Definition, guarantee, how they work

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  • Stablecoins are cryptocurrencies designed to maintain a stable price over time.
  • Stablecoins are often pegged to a fiat currency, such as the US dollar, and backed by collateral.
  • People mainly use stablecoins on DeFi platforms and to hold money within the crypto ecosystem.

While cryptocurrencies and the crypto ecosystem can present exciting and rewarding opportunities, many cryptocurrencies are extremely volatile.

You might not want to spend a bitcoin if you think its price could increase tenfold in a year. Or you might not want to borrow cryptocurrency that might drop in value after receiving the funds. Additionally, it can be difficult and expensive to transfer money between traditional financial systems and cryptocurrency networks.

Stablecoins help crypto users solve both of these issues.

What are stablecoins?

As the name suggests, stablecoins are cryptocurrencies designed to provide stability within a cryptocurrency system. They are often pegged (i.e. have a fixed exchange rate) to a fiat currency, such as the US dollar.

“In an ecosystem like cryptocurrencies, where volatility is typically high, this is an important property,” says Paul Brody, principal and global blockchain leader at Ernst & Young. “If you want to take advantage of blockchain technology without exposing yourself to the price volatility of crypto, this is the way to do it.”

For example, a USD coin (USDC) is intended to always be worth $ 1. Although the purchasing power of the dollar may change over time, it is much less volatile than cryptocurrencies.

There are also stablecoins tied to a commodity, like gold or oil, but fiat peg stablecoins are currently the most popular options.

How do stablecoins work?

The indexed value of a stablecoin is what makes it useful in the crypto world. But this is only possible if coin holders can be assured that they will be able to cash out their stablecoins. To ensure that this can happen, the creators of stablecoin keep reserves of other currencies or assets.

“It’s called collateralization,” says Stephen Stonberg, CEO of Bittrex Global, a cryptocurrency trading platform. “In addition to being tied to another asset, the collateral also includes the buying and selling of affiliated assets through algorithmic mechanisms.”

For example, a stablecoin issuer might promise to hold $ 1 in a bank account for each of the cryptocurrency coins it creates. As long as the warranty – or reserves – is available, coin holders know they will be able to exchange a coin for $ 1. However, there is a risk that the stablecoin issuer does not have enough reserves.

Government agencies have discussed ways to regulate stablecoins and have taken action against organizations that may have distorted their reserve holdings. And stablecoin issuers can share some details about what they hold and where they hold their reserves.

Nonetheless, if you are planning to purchase stable coins, a lack of proper reserves is a potential risk to consider. “In my opinion, the only really acceptable answer is an independent audit,” says Brody. “Not only do you need to know what assets are supporting a particular token, if it is an asset-backed token, but you also need to be sure that those assets are not pledged against other liabilities. . ”

Two common approaches to stablecoin collateral

Stable coin issuers can choose how they wish to keep their stablecoin collateral on reserve. The specifics vary depending on the stablecoin, but most fall into two categories:

  • Off-chain or asset-backed collateral. Asset backed stablecoins maintain reserves in non-blockchain assets. The safest options may be those that hold fiat currency in regulated accounts. But some may hold commodities, such as gold, in reserve. Or some keep part of the funds in fiat currencies and invest the rest of the collateral. “There is a bit more risk here because significant price changes in these assets could threaten the ability of token holders to cash out,” Brody said.
  • Chain collateral or backed by cryptocurrencies. Cryptocurrency-backed stablecoins use cryptocurrencies as collateral. You can deposit and lock other cryptocurrencies to create these stablecoins, and they’re usually oversized to account for volatility. For example, the DAI stablecoin is pegged to the USD (one DAI is equal to $ 1). But you might have to lock in $ 150 of Ether (ETH) to create $ 100 of DAI.

“Another variation of stablecoins are on-shore and off-shore stablecoins,” says Stonberg, a reference to whether stablecoin issuers keep reserves within our countries outside of the United States, which could affect regulatory oversight. “Ultimately there will be a market for both types of stablecoins.”

There is another type of stablecoin that does not have any guarantees. Instead, they use automated algorithms to try to create or reduce the supply and keep the price stable. However, these algorithmic or “stately style” stable coins did not catch on.

How do people use stablecoins?

Stablecoins are mainly used in two ways.

First off, you might want to keep some money in the cryptocurrency system, but you don’t think it makes sense to invest in bitcoin (or some other cryptocurrency) just yet. . Holding the funds in a stablecoin could limit your risk. It’s a bit like keeping money in a brokerage account while waiting to make an investment.

The other, and perhaps more popular, way people use stablecoins is by participating in decentralized finance (DeFi) projects, such as crypto lending and borrowing platforms. Minimizing the risk of volatility for users could make it easier to understand the cost (or profit) that may arise from these transactions.

“For most businesses and individual users, the ability to use stablecoins to manage risk while accessing DeFi and other online services will be the key value proposition and that is definitely what is of interest. our corporate users, ”said Brody.

The financial report

For individuals and institutions alike, stablecoins allow people to stay in the crypto world without the risk typically associated with cryptocurrencies. In Stonberg’s eyes, “what is unique and important about stablecoins is that they represent the bridge between two worlds – cryptocurrencies and traditional finance.”

However, if you plan to buy Stable Coins or use them to lend or borrow money through a DeFi platform, be aware that there is always a risk.

Asset-backed stablecoins might not hold enough assets to fully secure their outstanding coin balance. And even if they are oversized, crypto-backed stablecoins could run into problems if other cryptos experience significant declines.


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