Over the past decade, cryptocurrency and blockchain technology grew to a point where they have the potential to disrupt our traditional financial economy and many other sectors. The top crypto tokens may even be considered an alternative asset to precious metals such as gold. One of the main benefits of cryptocurrency is that they can be traded and are a separate asset class for investment. This is also the case for stablecoins.
However, cryptocurrencies are also famous for their volatility. Their stability is short term; you never know when the market will rise or fall. One day they may be worth thousands of dollars and before you know it they might not be worth much.
To address these problems of crypto tokens, stablecoins were introduced. But what is a stablecoin? What is the future of stablecoins? How are they better than cryptocurrencies? Let’s find out.
What is Stablecoin?
As the name suggests, stablecoins have price stability, unlike cryptocurrencies. The main reason they have been able to do so is that they are backed by stable assets such as fiat currencies. There are stablecoins backed by the U.S. dollar, as well as hundreds of other fiat currencies like the Japanese Yen, Chinese Renminbi etc.
The global market cap of stablecoins today is US$75.3 billion, or 3.77% of the total cryptocurrency market cap worth $2 trillion. Stablecoins’ 24-hour trading value of $75.9 billion now represents 20% of the trading value of all cryptocurrency of $370 billion, according to data on CoinGecko.com as of April 16.
Think of a stablecoin as our traditional banking system integrated with blockchain. Stablecoins were invented to bring in the benefits of cryptocurrency along with price stability. Cross border payments are made easier while also maintaining liquidity, security, and transparency; traders maintain freedom and privacy in financial transactions using stablecoins.
However, stablecoins are still a synthetic asset with value tied to an asset of commonly accepted value. If any component of the stablecoins’ back-end system does not functioning properly, the stablecoin could become unpegged from the cryptocurrency and lose investor trust.
The Four Types of Stablecoins
Fiat Collateralized Stablecoins
The most common types of stablecoin are Fiat collateralised stablecoins. These stablecoins are backed by fiat currencies like the U.S. dollar. These were the first type of stablecoin and are considered to be the most popular too.
If the underlying fiat currency is not stable, then the stablecoin also may not be stable. For example, in the past, the U.S. dollar was backed by gold reserves, whose value and supply is constantly fluctuating. Similarly, a fiat-collateralized stablecoin has its price fluctuate according to the fiat currency its tethered to.
The second type of stablecoin is a crypto-backed stablecoin. They are generally backed by decentralised crypto assets such as Bitcoin, Ethereum and so on. However, the value of any digital asset is fluctuating, making its stablecoins equally volatile. These are much less popular that fiat-backed stablecoins.
A commodity-backed stablecoin is pegged to tangible assets such as precious metals like gold (like XBullion GOLD). These stablecoins are dependent on the reserve holdings and value of the asset.
The final and most complex form of stablecoins are Algo-based stablecoins. They have no collateral and rely on smart contracts and use algorithms to adjust the supply to maintain a stable market value. The algorithm needs to accurately respond to market movements and ensure it doesn’t get manipulated.
Stablecoins share the risks associated with cryptocurrencies, mainly cybersecurity and regulatory risks. They are also highly dependent on how the reserves are held and maintained. You need to research the company and the collateral backing the stablecoin.
The Future of Stablecoins
Stablecoins have gained quite a lot of traction, mainly due to their price stability linked with collateral reserves. Stablecoins are used as base currency for trading and are commonly used on DeFi platforms which earn high interests for stablecoins lent/borrowed on the market. Defi platforms are typically operated on distributed ledger technology (DLT) such as blockchain which don’t have intermediaries between transacting parties. They decentralise the regulation of currency for all stakeholders.
The global financial economy requires a payment system where you can make payments without any delay, and that is cost-effective and free from intermediaries; stablecoins can fulfil this need. With new stablecoins constantly being launched, soon there may soon be one that’s pegged by every fiat currency in the world or a basket of currencies.
As the governments are inclining more towards central bank digital currency (CBDCs), you may see state-issued collateralised stablecoins in the future. But the government may have all rights reserved for such coins. If you prefer decentralised tokens, you can opt for crypto-backed stablecoin.
The first decentralised cryptocurrencies, Bitcoin and Ethereum are still struggling to gain mass market adoption. However, a stablecoin backed by fiat have better chances of being adopted as something the public can trust and embrace. People can accept stablecoins as digital counterparts of fiat currency. But whether it will replace fiat currency completely seems unlikely given that currently fiat currencies still massively eclipse their stablecoin counterparts in circulation.
Stablecoin vs. Cryptocurrency – Which is Better?
If you compare stablecoins and cryptocurrencies, stablecoins may emerge on top. They are related to each other but do have some fundamental differences.
Cryptocurrencies have much higher volatility. In comparison, stablecoins do not possess the volatility of cryptocurrencies. They can be pegged or collateralised by fiat currency, cryptocurrency or any tangible or decentralised asset. Any fiat-backed stablecoin is stable, making it the perfect alternative to fiat currencies.
One unit of a stablecoin is worth the same unit of its underlying currency or asset. So if you have coins backed by the US dollar, one stablecoin will be equal to one USD’s value. On the other side, a crypto coin can be worth more or less than a unit of currency.
Cryptocurrency fails to comply with government regulations due to multiple reasons. In contrast, a stablecoin is just like digital tokens of money, and they are more regulation-friendly. This leads to better public adoption.
Top Stablecoins in the Market That Are Pegged to the U.S. Dollar or Gold
Tether (USDT) is one of the most popular and widely used stablecoins in the market. This coin is backed by the USD and has over $47 billion market cap. It maintains a 1:1 ratio with the dollar. It was launched in 2014 as Realcoin by Brock Pierce, Reeve Collins and Craig Stellars. When new UDST tokens are issued, the same amount is added to the reserves. Also know that there are many competitors to Tether, such as DAI and USDC. Tether has not been a stranger to scandal, especially after it admitted in 2019 that its coins were partially backed by loans to the company and “cash equivalents”, which may include other cryptocurrencies.
As an Ethereum-based stablecoin, DAI development is overseen by the Maker Protocol and the MakerDOA decentralised autonomous organisation. You may notice the price of DAI as $1; this is due to the price being pegged to the U.S. dollar. The price is collateralised by many cryptocurrencies deposited into smart contract vaults every time new DAI is minted.
USDC is also one of the leading digital stablecoins pegged to the US dollar. Created by Circle, USDC is issued by regulated financial institutions, backed by fully reserved assets and is redeemable on a 1:1 basis for US dollars. It is governed by Centre, a membership-based consortium that sets technical, policy and financial standards for stablecoins that includes financial institutions like Goldman Sachs. As of April 2021 there are over 13.1 billion USDC in circulation, making USDC the stablecoin with the second-highest market capitalisation, after Tether.
Stablecoins can be the new currency. They can be used just like fiat currencies with the added benefits of digital assets; plus you can purchase them directly on the exchange. They are also collateralised, so you do not have to worry about price volatility. You can also buy stablecoins such as Tether and USDC from Zipmex today at the best market rates.
However their value remains subject to risks such as currency inflation and reliability. Unlike Central Bank issued fiat, one can’t really know if the company issuing the stablecoin will allow us to redeem the stablecoin at face value because of a lack of auditing and regulation. Whether the company or entity issuing the stablecoin is to be trusted is still up to retail investors and regulators. Retail investors must also do their part in understanding the risks associated with purchasing digital currencies and should conduct their own research.
When wider scale adoption of stablecoins comes, we may just have a stablecoin backed by every fiat currency in the world one day.