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What Is a Stablecoin And How Does It Work?

What Is a Stablecoin
Written by Peace

Many believe cryptocurrency is the currency of the future that has already began. But a concern has remained about its high volatility.

This is the solution stablecoins aim to bring. But what is a stablecoin and how do they do it? Let’s find out.

What is a Stablecoin?

A cryptocurrency that is pegged to a fiat currency like the US Dollars, or asset like Gold is known as a stablecoin.

Stablecoins fills the major loophole of cryptocurrencies that limits the widespread use of popular digital coins like Bitcoin in everyday transaction.

A better view of Stablecoins

Popular cryptocurrencies like Bitcoin still remain unstable and highly volatile. For instance, between March 2020 and April 2021, Bitcoin saw an incredible upward soar from $4,000 to $64,000 only to come crashing by 50% two months after.

Studies have shown that cryptocurrencies can make 10% change in value in a few hours.

Although this volatility can be beneficial when used in everyday transactions, it poses a risk to both sellers and buyers.

The seller may run into a loss if the value of the digital currency depreciates, while the buyer will if it appreciates after the transaction.

Read Also How Is the Price Of Bitcoin Determined? 

Why Stablecoins are important

Stablecoins like the USDC are pegged to a fiat currency like the US Dollars, when this is done the fiat currency is retained in a reserve regulated by a centralized bank. 

Stablecoins offer a solution to the rapid volatility of unstable digital coins while also retaining their profound qualities. These qualities include:

  • Globalized: stablecoins are available and accessible to anyone with internet access.
  • Easy transactions: because it hosted on the internet, it makes transactions faster, cheaper and safer
  • Programmable: thanks to the blockchain technology anyone can add commands to existing stablecoins.

What can Stablecoins be used for?

  • To limit volatility: when cryptocurrencies are pegged to a more stable currency or asset, it minimizes the fluctuations in the value of the digital currency. This makes digital coins more credible and reliable.
  • Assets trading: the blockchain makes it possible to trade, save and transfer stablecoins without the interference of banks.
  • Send money cheaper: transfer fees in the crypto space are insanely cheap. A transaction worth a million dollars of a stablecoin would cost less than a dollar.
  • Make profit: it also offer interests higher than that of banks when you buy and save stablecoins.

Classes of Stablecoins

Stablecoins are classified based on the backup system that give them stability. Based on this, there three classes which are:

  • Fiat-pegged Stablecoins:

These stablecoins use a fiat currency or commodity like Gold as a collateral guaranteeing its value. This is done by holding the fiat currency in a reserve that is regulated by a centralized bank. TrueUSD is a popular example fiat-pegged coin while Digix is backed with Gold.

  • Crypto-pegged Stablecoins:

Here stablecoins are pegged to other cryptocurrencies. This sounds problematic you might wonder, how can you back a volatile coin with another volatile coin?

Well this have been remedied by a process called over-collateralization (i.e making sure the backup cryptocurrency is valued more than the stablecoin that is being created at least by 50%).

A backup cryptocurrency of $30 million can be kept as reserve to issue a $15 million stablecoin. This serves as an insurance against volatility.

  • Algorithmic Stablecoins

This class of stablecoins instead of keeping assets as reserve, operate by controlling the amount of the coin in supply via a preset computer program or algorithm. 

This is the same principle employed by centralized banks, who don’t depend on reserves to preserve the value of the currency they issue. TerraUSD (UST) is an example of algorithmic stablecoin.

Read Also What Is Etherscan, And How Do You Use It?

Regulation of Stablecoin

Stablecoins are a routine subject to the scrutinizing lenses of regulators, maybe because of its whopping $130 billion market valuation, and the disruptive potential it has on the whole financial system.

International agencies like international organization of securities commissions (IOSCO) has pronounced that stable coins alongside payment systems should be regulated as a financial market infrastructure.

This pronouncement was made in October 2021. 

Most popular stablecoins

Stablecoins fall shy in popularity when compared to other cryptocurrencies because they do not offer the “gold-rush get rich quick” opportunities.

Notwithstanding, some of them have managed to gain substantial popularity. Among them are:

  • Tether (USDT): valued at $82 billion
  • USD Coin (USDC): valued at $49 billion
  • Binance USD (BUSD): valued at 17 billion 

This quite an appreciable sum until you compare it with the big names in cryptocurrency like the Bitcoin and Ethereum that is worth a collective $802 billion.

Conclusion 

Stablecoins has been an honest attempt to solve the major limitation of cryptocurrencies which is instability.

But the question to how effective they will turn out to be and how profitable they will become are yet to be answered.

There are a lot of potentials in stablecoins but one is advised to seek professional guidance before investing.

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Peace

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