General Crypto

Stablecoins: What and Why

In today’s post, I am going to explore the world of stablecoins. These handy little cryptos are useful as they aim to help curb the volatility in price in the crypto markets and give you a safe haven. They have a number of use cases, and there are a few different types, with benefits and issues associated with each.

For the usual disclosure, I am not a financial advisor, I don’t even work in finance at all. My day job is as a telecommunications software engineer. Treat everything you read here as some educational resources and not financial advise.

What Are Stablecoins

Simply put, a stablecoin is a crypto currency whose value is tied to something else. This could be fiat or another crypto currency, some real world asset such as gold, or the price held in place by some magical algorithm doing it’s thing behind the scenes.

Because they are backed by some other asset, the price for the stablecoin tends to remain, well, stable. Take Tether (USDT), which is a USD backed stablecoin. It’s price stays fixed at the $1.00 USD level, so you always know that however many USDT you have in your wallet, you could liquidate for that many actual US dollars.

Fiat Backed Stablecoins

The first type of stablecoin we are going to take a look at, is also the simplest one to understand- the fiat backed stablecoin. These stablecoins are literally backed in a 1 to 1 ratio with their fiat counterparts, meaning for every $1 in crypto that is issued, $1 in the backing currency is stored in an account owned by the organization issuing the crypto.

This means the price is entirely fixed to the value, as you can always take your crypto the issuer, and turn it in for the backing fiat. This also means that fiat back stablecoins are less vulnerable to hacks, as none of the actual collateral is stored on the blockchain, only the issued crypto currency.

Fiat backed stablecoins are not very decentralized however, as there is that central authority that acts as the custodian to hold all the fiat and insure the crypto. This of course makes them the target of attack if any hackers want to try to take a run at it, so it’s important to trust the company that is backing the stablecoin.

Fiat backed stablecoins also require regular auditing to ensure that the fiat currency that is supposed to be there in order to back the crypto, is actually in the accounts it is supposed to be in, so there is quite a lot of overhead and management costs that can go into running a stablecoin backed by trusty old fiat currency.

You also need to take into account the fact that a fiat backed stablecoin is going to be subjected to the laws and policies of the country whose fiat is backing the crypto. This could mean exchanging the coin into actual fiat could be a lengthy process using standard bank transfer mechanisms, if you go directly through the issuer.

Some examples of fiat backed cryptos would be Tether (USDT), Binance USD (BUSD) and USD Coin (USDC).

Crypto Backed Stablecoins

A crypto backed stablecoin is one that is backed by another crypto. There is no real would bank account with a large sum of fiat money backing the currency, everything is stored on the blockchain only. This also means that the price of the crypto is only soft pegged to whatever it is targeting, not directly tied to it.

As this reintroduces a bit of the market volatility back in, the amount of collateral that needs to be put up to back the stablecoin is higher than the value of the issued stablecoins. This over collateralization of the backing crypto allows for the price of that asset to come down without immediately affecting the price of the pegged stablecoin. The more volatile the backing crypto, the more collateral above the issued amount needs to be there.

This does have a risk that if the backing crypto were to crash and bottom out entirely, you could see the value of the stablecoin fall below what it should be pegged to, even getting entirely liquidated if the backing crypto were to fall to zero. On the other side of the coin, if the underlying asset were to increase in value, you would not see the stablecoin’s price increase, the price would only ever go down as a result of being under collateralized.

A crypto backed stablecoin is more decentralized, as the collateral can be stored in something like a smart contract on the blockchain. They can also be more easily liquidated at the issuer, as it’s all done on the blockchain and doesn’t have to rely on the old school banking systems. And due to the fact everything is on the blockchain, it’s transparent and anyone can audit at anytime to see that the required backing funds exist where they should.

An example of a crypto backed stable coin would be Dai (DAI).

Non-Collateralized Stablecoins

A non-collateralized stablecoin works a lot like a standard fiat currency. There is no backing reserve of something to drive the price, and it works on the open market much like any other crypto would. What makes the price of one of these stablecoins remain solid is how they handle supply.

When more people want the currency then there is available, the price for the currency would increase, and then a rebase happens and more of the currency is created, which drives the price back down. When more people want to sell than buy, some of the currency is bought back and taken out of circulation/destroyed. This is how a central bank manages the money supply for a country.

The other approach it can take is to increase and decrease the amount of crypto in every wallet, as opposed to issuing or buying back the circulating supply on the edge.

One project that falls into this category is Ampleforth (AMPL), which takes the latter approach and increases/decreases the amount of crypto in all holders wallets during the daily rebase of the currency. The dollar amount that you own stays the same, but the amount of crypto is what changes.

Uses For Stablecoins

There are a lot of use cases for stablecoin. If someone wants to just dabble in crypto, but doesn’t want to shoulder the risk in holding any of the more volatile cryptos, stablecoins are a good way to get your cash into the digital space without worrying if Bitcoin (BTC) is going to dump half it’s value tomorrow.

Another good use is for transferring large sums of money quickly around the world. A standard bank transfer can take days to complete, and can come with very hefty fees. Send that same amount using something like Tether (USDT) and suddenly the transaction can be completed in a few minutes, at a fraction of the cost.

Another big use for stablecoins that a lot of active traders do, is to keep some sitting on the exchange to be used as “dry powder”. It sits there waiting for the dip, and then it’s already on the exchange and ready to be thrown into an order on a whim. This is far better than trying to quickly convert from fiat into the exchange to buy your crypto, so if you’re looking to do some more active style trading, keep some stablecoin at the ready.

It’s also what you of course would turn your crypto into when you decide the top is here and it’s time to sell off and take your profits. Then you keep your stablecoins at hand and wait for the next time you are ready to buy in and ride the wave.

Conclusion

Stablecoins are a very useful crypto, not for the appreciation in value that you hope to get from every other crypto, but from the fact that it should remain at a nice stable price. It gives you your safe hideout in the sea of crypto volatility. It’s not going to make your rich on it’s own, but it’s a useful tool to help get you there.

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Want some more content right now? Check out some of my previous posts:

Proof of Stake (PoS)
Smart Contracts: Code Is Law
Crypto Wallet: How To Pick One