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How Do Stablecoins Work And Why Do You Need Them

Most cryptocurrencies are not just a store of value. They are also a medium of exchange. However, due to the fluctuation of most of these coins, it gets harder to trade on a day-to-day basis using them. Stablecoins are not like the other coins. They are far more advantageous and present their holder with one thing the others can’t provide; stability.

What Are Stablecoins?

Stablecoins are types of cryptocurrencies. Their prices are designed to be pegged to a cryptocurrency, fiat money, or exchange-traded commodities (such as precious metals or industrial metals).

What Are The Benefits Of Stablecoins?

When it comes to using cryptocurrencies to trade, there is the problem of instability. A cryptocurrency worth a dollar this minute can reduce in value in a matter of seconds.  The introduction of stablecoins like USDC and USDT is an attempt to bring stability into crypto trading. The following are the benefits that stablecoins offer;

Stability

Unlike Bitcoin and other cryptocurrencies that fluctuate at any time, the price of stablecoins is stable, and the value can be quickly recovered without waiting on the decision of the market. Stablecoins are safe to hold because of their durable nature. Although their anonymity also characterizes other coins, stablecoins have proved to be a far more effective way of keeping funds. That is because, unlike other coins that are subject to speculative markets or dramatic rise and fall, stable coins don’t lose their value.

Lower Risk

With stable coins, you can trade your volatile currency for stable coins to lower the risk. For example, when you trade a volatile coin like Ethereum for tether, you get to retain that value of Ethereum without fear of fluctuations. Then, when you are ready to trade Ethereum again, you can simply exchange the tether for Ethereum with the same value you traded it in. 

Speed, Lower fees, And Convenience

Exchanging with stable coins is quicker and more convenient than using fiat money. Also, by using stablecoins, you get to save more money on charges due to transferring funds in fiat currencies.

Are Stablecoins Truly Stable? How Stablecoins Work.

Stablecoins have an unchangeable, stable nature. The whole point of introducing them is to regulate the cryptocurrency market and allow traders to exchange more conveniently. All coins have their ways of maintaining their price stability in order not to lose relevance.

How then are stablecoins able to keep their stable nature? There are two significant ways by which companies can peg the value of their stable coins. First, the coins can either be collateralized or non-collateralized. Under the collateralized stablecoins, we have the fiat-backed, Crypto backed and commodity-backed stablecoins. Non-collateralized stablecoins include the algorithmic stablecoins, i.e., those backed by a smart contract. Both methods have their pros and cons and have been practiced over the years.

Collateralization Of Stablecoins

First, for a stablecoin to maintain its nature, the exchangers have to believe that the coin can keep its stable nature. Once users lose their trust in the stablecoin, it loses its nature, and the price crashes. To build trust, companies who create stablecoins back the coins with collateral. The collateral is used to prove to the users that the coin is truly stable. For example, every USDT is backed by a dollar, which is the worth of the coin. Now, while some stablecoins are backed by fiat currency, some are backed by cryptocurrencies, and commodities back some others. Each backing has its pros and cons.  

Fiat currency-backed stablecoins are the crypto coins pegged against fiat currencies like dollars, euros, yen, and others, which are used as collateral. The collateral carries the exact value of the coin and is mainly stored in financial institutions regulated by the government.

Some pros of fiat-backed stable coins are

  • Stablecoins backed by collaterals is far more trusted than other coins as it sends a vital sign that the coin is indeed stable.
  • The price is stable.
  • The method is simple.

 Some cons of fiat-backed stablecoins are

  • The coin is frozen and can’t be used for anything else.
  • The risk is attached to the collateral—for example, the closure of the collateral company.
  • It is hard to prove that the company has enough collateral to back each coin.

Cryptocurrency-backed stablecoins are stable coins pegged against crypto assets.  It is a decentralized model characterized by transparency. However, one of the most significant disadvantages of this pegging system is the volatile nature of the collateral. 

Pros of crypto-backed stablecoin are

  • The collateral exists on the blockchain (it is decentralized)
  • It can be liquidated fast
  • It is easy for investors to monitor the collateral.

