What is a Stablecoin?
Bitcoin (BTC) and Ethereum (ETH) are the two dominant cryptocurencies, but their prices are volitile. Speculation with cryptocurrencies can cause prices to increase or decrease. In the long run, this will affect the real world adoption of cryptocurrencies. Businesses and consumers, do not want to be exposed to unecessary currency risk.
This is where stablecoins are needed. A stablecoin is backed by a reserve which corresponds with the coins in circulation.
In this guide, we will look at different types of stablecoins, why stablecoins are important, and what they bring to the market.
Definintion of a Stablecoin
A stablecoin is any cryptocurrency pegged to a stable asset, such as gold or fiat currencies. Often times stablecoins are linked to a DAO (decentralized autonomous organisation) which controls issuance and pricing.
A traditional stablecoin is backed by a reserve which corresponds with the coins in circulation. The collateral can be fiat currency like (ZAR, USD, or EUR), a cryptocurrency or another asset like gold. In theory, a stablecoin will remain constant in price, as it is a representation of a known amount of an asset.
Importance of Stablecoins
Cryptocurrencies like Bitcoin (BTC) and Ethereum (ETH) are, by all means, disruptive and game-changing, they serve as an exemplary medium of exchange, but given their volatility, this can pose a problem for users. You cannot pay someone a salary with cryptocurrency, if the purchasing power of their salary keeps fluctuating. It is also difficult to transact with.
Many users also simply want to hold their cryptocurrency and not use it. There are many factors which point to the crypto-world needing a stable coin.
Do we need a Stablecoin?
One of the most common arguments for stablecoins is that they are a hedge against volatility. Cryptocurrencies have been too volatile for mainstream use. Loans, salaries and other basic financial contracts are poorly served by volatile currency.
Stable currency isn’t available in much of the world. You can insulate yourself from market volatility by holding stablecoins instead of cryptocurrencies like Bitcoin (BTC) or Ethereum (ETH).
Types of Stablecoins
There are a wide variety of stablecoins, which are generally divided into 3 types.
A fiat-collateralised cryptocurrency is a cryptocurrency that is backed by real world currency like the Rand (ZAR), or United States Dollar (USD). It works by depositing fiat into a bank account and issuing stablecoins to a ratio to the fiat. Usually a 1-to-1 ratio.
When a useris ready to liquidate their stablecoins back into fiat, their stablecoins are destroyed, and the fiat is returned to the user. Some examples of fiat-collateralised stablecoins are Tether (USDT), and TrueUSD (TUSD).
The main benefit of this sort of architecture for a stable coin is the price stability, this type of stablecoin can be 100% price stable. This is the simplest type of stablecoin.
Fiat-collateralised stablecoins are often centralised as a trusted custodian. Fiat-collateralised stablecoins are also highly regulated and needs audits to ensure transparency.
Crypto-collateralised stablecoins try to combat centralisation by moving away from banks and fiat. They work similar to fiat-collateralised stablecoins, except this time the collateralised reserves are not fiat, but instead as the name suggests, another cryptocurrency or multiple cryptocurrencies.
By doing this, the entire ecosystem of the stablecoin can live on the blockchain. Crypto-collateralised stablecoins are over-collateralised. This means that for every Rand (ZAR) or Dollar (USD) of the stablecoin, there is more than one Rand (ZAR) or Dollar (USD) of cryptocurrency in reserve. the more volatile a cryptocurrency is, the higher this ratio needs to be.
This type of stablecoin, in most scenarios is fully decentralised. Crypto-collateralised stablecoins can be liquidated quickly, and cheaply. It is also very transparent, as the history of transactions can easily be inspected.
Crypto-collateralised stablecoins still need to overcome some challenges. They are less price stale than fiat and can be auto-liquidated during a price crash.
Non-collateralised, as its name suggest, are stablecoins that are backed by nothing, but their supply is algorithmically governed by its smart contracts which keeps expanding or contracting to keep the price stable.
A non-collateralised stablecoin maintains value by people expecting that it will maintain a certain value. The main non-collateralized approach is the seigniorage shares method. The seigniorage shares method uses smart contracts that automatically expand and contract the supply of the non-collateralized stablecoin using algorithms to maintain its value.
Stablecoins are crucial to the survival of the crypto-sphere, and brings much needed stabilisation. Stablecoins are a massive opportunity in the cryptocurrency market because it addresses such a large market.