Stablecoins are an essential part of the crypto ecosystem. What makes them different from other currencies like Bitcoin and Ethereum is that their price is stable relative to another asset. Most cryptocurrencies are prone to fluctuations, sometimes dramatically so. This can be great for speculators who quickly trade in and out of currencies to make a profit, but for certain use cases like spending crypto or portfolio diversification during times increased volatility, stable prices are crucial.
What makes stablecoins, stable?
Actually, it is important to realise that no asset out there is ever completely stable. Whether we’re talking about gold, real estate, the US dollar or Bitcoin, price discovery is an ongoing process. However, unlike cryptocurrencies that are completely exposed to whatever the market dictates, stablecoins are designed to absorb reasonable fluctuations while retaining a fixed value. When it comes to real-world applicability, they behave more like strong fiat currencies such as the US dollar, but then with the benefits of crypto.
There are two main types of stablecoins:
- Fiat collaterised
- Crypto collaterised
Fiat collaterised (trusted)
This type of stablecoin is collaterised by an equal amount of fiat currency, usually held by a central custodian. For a USD stablecoin for example, you send one USD to the custodian and in return you get 1 unit of that stablecoin which equals 1 USD in value. Holders of these tokens are then guaranteed the option, at any time, to redeem their token for fiat again. This type of stablecoin includes tokens pegged to fiat currencies like USDT (US dollar), GUSD (US dollar), QCAD (Canadian dollar) and EURS (euro). Other stablecoins may be pegged to different assets such as DigiX, where one DGX coin equals one gram of gold.
Crypto collaterised (trustless)
Basically, these stablecoins are backed up by another cryptocurrency which unlike their fiat collaterised counterparts makes it possible to keep third parties (i.e. a central custodian) out of the equation. Crypto collaterised stablecoins are generally over-collaterised. This means that as the price of the base cryptocurrency fluctuates, the price of the stablecoin in unaffected. A good example of this type is DAI, the stablecoin created by the MakerDao project. Based on Ethereum, it is one of the most prominent stablecoins in the DeFi ecosystem embedded in many borrowing and lending protocols such as Aave and Compound.
There is a third model for creating stablecoins that uses smart contracts programmed to maintain the peg by increasing and decreasing the supply of the stablecoin to counter fluctuations in the market. This model is referred to as non-collateralized but it is still somewhat experimental with no significant market share to speak of.
Use cases for stablecoin
Stablecoins are an important part of driving crypto adoption. They have always been considered a crucial part of making crypto go mainstream and being accepted worldwide with a range of use cases supporting that.
Crypto money designed for spending
Stablecoins make it possible to turn crypto holders into crypto spenders. As a form of digital fiat currency, stablecoins are perfect for payment systems used in everyday transactions and global commerce. For example, Flexa is big on stablecoins and has created partnerships with merchants to accept stablecoins for payments. It helps to lower processing costs, reduce fraud loss, and reach entirely new sets of customers. The company says that already 40,000 points of sale across the US and Canada are connected to Flexa payment services, tapping into the crypto-economy and all the benefits digital currencies have to offer.
Better trading experience
For crypto traders, stablecoins make it easier to move between crypto and fiat currency at lower cost that cashing out completely. The reason for doing this could be hedging exposure to seek protection from extreme volatility in assets that are uncorrelated to crypto assets. Similarly, when buying crypto involved stablecoins as a bridge currency, it gives traders the ability to wait for the perfect time to take their positions. This would be a different experience using a direct fiat-to-crypto service such as Bitcoin ATMs.
Like with any other asset, it’s important to diversify the stablecoins you hold in your crypto portfolio. This applies to both the fiat currency they are pegged to but even within the same fiat currency it is advised to hold more than one stablecoin.
For example, holding stablecoins across USD, EUR, CAD and JPY achieves diversification, but still leaves you exposed to the reliability of a single stablecoin per fiat currency. If you’re only holding GUSD for US dollar, then all your eggs are still in the Gemini basket. Instead, it’s better to spread your USD stablecoin holdings across a number of coins such as GUSD, USDT, DAI, USDC and so on.
Originally published at https://academy.aax.com on September 7, 2020.