Cons of crypto-backed stablecoins are

  • Even though the collateral is on the blockchain, it is incredibly volatile, and the value might suffer a decrease. That means more of the cryptocurrency has to be used to back the stablecoins. In this case, the company will hold over a hundred and fifty percent of the cryptocurrencies to make up for the decrease in value.
  • The success is tied to the performance of a cryptocurrency. It is therefore not safe to use as collateral. 

Commodity-backed stablecoins are coins pegged against hard assets like precious metals, especially gold. Another hard asset used as collateral is real estate.

Pros of commodity-backed stablecoins include

  • It is safer to use because the coin is backed completely
  • Price is stable.
  • It is highly liquid 
  • The method is simple to understand and use.

Cons of commodity-backed stablecoins include

  • It requires a trusted third party to hold. The third-party will most likely demand payment or collect a commission for having such an asset.
  • A regular audit is needed to ensure the asset is in good condition and untouched.

Use Of Smart Contracts In Maintaining The Coin Supply In The Exchange Market

Each stablecoins company has a set of rules (smart contract) that guide the increase or decrease of the number of coins in circulation. For example, in cases where there is an increase in demand for a stablecoin, the smart contract increases the supply of the coin in circulation to stop the value from increasing. And if there is an increase in the sale of the coin, the smart contract reduces the coin in circulation to prevent the coin from reducing in value. That way, the coin continues to maintain its value. Please note that Coins that are backed by smart contracts do not use collateral.

Pros of stable coins backed with a smart contract include

  • The company does not need to hold any assets to back the this coin.
  • It has an independent nature.

Cons of stablecoins backed with a smart contract include

  • Manipulating the supply of the coins is not realistic, as it doesn’t guarantee that the coin will hold.
  • The scheme is complex to implement.
  • It is highly vulnerable and susceptible to sudden crashes.
  • There’s no way the system can be liquidated in case of a sudden crash.
Stablecoins

Is Stablecoin a good investment?

Since the value of stablecoins doesn’t increase, how do the creators and the users benefit from creating and using the coins? 

The Company

Some companies make money from the fees charged on the use of the stablecoins, while others use stablecoins to draw users’ attention to their other products or services. Another way companies make money from stablecoins is through the appreciation of the collateral. According to the books, stablecoin does not change its value. In the case of an increase in the value of the collateral used to back the coin, the profit goes to the shareholders of the creator company. Companies can also make money from stable coins by lending out and receiving interest on the money loaned. 

The Users 

Ordinarily, these coins do not bring in profit if held like other volatile coins. Because of the nonvolatile nature of stablecoin, it does not promise a massive return like volatile currencies when held. However, there are different ways to rake in profits through the use of stablecoins. One of the benefits of stablecoins is the reduction of risk. People who trade take a lot of risks when they invest in Crypto. A fluctuation in the market can cause them to lose billions in the twinkle of an eye. Stablecoins can serve as a strategy to reduce that risk for investors when they swap their volatile crypto for stablecoins. This prevents a decrease in the value of their investment,  thereby saving them more money.

A List Of Stablecoins 

  • USDT (Tether) – fiat collateralized
  • TUSD – fiat collateralized 
  • GUSD- fiat collateralized
  • USDC- fiat collateralized
  • DAI – cryptocurrency collateralized.
  • BUSD- fiat collateralized
  • HUSD- fiat collateralized
  • USDN- contract backed (algorithmic) and crypto collateralized
  • PAX- commodity collateralized
  • RSR- commodity collateralized

A lot of questions keep arising as regards the permanency of stablecoins. Are they just a temporary solution bound to fail? Do enough assets completely back the coins? Well, these coins have proven to be a haven over the years, most especially because of their consistent nature. So, nothing can be concluded just yet about the existence of stablecoins. 

In conclusion, while they are still around, stablecoins should be used to full advantage by both investors and creators. Just make sure to consult an expert to guide you through your investment journey. However, as stable as these coins are, there are still risks of making losses.