What is a stablecoin?

There are many types of cryptocurrencies and coin in addition to Bitcoin. In this article, we will be talking about a type called stablecoin, which as their name suggests, try to maintain a fixed value of $1.

Stablecoin: a definition

What if there was a way that you could buy a cryptocurrency that would basically be cash, meaning that its value did not change, but it would still be transferrable as a crypto?

A stablecoin is a specific under-category in the vast realm of altcoins (altcoins being every other coin that is not bitcoin). It is a cryptocurrency that offers all the advantages of a cryptocurrency, with the stability of a fiat currency. A stablecoin can be pegged to a fiat currency like the US dollar and should always be worth one dollar. By contrast, Bitcoin was meant as a store of value, but the fact that it is not widely adopted and that its value fluctuates by great amounts makes it a speculative investment.

Some of the most popular stablecoins include Tether (USDT), USD Coin (USDC), Binance USD (BUSD), TerraUSD (UST) and Dai (DAI).

 

The use of a stablecoin

Imagine that you buy 100 bitcoins for $100 and that the price of Bitcoin rises to $1’000. You might want to exchange $500 worth of bitcoins with a stablecoin like Tether (USDT) to then can maybe, 1. buy after a future price drop or 2. protect some of your winnings. A stablecoin can thus be seen as a way to secure your cryptocurrency wallet.

In the same idea, platforms like AAVE or Compound, which allow you to stake crypto for a return, also give you the opportunity to stake stablecoins with a return rate which you can really count on. After all, a 20% APR on Ethereum means nothing if the value of ETH drops 50% during the investment lifetime. By contrast, such an APR on a stablecoin – with its value being protected, pegged to a fiat currency – looks much more interesting.

 

How do stablecoins work?

There are two main ways to make stablecoins work, the first being collateralization, and the second through algorithmic mechanism or smart contracts manipulation. Big words for, in the end, relatively simple mechanisms.

Fiat collateralization means that each coin is back by something. In many situations, a coin’s collateral is one US dollar, but it can also be the fiat currency of any country such as the Euro or the Swiss Franc, or even a commodity like gold. Tether is a company that releases each of their USDT backed by one US dollar – though they were recently exposed to have too little backing. The main issue with stablecoins is that every dollar invested in these cannot be invested. The collateral can also be lost or stolen and proving ownership of the collateral can sometimes not be so easy.

Moving on to the second method, also called algorithmically pegged stablecoin. The main advantage of this method is that it is very easy to audit: one look at the smart contract is enough to check that everything is in order. Another benefit is that there is not physical asset to lose or steal. The only issue is their increased volatility, tied to the way they work: to correct value, the supply is adjusted by increasing or decreasing the number of available coins on the market.

 

Issues of stablecoins

While stablecoins are generally more secure and less volatile than altcoins and Bitcoin, there are still some critics applying to them. One might want to consider these before throwing their entire savings into DAI or USDT.

First, there is a lack of insurance. When you put your money into a bank savings account, it is insured by the government. The FINMA will reimburse you up to CHF 100,000 if an issue arises like the bankruptcy of your trusted bank or an eventual theft. If the company that issues your stablecoins goes bankrupt, there is a high chance that your savings might be lost.

Secondly, there is the collateralization issues, such as the rumour that Tether does not actually own a dollar for every USDT issued. If trust fails, the value of USDT could fall, going even below a dollar. Tether is only worth what people think it is worth. Right now, it is one dollar, but it could go below that if the public finds out a fraudulent collateralization.

 

Conclusion

Stablecoins are a great advancement for cryptocurrencies, providing a tool which can be used in many ways. However, though not so volatile as altcoins, they also come with risks that the buyers should be aware of.

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