Stablecoins have become an essential part of decentralised finance, also known as DeFi. They are used for trading, purchases and so much more. But what are stablecoins and how could they work for you? This is what we look at in this blog post.
We share your guide to stablecoins and everything that we think you need to know about them.
What Are Stablecoins?
Stablecoins are cryptocurrencies that are pegged to other currencies. These other currencies include the GBP, euros and the US dollar for example. A stablecoin can also be pegged to an asset, like the price of gold for example.
Due to the fact stablecoins are pegged (or tied, if you prefer), to the value of assets and currencies that are less volatile, it means that they can provide an alternative way for people to participate in the world of crypto without having exposure to the wide price swings that come with cryptocurrencies.
That’s the main draw of stablecoins for many investors. They provide the speed of crypto and the stability of other trusted assets and currencies.
Why Do People Buy Stablecoins?
Stablecoins are used by some as a cash alternative. Stablecoins can minimise fluctuations in holdings because they stay pegged to a fiat currency or physical commodity. They are also used for building and protecting wealth. We have seen many cases of people buying stablecoins as an alternative to their local currency. This is especially the case for people whose local currency has devalued through inflation.
People also buy stablecoins as a form of payment. In some areas of the world, it can be difficult to get physical currencies. In these locations, stablecoins are a viable solution to buy and sell services or products. Some people purchase stablecoins as a way of trading. This is possible because some cryptocurrency exchanges will offer stablecoin pairs against fiat currency, crypto assets and other crypto coins.
How Are Stablecoins Used?
There are lots of different ways in which stablecoins are used. One of the most common ways that stablecoins are used is for hedging against market volatility. This is because stablecoins can pull funds out of volatile cryptocurrencies. This is especially the case during extreme market fluctuations.
Stablecoins are also used as an alternative and cheaper overseas payment solution. This is because stablecoins do not require the middlemen such as traditional banks and clearing houses. In turn, this avoids many of the traditional transaction fees that are often incurred with money transfers overseas.
Stablecoins are also used to get faster payment transfers. When you transfer money with traditional banks it can take 3-5 days. However, as transfers and transactions with stablecoins do not take place through a bank or clearing house, payments can be completed as quickly as a few minutes up to a couple of hours.
What Are The Drawbacks Of Stablecoins?
As with all investment opportunities and digital currencies, there are benefits and drawbacks. It is as important to understand the uses and benefits as much as the drawbacks so you can make the right decision for your investment.
One drawback of stablecoins is that they are primarily centralised. This means that stablecoins can be criticised by advocates of a fully decentralised system. By stablecoins being controlled by centralised entities, some believe that they are not completely trustless.
Another drawback is that stablecoins come with counterparty risk. Due to the fact you are purchasing stablecoins from an issuer, you are trusting that they will keep their promises and you will be able to redeem your coins for the appropriate amount of fiat currency. It’s important to note that if the entity controlling the stablecoins becomes insolvent or its reserves are mismanaged, you could lose your money and investment.
There is another drawback of stablecoins because of the smart contract risk. If, for example, there is a bug in the code that governs that stablecoin, this could lead to a loss of investment and money for you, the investor.
Stablecoins also have a lack of transparency, which can be a drawback to a lot of potential crypto investors. There have been some cases where stablecoin companies skirt around or even ignore audit requests. This means that users will never really know if the necessary reserves to hold the peg are actually in place. Without audits taking place, these funds could be embezzled. They could also be used for other purposes other than collateralization.
Are My Stablecoins Backed By Cash?
As we always say, it is important to do your own research and shop around. Some stablecoins are completely collateralised by cash. In these cases, the holding will be at least 1:1 in reserves. This will enable the stablecoins company to maintain its peg.
However, each stablecoin company and stablecoins project with manage peg maintenance and collateralization uniquely, in their own way. This is why it is important that you review all documentation from the company. This will help you understand their process and if their process works for you.
What Are The Different Types Of Stablecoins?
