What Are Stablecoins and How Do They Work?
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What Are Stablecoins and How Do They Work?


One of the big reasons people use cryptocurrencies, and why other people hate cryptocurrencies, is the volatility. Ten years ago, a bitcoin was worth just a couple cents. Nowadays, one bitcoin is sold for more than 7,000 dollars, that’s a really big change. In one day, prices can fluctuate with hundreds, if not thousands, of dollars. That’s really difficult when you’re using it as a means of payment. The 5$ sandwich you just bought might turn out to become a 10$ sandwich in just a couple hours. The people in the blockchain industry saw this happening and thought of a solution to this issue. The first thought might be, isn’t the solution the traditional FIAT-currencies? Well, they kind of are but at the same time they are the system that cryptocurrency is battling, so why’d we support that?

Stablecoins

Then came a new term; ‘stablecoins’. Basically, the term explains itself, it’s a coin that remains stable. This means it will always hold the same value. So, whenever you are confident the crypto you are holding is up for a rollercoaster-ride downwards, you sell your crypto for a stablecoin and you will secure your valuables. Now, many questions might pop up immediately, how do you maintain this value and what kind of stablecoins are there? Let’s find out, shall we!

How does a stablecoin remain its value?

You decided you want to buy a stablecoin in order to keep the value of your holdings at the same level, great. With that, you are wondering how all of this works behind the scenes. In general, stablecoins remain their value because of the collateral item or asset that’s attached to the stablecoin. The goal for the stablecoin is to have its value never exceed the value of the collateral in reserve, to put trust in the way people can use these stablecoins. There are no mine-able stablecoins not are they pre-mined by any central party, stablecoins are created to supply the market and its investors with a trading angle at any time. All the properties of the traditional markets are suddenly available to the cryptocurrency world, low costs, high-speed and secured value. 

There are dozens of different stablecoins nowadays and they all work in a slightly different way. To answer the question of how they retain their value, we should categorize these stablecoins to where they belong. The available options are;

  • Fiat-backed
  • Commodity backed
  • Cryptocurrency backed
  • Algorithm backed

Fiat-backed

These are the more traditional stablecoins. The first stablecoins that were ever created are backed to the US dollar. Nowadays, there are more FIAT-backed stablecoins that are pegged to the value of several other fiat-currencies like the Euro or the Great British Pound. The value of these coins is pegged to the fiat currency. In the case of Tether (USDT), one USDT = one USD. This will always remain the same, the only thing that changes is the circulating supply. Whenever the stablecoin is exchanged back to the US dollar, the coin is burned and does no longer exist. The problem here is, the coin is centralized. It’s an off-chain solution that requires the collateral to be held in custodian by one central organ. We have seen it happening with Tether that people did not longer trust the company behind Tether, Bitfinex, to hold the precise amount of dollars pegged to the circulating supply. An external party performed an audit to confirm they did have the required dollars as collateral.

Another example of a fiat-backed stablecoin is Facebook’s libra. They have announced that their plan is to have their stablecoin backed to the value of multiple fiat-currencies like the US dollar, the Euro, Japanese Yen, Pound sterling and the Singapore dollar. This will keep its value stable at all times, no matter the situation of the individual currencies. 

Commodity backed

This kind of stablecoins are not backed by traditional money, they are backed by commodities like gold, oil or whatever else you could think off. In practice, most of these currencies come back to the traditional precious metals like gold and silver. The value of these commodities can fluctuate quite a bit, but it’s another way of investing in these precious metals without actually having to own these precious metals. A downside is the centralized nature of these stablecoins. Especially when it comes to commodities, they should be available for constant audits by external parties, to see if they actually have the number of commodities they claim to have.

Last year, we saw another attempt at creating a new stablecoin. Venezuela announced its ‘Petro’, which should replace their nation’s fiat currency for a new virtual coin, the Petro. The coin was supposed to be backed by the oil-reserve in the country. It’s unclear whether this is true, but the Venezuelan government is forcing the use of the Petro fiercely. 

Cryptocurrency-backed

Because of all the centralized stablecoins, the real decentralized warriors thought it was time for a change. Instead of trusting your money with a centralized party like the traditional system, they thought it was time for a decentralized alternative. In this case, the stablecoin is backed by a cryptocurrency, usually by means of a smartcontract. These are the more complicated stablecoins with extremely innovative systems that will stabilize the value of the currency. For example, the stablecoin DAI, a soft-pegged stablecoin that’s hosted on top of the Ethereum blockchain. If you want to create DAI, you need to deposit some Ethereum into a smart-contract that goes by the name “collateralized debt position”. The system under the hood is extremely complicated and tough to understand, although it’s completely transparent. Anyone can take a look at what’s happening and even vote about upcoming changes and such. As of the recent upgrade that was voted by all the holders, DAI is now backed by multiple assets and the single-collateral version is now known as SAI. Innovation.

Algorithm backed

This is difficult. It’s a system that’s supposed to be the alternative to the traditional economic models that we now today. But, it’s really hard to keep things afloat as regulatory concerns are tough to keep up with. With this stablecoin, there’s nothing backing up the value of the coin. It’s simply working with supply and demand and complex algorithms that increase and decrease the value of the coin. There have been several attempts of creating such stablecoins with all of them having a slightly different idea of what the model should be. One example is Basis, which sadly announced they will return their raised capital to their investors. Things didn’t work out as they planned and even though they raised 133 million, they could not find a way to get the system rolling. 

Stablecoins are very interesting for anyone in the cryptocurrency industry. If you want to catch a trade at the right time, you can hold some of your belongings in stablecoins to keep the same value and jump in at the right time. Or, you want to use cryptocurrencies to make payments but you do not wish to have your value fluctuate all the time, then stablecoins are your way to go as well. You might wonder, what are the best stablecoins out there? That’s what we’ll zoom in on in our next article!


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