What is a stablecoin?

A stablecoin is a cryptocurrency created with the purpose of keeping its value stable. To maintain this little variability in their market price, they need a backup backup. The backup relationship is made with other financial assets, fiat currencies, raw materials and even other crypto assets. 

Las stablecoins or stablecoins They are nothing more than cryptocurrencies created with the purpose of maintaining a price with little variation in the market, generally representing a fiat currency within a blockchain. In this way, stablecoins seek to maintain the characteristics and advantages of cryptocurrencies, while representing fiat assets with a certain proven stability in their valuation.

To achieve stability in their valuation, stablecoins generally use collateralization with another financial asset. In this way, they seek to keep their value stable in the face of various market situations.

Why were stablecoins created?

All the stablecoins emerged from the need to control the extreme volatility of cryptocurrencies. Cryptocurrencies, despite being a complete economic revolution, are very unstable in their valuation. This volatility is linked in many ways with speculation in the markets. A situation that is evident in the continuous bullish and bearish trends suffered by the cryptocurrency markets.

The objective behind this is to allow the use of stablecoins by users concerned about said volatility. Well, resolving this point would accelerate the adoption of cryptocurrencies by users and businesses.

In this regard, rune christensen, Founder of MakerDAO, commented that:

“The real key to unlocking the great potential of blockchain will come with the widespread adoption of stablecoins.”

What are the ways of supporting stablecoins?

To maintain the value of stablecoins they need a physical, monetary or tied to another cryptocurrency. These backup strategies are what help achieve that purpose. In this way they have managed to offer members of the community consistency in the prices of crypto assets. The forms of backup for stablecoins are as follows:

Fiat currency support

This is the most common backup method for stablecoins. Generally, the cryptoactive is backed by guaranteeing each token of the network in the same proportion (1: 1). Currencies such as the US dollar, the euro or the Japanese yen are used. This means that for every token, its value will be guaranteed by one unit in fiat currency.

However, this system has its contradictions with the fundamental concept of a cryptocurrency. Well, cryptocurrencies are oriented not to depend on a centralized entity like fiat currencies do.

Another point against is that they can present inconveniences regarding the transparency of their reservations. To avoid this situation, audit processes must be constantly carried out. All in order to guarantee an ideal backup of the issued tokens. Additionally, fiat-backed stablecoins need to raise capital to project broad adoption of the cryptocurrency itself.

Examples of this type of stablecoins are: USDC, BUSD, TrueUSD y Tether (USDT).  Both backed by the US dollar and managed by companies that act as central entities. In case of Tether (USDT) It is one of the most successful: built in 2014, its participation is currently around 2.600 billion dollars. At Bit2Me we have dedicated a space for you to get to know the project more closely USDT.

Support in commodities

This is another fairly common form of backup in stablecoins. This works on the basis of supporting the value of the stablecoin using commodities. Among these are gold, silver, diamond or oil. The backup ratio can be as simple as a 1: 1 value or depend on inexpensive formulas.

For example, Digix Gold, is a stablecoin that establishes that; every gram of gold equals token DGX. In this way, it manages to provide the crypto asset with a balance in its price. In this case, the gold is also kept in bullion as a reserve. This allows them to be certified and audited by a trusted third party, providing assurance of their endorsement.

Support for other crypto assets

This is another widely used stabilization scheme that is generally very complex. This is because a complex economic system is used to stabilize prices. This seeks to protect the price of the stablecoin with respect to the change in the value of the backup crypto asset. However, this system aims to get rid of the centralism of supporting stablecoin using fiat currency.

The method this time is to back up a token with the reserves of another cryptocurrency. But this can result in a drawback caused by the instability of the cryptocurrency itself.

However, the proposed solution is to grant the token a double backup by the other cryptoactive, that is, a 1: 2 ratio, that even with the price variations in the market that the cryptocurrency suffers, the token can maintain the desired stability in yours. As a curious note, most stablecoins that use this method are tokens of the type ERC-20. An example of this system is DAI, a cryptocurrency backed by the value of Ether and a wide portfolio of tokens on this blockchain. In fact, here at Bit2Me Academy we also dedicate a space so that know everything about DAI and its creators, MakerDAO.