There are four different types of stablecoins. Each one works slightly differently from the others. As a stablecoin investor, you need to take the time to do your own research. Below we have given a brief overview of each type of stablecoin and how it works. This means that you can see, in brief, which could work better for you and your investment. Later in this blog post, we go into more detail about the benefits and criticisms of each type of stablecoin.
With fiat-backed stablecoins, the value of the stablecoin is pegged to a fiat currency such as the GBP, Euro or US dollar for example. The fiat reserves will ensure that you have a collateralization ratio of 1:1.
The value of a commodity-backed stablecoin is pegged to a single commodity. In some cases, it is linked to an index of commodities. Collateral reserves are then tied to the commodity.
When you invest in crypto-backed stablecoins, you will find that the value of the stablecoin is pegged to another cryptocurrency or crypto coin. Many stablecoins that are backed by a cryptocurrency will hold more collateral than is needed. This will also be held in different cryptocurrencies to ensure a peg.
No collateral is required to start or even operate true algorithmic stablecoins. Instead, algorithmic stablecoins rely on smart contract algorithms. These are then based on both supply and demand.
Is A Stablecoin Peg The Same As Collateral Currency?
It’s important to note that a stablecoin peg is not the same as its collateral currency. Instead, the peg is the value of the stablecoin it is tying itself to. For example, if a stablecoin is pegged to a Euro, that means one unit of stablecoin is equal to one Euro. The collateral currency is what backs up the stablecoin. It is the stored value that helps the stablecoin maintain a peg. One example of this is a stablecoin that is pegged to the Euro. However, it is also backed by various assets. These assets could include fiat currency or gold, for example. This is what essentially proves the value of the stablecoin.
What Are Asset-Backed Stablecoins?
Asset-backed stablecoins gave real assets held in reserve. This is done as collateral for the stablecoin.
You will find that any asset-backed stablecoins available are fiat-backed. This will be done using a fiat currency such as the GBP, US dollar or Euro for example. Other asset-backed stablecoins will use commodities. These commodities will include things like gold or even other cryptocurrencies as their collateral.
What Are Fiat-Backed Stablecoins?
Fiat-backed stablecoins are pegged to a traditional fiat currency. This could be the GBP, US dollar or Euro for example. They will then maintain their peg by using the collateralization ratio of 1:1. This means that for one stablecoin there is one unit of fiat currency which is held in reserve.
There is one primary criticism of fiat-backed currency. This is because the collateral must be held by a custodian. In turn, this means that users are having to trust a centralised organisation.
The Benefits of Fiat-Backed Stablecoins.
Fiat-backed stablecoins are easy to understand the value of because they are pegged to a traditional fiat currency. They offer a stable price due to them being pegged to a fiat currency. Fiat-backed stablecoins also allow for an almost instant transfer and payment.
The Criticisms of Fiat-Backed Stablecoins.
The centralised structure of fiat-backed stablecoins can be a concern for some investors due to the financial regulations. It is also not possible for large cash reserves to be used while they are in reserve. Fiat-backed stablecoins can be difficult to maintain peg at scale. This is because large reserves are required.
What Are Commodity-Backed Stablecoins?
The difference with a commodity-backed stablecoin is that is uses a physical asset as a peg for the digital currency. This physical asset could be anything such as gold, oil or real estate for example. It is the case that asset backed stablecoins can be more volatile that stablecoins collateralised by fiat currency.
If you are looking for a more stable commodity-backed stablecoin, you could opt for gold-backed tokens. Not only are they fairly stable, but they also offer the advantage of being able to hold the value of an asset like gold, without needing to store and secure the physical gold bars or coins. When a stablecoin is backed by gold, it is often done with the use of a measurement on the metal. For example, one gram for one stablecoin.
Some commodity-backed stablecoin companies take a blended approach. To do this they take a mix of assets to back their stablecoins. This is similar to a precious metals index or using multiple fiat currencies for example.
The Benefits of Commodity-Backed Stablecoins.
Commodity-backed stablecoins are a simple way to peg value to a physical asset, such as gold, without needing to store it. It also offers more stability than crypto-backed stablecoins or algorithmic stablecoins. Many users like commodity-backed stablecoins because it gives them a way to diversify their crypto holdings.
