them to be used as a factor in the stability of the crypto industry.

In addition, the stablecoin performs the function of protecting against inflationary processes. Stablecoins can be especially in demand in those states where there is a high level of inflation, so that the population can save their investments from depreciation.

Stablecoins also perform the function of integration with the classical financial market. Thanks to them, the cryptocurrency market and the traditional one can interact with each other through the use of cryptocurrencies as a loan on classic credit platforms.

In addition, stablecoins are also used as a tool for hedging the portfolios of investors and traders.

Also, stablecoins allow you to hold assets in your wallet – when an investor has a lot of cryptocurrency, he converts it into stablecoins and waits for the volatility to end to sell it. 

For a crypto speculator, stable coins are useful if he wants to temporarily fix his profit and “sit out the fall. 

What is the point of stablecoins? In general, stablecoins today remain an internal instrument of the crypto market with all the pros and cons of this specific financial environment.

The initial expectation that this type of asset will become an alternative to the usual fiat currencies is unlikely to be justified.

What is the general purpose of stablecoins? At the moment, stablecoins have made the cryptocurrency market more stable and predictable. Thanks to them, the number of businesses investing in cryptocurrencies has increased. They help protect assets from the effects of inflation. It is to be expected that the number of stablecoins will increase, and perhaps they will be able to completely replace unstable and little-known cryptocurrencies.

 

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