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What Are Stablecoins?

By iTrustCapitalSeptember 04, 20215 minutes read

The Evolution of Stablecoins

Generally, cryptocurrencies are known for their high volatility. Their value can take a drastic and sudden turn either upward or downward within a little space of time. 

This peculiar feature of cryptos increases the risks involved in buying the currency and is also one of the reasons why some investors are reluctant to put their funds into the asset class as they are not ready to gamble with their money.

To tackle the issue of high volatility for cryptocurrencies, a newer breed of crypto coins that are slowly gaining popularity was created. These coins are known as stablecoins.

What are Stablecoins?

Stablecoins are types of cryptocurrencies where their price is linked or pegged to real and stable assets like fiat money. Most stablecoins are linked to the US dollar, while others can be linked to other fiat currencies issued by governments like the euro or yen, or even exchange-traded commodities such as precious metals or industrial metals. Some stablecoins are even pegged to another cryptocurrency. 

The method of using gold is not common today. Countries like Britain stopped using the gold standard in 1931 while the U.S. terminated the method in 1933 and replaced it with the fiat money method.

When a stablecoin is linked to a fiat currency like the US dollar at 1:1, it means that for every stablecoin you buy, you have an equivalent of $1 at your disposal. If you decide to sell that stablecoin, you will get your $1 back since the value of stablecoins does not fluctuate.. 

The first-ever stablecoin, BitUSD, was launched on 21 July 2014, followed by NuBits in September. These two projects were not pegged to fiat money, instead, they were collateralized through other cryptocurrencies. 

Those two stablecoins are not very popular today; they have been overshadowed by other types of stablecoins like Tether (USDT), USD Coin (USDC), Binance USD, Dai token (DAI), TerraUSD, TrueUSD, Paxos Standard (PAX), HUSD, Reserve Rights, Neutrino USD, Gemini Dollar (GUSD), and more.


Types of Stablecoins

There are different types of stablecoins depending on which asset they are linked to. They are grouped into: fiat collateralized, commodity-backed, crypto collateralized, and algorithmic stablecoins.


Fiat Collateralized Stablecoins 

These types of stablecoins have their value attached to fiat currencies, such as the US dollar or the Euro.

This is the most common type of stablecoin and it is usually backed at a 1:1 ratio. This method requires a custodian that will oversee the fiat currency used as collateral and also guarantee the issuing and redemption of the stablecoin tokens.

Examples of stablecoins backed by fiat currency include:

USD Tether (USDT): Launched in 2014, Tether (USDT) is one of the well-known and oldest stablecoins. The tokens are issued by Tether Limited which is under the authority of the owners of Bitfinex.

USD Coin (USDC): The USDC came to light on the 15th of May 2018 and was eventually launched in September 2018 by a consortium called Center, under the company Circle. 

The stablecoin is pinned to the U.S. dollar but its operations run on Ethereum, Stellar, Algorand, and Solana blockchains, and also on the Hedera Hashgraph system.

Gemini Dollar (GUSD): GUSD was launched in 2018 by the cryptocurrency exchange Gemini, owned by Cameron and Tyler Winklevoss. The Gemini Dollar is pegged to the US dollar but is an ERC20 token built on the Ethereum network. 

TrueUSD (TUSD): TUSD is a stablecoin that is pegged to the US dollar but runs on Ethereum. It was launched in 2018, by TrustToken, whose co-founder and CEO is Rafael Cosman.


Commodity Collateralized Stablecoins

These types of stablecoins are backed by stable assets, like precious metals, oil, or real estate. Since the value of this type of stablecoin depends on the asset it is pegged to, one gold-backed stablecoin would equal one gram of gold, for example.

Commodity-backed stablecoins are centralized, unlike cryptocurrencies. This feature protects it from volatility. One example of a stablecoin backed by physical gold is Digix Gold (DGX).


Crypto Collateralized Stablecoins

These are stablecoins whose value is backed by other cryptocurrencies, usually Ethereum. Since cryptocurrencies are known to be volatile, to ensure that the value of the stablecoins pegged to them does not fluctuate, crypto-backed stablecoins are overcollateralized.

As a simplified example, this means that a $1 crypto-backed stablecoin can be linked to an underlying crypto asset that is worth $2 so that when the value of the underlying crypto decreases, the stablecoin can still remain at $1. Examples are the Maker Dao’s DAI token and the Havven.


Algorithmic Collateralized Stablecoins 

This type of stablecoins is neither backed by real or digital assets. Their values are controlled utilizing a computer algorithm. For instance, if the value of an algorithmic stablecoin is pegged to $1 USD, and later on starts to rise, more of that stablecoin will automatically be issued and released to bring the price down.

However, if the price begins to fall below $1, the algorithm would cut the supply of the stablecoin to bring the price back up. The concept of these types of stablecoins was taken from Robert Sam's Seigniorage Shares proposal and examples are Basis, Carbon, and AMPL.


Use Cases of Stablecoins

Stablecoins can be used to perform different financial activities. At first, when cryptocurrency exchanges were not connected with the traditional banking system, stablecoins were used to buy other cryptocurrencies, like bitcoin.

They are also used as payment methods for services within and outside a particular country, since payments with government-issued currencies can take longer periods, even up to a week, when paying to a different country.

When executing smart contracts on the blockchain, stablecoins can also be used for escrow services to transfer money. Smart contracts do not require any middleman to stand between the two parties or any legal authority before they are executed. 

However, the smart contract has to be programmed first before transactions can occur automatically. Fiat Money cannot go through these programming processes, but stablecoins can.

Stablecoins serve other purposes like using them to pay salaries, wages, or even rent in some countries. They can also be used for long-term loans. Because of its high-interest rates, stablecoins are better used for lending than fiat money.

When using a traditional savings account to lend money, a user can receive a maximum of 2.15 Annual Percentage Yields (APY), however, when using a stablecoin to lend money through a decentralized crypto lending platform, historically he APY has reached up to 15%.

Stablecoins are also used by some as a long-term store of value, hedging against inflation, common to fiat currencies. To sum it all up, when making software-related transactions, using stablecoins to transfer money is oftentimes faster, cheaper and easier, compared with fiat currency.


Limitations of Stablecoins

While stablecoins provide the stability of coins unlike cryptocurrencies, they have some setbacks or disadvantages. One of them is that stablecoin exchanges request the personal information of clients to verify them. This eliminates the concept of anonymity, a feature that is common in the crypto community.

While major stablecoins, like Tether, have a trusted foundation, many stablecoins are not as established. This makes them more prone to fluctuations and even total collapse. Investors should do proper research before investing in stablecoins.

Different stablecoins range in how centralized or decentralized they are. More centralized stablecoins may not appeal to individuals that prefer decentralization - a core value within the crypto society.