The Criticisms of Commodity-Backed Stablecoins.
One main criticism of commodity-backed stablecoins is that if the commodity they are pegged to crashes, the value of the stablecoin will go down or crash too. The accounting requirements for commodity-backed stablecoins can also be vague. Further to this, ensuring collateral reserves can be a challenge for a lot of commodity-backed stablecoin companies.
What Are Crypto-Backed Stablecoins?
As the name suggests, a crypto-backed stablecoin is backed by cryptocurrencies. These crypto-backed stablecoins hold their value at a 1:1 ratio and are pegged to a different, often more established cryptocurrency. You will find that some crypto-backed stablecoins are overcollateralized. By this, we mean that they hold more than they need. This is done to minimise the risk of losing their peg.
You will often find that some crypto-backed stablecoins use a number and selection of multiple cryptocurrencies, crypto and fiat currency. This is done to collateralise the stablecoin. In turn, this means that if the crypto-backed stablecoin was to have an extreme drop in value, the crypto-backed stablecoin would still be able to maintain its value.
The Benefits of Crypto-Backed Stablecoins.
Cryptocurrency-backed stablecoins offer users a greater level of decentralisation. There is also no custodian to store and hold reserves. Further to this, there is a built-in audit. This is due to the blockchain technology which makes up all cryptocurrencies.
The Criticisms of Crypto-Backed Stablecoins.
Crypto-backed stablecoins are less stable than fiat-backed stablecoins. This is due to the greater volatility in cryptocurrencies. The value of crypto likely backed stablecoins will crash quickly if the price of the collateral currency drops. Crypto-backed stablecoins can also be very difficult to adopt.
What Are Algorithmic-Backed Stablecoins?
Many Decentralised Finance (De-Fi) purists consider algorithmic-backed stablecoins to be the pinnacle of the dollar-pegged stablecoins. This is because algorithmic-backed stablecoins don’t require any centralisation. They also have no reliance on an underlying reserve.
The fact the algorithmic-backed stablecoins are non-collateralised means that these stablecoins do not necessarily require any assets held in reserve to function. Instead, algorithmic-backed stablecoins use complex formulas in smart contracts. This is done to create or destroy tokens to maintain parity with the chosen peg. The chosen peg tends to be one dollar.
You will find that some of these stablecoins will provide rewards to the user when they are valued over their dollar peg. This is known as ‘seigniorage shares’ and it helps to bring the token back down to peg value.
Algorithmic-backed stablecoins function as standalone central banks. Existing tokens are then burned when the value falls below the fiat peg. However, if the price goes higher than the tracked currency, then new tokens are created.
Could Stablecoins Be The Future Of Money?
Stablecoins have received a lot of attention in recent years, and their popularity among crypto investors has increased in popularity too. However, the jury is still out on where stablecoins fit within the future of finance. In some cases, experts have seen that stablecoins are the only option for people who need their crypto to maintain a stable value, while still being useful and effective for everyday purchases.
Some finance experts fear that central banks may take over the role that decentralised networks play in stablecoins and go on to issue their currencies. So-called CBDC, also known as Central Bank Digital Currencies, would have all the capabilities of cryptocurrency. However, they would have this without any of the privacy protections and pseudonymity that cryptocurrencies provide to crypto investors and crypto users.
We don’t have a crystal ball, and this means that is hard to tell how long worldwide adoption of cryptocurrencies and stablecoins will take. However, in the meantime, stablecoins fill a valuable space in the crypto ecosystem and we think they will for a long time to come.
Want to know more about stablecoins and how they could work for your crypto investments? Contact our team now. We have a UK-based team of crypto specialists that will be happy to answer any questions or support you in making the best decision for your investment.
The world of crypto is huge and there is a lot to learn. Feel free to follow us on social media and read our blog posts to learn about cryptocurrencies. We always try to keep our language simple, but if there is a particular question you want to answer, give us a call or pop into the office and say hello!