In response to one of my recent articles, a reader asked for a more in-depth explanation of what stablecoins are and how they work. As I thought about this question, I realized that sometimes it is good go get back to basics and that many people may want to know more about the how and why of stablecoins. My goal in this article and video is to provide a basic, beginner's overview of stablecoins by answering 8 common questions. I want to give credit to Arik Schenkler for asking these questions, and the original post can be found here.
1. Is there a mechanism to buy stablecoins using US$ and not via exchanges?
Different stablecoins are purchased in different ways. For example, the USDC stablecoin is purchased through a company called Circle, but a stablecoin like Dai is created by locking ETH into a decentralized smart contract. So, stablecoins don't always have to be purchased from an exchange. They can be purchased from exchanges, companies, and decentralized organizations.
2. What is the price of buying new stablecoins? How much does the system earn? For example if I want to buy 100 stablecoins do I need to pay 105 US$? 100 US$? Or 95 US$?
The price of stablecoins fluctuates but is usually around 1$. On Coinbase, I can directly exchange $1 USD for 1 USDC with zero fees. On the other hand, if I want to buy Dai on Coinbase, I can be charged a fee of up to 10%. Companies make their money by charging a variety of fees and different issuers will make their fees in different ways.
If I want to generate Dai from a smart contract on Maker's official portal, I have to deposit more ETH or BAT collateral than the amount of Dai I take out. Different stablecoins have different generation mechanisms, so it depends on the coin, but the price should always be close to $1 US Dollar.
3. Is there a way to sell my stablecoins and get back my fiat currency?
Yes. Stablecoins can be exchanged, traded, and sold just like any other crypto.
4. How much do I get back?
This depends on the coin. Some stablecoins like USDC are backed by actual US Dollars sitting in vaults. With USDC, you will get exactly $1USD. By contrast, Dai is algorithmically pegged to the dollar, and the price fluctuates by a few cents. Depending on the current price of Dai, you might get either 98 cents or $1.02.
For example, Dai is a "stablecoin" that is linked to the USD, but we can see that it is trading right now for a price slightly above $1 on Coinbase. The advantage of selling your stablecoins is that the price that you sell them for should be very close to the price that you purchased them for - hence the term "stablecoin."
5. What happens to those stablecoins, are they burned?
These coins are removed from circulation.
6. Who certifies the amount of the stablecoin reserve?
Once again, this question depends on the specific stablecoin. With Dai, there really are no reserves because Dai is generated by users depositing crypto into smart contracts. The reserves themselves are not audited, but the smart contracts are. This last audit was performed a few months ago by the Callisto Network. Stablecoins such as USDC that do keep reserves are audited as well.
7. How can I trust stablecoins?
There is risk involved with every type of investment and the amount of risk that each of us is willing to accept is different. As much as I can, I look to third-party audits to verify that a project is secure. If I can't find a third-party audit, sometimes I will listen to other crypto users that I trust.
8. Where are stablecoins used?
Stablecoins are used anywhere that a person wants to hold an asset that does not excessively go up or down in value. Let's suppose I am a Bitcoin trader. I have just sold a lot of Bitcoin for a profit. If I transfer that money to actual US Dollars, I will have to pay a lot of transaction fees and use a crypto off-ramp. If I transfer that money to a stablecoin, I can "lock in" my trading profits to a stable asset while also having the ability to rapidly make new investments if I see an opportunity.
Graphs from: https://www.coinbase.com/
Image Credit: https://www.pexels.com/@neo8iam