Stable tokens but without a direct backup from another asset

The stablecoins under this figure do not have directly endorsement or guarantee of any asset that helps them stabilize their price. On the other hand, they use a perspective called Seigniorage shares or seigniorage actions. This system uses smart contracts to act as a central bank. With which it is allowed, according to supply and demand, to increase or decrease the contribution of money on the blockchain. An action that stabilizes the value of token in the market.

An example of this type of stablecoin is NUBITS y USDX. However, the operation of these stablecoins is strongly criticized for their poor decentralization. Furthermore, they are strongly linked to current securities regulations in many countries. For example, the platform BASIC, It ceased its functions due to the regulations of the SEQ.

Stablecoin public vs. private

Stablecoins can also be classified as public and private. Private are those issued by commercial and public companies are issued by central banks. Stablecoins also offer the possibility of developing an international currency, linked to a basket of fiat currencies or commodities. This would further reduce volatility. They can protect themselves against fluctuations in the value of national currencies. It also has the potential to dramatically increase the efficiency of cross-border settlement.

To date, private companies have been the pioneers in the development of stablecoins. This is due to the barriers faced by central banks seeking to offer fiat digital currencies.

For example, a major commercial bank, MUFG (Mitsubishi UFJ Financial Group). His plan is to roll out a stablecoin that will peg 1: 1 to the Japanese yen. The MUFG stablecoin, will be launched in select quantities to customers in Japan. This as part of a large scale test suite. Users will be able to use an application to convert their fiat deposits into MUFG currencies. They can then be used to make payments in stores and restaurants and can be transferred to the accounts of other users.

Another example of the development of stablecoins in the private sphere is the launch of a US dollar stablecoin for Circle. This is a payment company backed by Goldman Sachs, with the support of Coinbase.  CircleUSDC, it runs on the Ethereum blockchain and is intended to be used by customers for payments and transactions within the cryptocurrency space.

Stablecoins use cases

Global currency

Stablecoins are designed to tackle the problem of volatility, acting like a bridge between cryptocurrencies and fiat currencies. A stable and decentralized digital currency could become a medium of global exchange. This is an especially important application in emerging markets experiencing debilitating levels of inflation and economic chaos, such as Argentina and Venezuela.

Decentralized Financial Services

Institutional arrangements currently restrict access to capital markets. Financial market transactions generate friction, and transaction costs are scale-sensitive, and information costs are considered the most important component of these costs.

The rationale for the existence of a banking system is that banks can function as financial intermediaries. This is because banks have a competitive advantage in gathering information and evaluating credit risk. However, the relationship between finance and the economy is not neutral. Misallocations of funds can occur and financing and capital gaps can arise.

Given this, small companies are at a disadvantage. This is because capital markets tend to prioritize large, established companies. As a result, small and new businesses find it difficult to obtain seed capital and early expansion.

Stablecoins seek to solve this problem by allowing access to financing. Example of it; they are the fair loan and derivatives markets. They also seek to reduce costs in the supply chain and international trade by eliminating intermediaries who charge fees for guaranteeing secure transactions, granting stable capital and intermediating cross-border initiatives.

Advantages and disadvantages of stablecoin

Advantages

1. Stablecoin are financially backed by real assets. This is especially true with fiat and commodity based stablecoins. Thanks to this, coin holders turn to an asset that is tangible and backed by real value. Allowing them to redeem these assets at the conversion rate to take possession of the actual assets.
2. It offers great stability in its market value. Although stability does not mean invariance, stablecoin prices are not as susceptible to large variations in cryptocurrency prices. These characteristics are something that investors of this type of cryptocurrencies greatly appreciate.
3. They offer great liquidity thanks to tokenization. This is especially true when stablecoins base their stability on commodities, as it brings more liquidity facilitating better price formation.

Disadvantages

1. The stablecoin scheme is highly centralized. The need for third parties, such as suppliers, custodians and the project itself, shows this centralization.
2. Audit processes are expensive and time consuming. This due to how intricate the operating system can be.