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What Are Stablecoins?
by Omor Ibne Ehsan · · 5 minute read
Stablecoins are cryptocurrencies which have their value pegged to another cryptocurrency, fiat currency or stock. Stablecoins can be used for various purposes, including staking, storing or trading with other cryptocurrencies.
Why Are Stablecoins So Popular?
Stablecoins are desirable as they possess the same benefits as other cryptocurrencies, such as speed, anonymity and decentralization, while not being volatile.
Stablecoins are excellent for people who want to take advantage of the utility digital currency provides while being immune to the cryptocurrency market's volatility.
How Do Stablecoins Work?
Stablecoins are blockchain-based digital currencies identified by one of four underlying collateral structures:
Fiat Backed Stablecoins
These are backed by 1:1 by fiat currency. Typically, the entity behind a stablecoin will set up a "reserve" where the fiat currency backing the stablecoin is securely stored or invested. The entity will keep $1 of fiat or fiat equivalent in their reserve for each unit of the stablecoin.
Some Examples of fiat backed stablecoins:
Tether is the first stablecoin to be introduced and has the largest market cap in the crypto ecosystem. Tether's value is pegged to the US dollar. For every USDT in circulation, Tether claims to have an equal amount of reserves. Tether is the most widely accepted stablecoin, with support from several exchanges. However, there are questions over Tether's reserves, which has led to speculation that Tether is operating a fractional reserve system.
Gemini Dollar (GUSD)
The Gemini Dollar is a stablecoin launched by the Winklevoss twins. The Gemini Dollar is fully collateralized, and is audited by BPM, an independent accounting firm. Gemini has stated that it will never issue more Gemini Dollars than there are dollars in the bank account.
True USD (TUSD)
TrueUSD is one of the newest stablecoins that was launched in 2018. It is similar to Tether, in that it is pegged to the US dollar. However, unlike Tether, the value of TrueUSD is kept stable by a reserve of US dollars. TrueUSD claims that they have legally verified their reserves.
Paxos Standard (PAX)
The Paxos Standard is a stablecoin backed by the US dollar. It is fully regulated by the New York State Department of Financial Services, and is audited by BPM, an independent accounting firm. Paxos Standard is distinct from the Paxos Gold, which is backed by gold.
Commodity Backed Stablecoins
Physical assets such as precious metals, oil, and real estate are used to back commodity-backed stablecoins. They provide an opportunity to invest in assets that are not easily accessible.
Those who want to exchange tokens for cash or gain possession of the underlying tokenized asset can also use commodity-backed stablecoins. These are more susceptible to price fluctuation as underlying assets are also volatile.
Paxos Gold (PAXG)
Paxos is a New York based company that offers gold-backed stablecoin. The gold is stored in an audited, insured and fully security protected facility. Each PAXG token is equivalent to one fine troy ounce of gold.
Venezuela launched its oil-backed cryptocurrency, the petro, in February 2018. The Venezuelan government claims to have raised $735 million USD from the initial sale of petros. The government also plans to use petros to pay for products and services such as food and medicine.
Tether Gold (XAUT)
Tether Gold is a token backed by physical gold. It was developed by Tether and is fully redeemable for the underlying asset. Each XAUT token is equivalent to one ounce of gold.
Digix Gold (DGX)
Digix is a Singapore-based company that offers gold-backed stablecoin. It is a decentralized platform that creates a token on Ethereum blockchain and represents ownership of physical gold.
Another cryptocurrency or digital asset backs a crypto-backed stablecoin as collateral. The process happens on the blockchain using smart contracts. These stablecoins are more decentralized.
When you buy a stablecoin like this, you lock your cryptocurrency into a smart contract in exchange for stablecoins of similar value. You may then withdraw your original collateral amount by putting your stablecoin back into the same smart contract.
To ensure the stablecoin's value, crypto-backed stablecoins are overcollateralized. For example, a $1 crypto-backed stablecoin may be linked to a $2 underlying crypto asset. Thus the stablecoin has a built-in buffer and can remain at $1 if the underlying crypto loses value.
Fundamentally, collateral is liquidated through smart contracts if the backing crypto price goes below the threshold to maintain the maximum stability of the stablecoin in question.
However, it would be best to keep in mind that these cryptocurrencies are less-stable than fiat-backed cryptocurrencies. Thus, a good idea would be to keep a tab on the prices of underlying assets.
Examples of such cryptocurrencies include:
MakerDAO is a decentralized autonomous organization that is responsible for the creation and management of the Dai stablecoin. The Dai token is a decentralized stablecoin that is pegged to the US dollar. It is an ERC20 token that runs on the Ethereum blockchain. Dai is an asset-backed cryptocurrency which uses crypto collateral to back the value of the Dai.
The Synthetics sUSD stablecoin is a new stablecoin that is a USD-pegged cryptocurrency. It is backed by Synthetix protocol's pooled collateral model, a decentralized platform based on blockchain technology.
Reserve Token (RSV)
The Reserve Token is a stablecoin that is backed by a basket of assets. It uses a system called smart collateral to ensure the price stability of the token. This token runs on the Ethereum blockchain.
These stablecoins do not have any significant assets backing them. Instead, advanced algorithms and smart contracts are used to peg the price of stablecoins to the representative currency. These stablecoins use highly complex algorithms to ensure maximum stability.
Some of these stablecoins do keep a reserve. A smart contract keeps track of the price of the underlying asset. When the price of the stablecoin goes up from the price of the asset, an algorithm takes some coins from reserve and adds them into circulation by adding them to liquidity pools.
When the price of stablecoin goes below the underlying asset, the number of tokens in circulation is reduced by moving them back to the reserve. This process always ensures the liquidity ratio of stablecoins in a pool such that the price ratio of stablecoin stays equal to the representative asset.
Examples of such stablecoins include:
- Ampleforth (AMPL)
- DefiDollar (USDC)
- Empty Set Dollar (ESD)
- Frax (FRAX)
Stablecoins can be used for various purposes. However, they are primarily used as a medium of exchange between different exchanges and cryptocurrencies to simplify buying and selling.
Stablecoins also have other valuable merits, such as staking without the fear of volatility when staking volatile cryptocurrencies and keeping these stablecoins as a reserve to buy dips in the market.
Moreover, stablecoins can also be used for day-to-day transactions due to their excellent privacy, speed and stability compared to traditional fiat currency.
Though all stablecoins are aimed towards stability, the algorithm used to achieve this stability to their representative assets varies significantly. This leads to some being highly volatile and some being highly centralized.
However, stablecoins are still very useful for everyday users and are an integral part of cryptocurrencies, and it is for you to decide which one is the best for you to use.