What Are Stablecoins And How Do They Work?

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The cryptocurrency world has seen a substantial influx of stablecoins over the years. Every stablecoin is a digital asset representing the value of underlying assets or code. Minting such assets requires companies to have sufficient reserves. 

The Rise of Stablecoins

Numerous stablecoins have come to fruition in the cryptocurrency space. These pegged digital assets make it easier for users to buy, sell, and trade Bitcoin and other cryptocurrencies. More importantly, they can rival any fiat currency-based system to transfer value globally. A blockchain-based asset is much faster, cheaper, and more efficient to use.

Unlike traditional crypto-assets like Bitcoin or Ethereum, a stablecoin has no fluctuating value. If 1 USDT represents $1, it needs to maintain that value at all times. Keeping the value at this limit prevents speculation and volatility. Some people even believe stablecoins can bring more positive attention to blockchain technology as a financial sector tool. 

How Do They Work?

A stablecoin is a very intricate creation, as it needs to meet specific criteria at all times. Ensuring the value never surpasses $1, but doesn’t drop below $1 either, is a lot more complicated than people think. After all, numerous exchanges have trading pairs between stablecoins and fiat currency. On the surface, nothing prevents traders from trying to influence the price of a stablecoin. In reality, things work a bit differently. 

The Fiat-Backed Option

In the cryptocurrency world, a common approach is to create a stablecoin that has its value tied to a fiat currency. This can be the US Dollar, Pound Sterling, Hong Kong Dollar, Euro, or anything else.  Opting for this method ensures the stablecoin can always be redeemed for that fiat currency. Assuming the issuer has the amount of fiat currency in reserve according to the number of tokens they create, this redemption process will be straightforward. 

One downside to this approach is how the entity issuing the stablecoin needs to be trusted at all times. If they are not transparent about their holdings,  questions will arise sooner or later. Introducing such counterparty risk is a problem and may ultimately hinder the growth of stablecoins beyond the cryptocurrency industry. For now, entities like Tether and Binance are somewhat transparent about their fiat currency reserves. Further improvements may be necessary. 

Using Crypto-Assets As Backing

Another concept to explore in the stablecoin segment is backing these assets with other crypto-assets. For example, a new stablecoin can be created, supported by Bitcoin reserves. In this instance, Bitcoin serves as the collateral for the new digital asset. The minting process for a crypto-backed stablecoin is often done through smart contracts to minimize counterparty risk.

That said, this model introduces an entirely new challenge. As crypto-assets are volatile, they don’t make for the best collateral. As such, a monetary policy o sorts has to be created. A governance system needs to be created, allowing holders of the governance token to put everything together. Whether these “decision-makers” act in the rest of the users’ best interest is never certain. 

Minting a crypto-backed stablecoin follows a different procedure. Rather than having stablecoins coined based on the fiat currency reserves, users need to use their crypto holdings as collateral to create the stablecoin. Once users return their minted stablecoins to the smart contract, they will receive their original collateral back. 

A Code-Based Approach

A smaller niche market in the stablecoin industry aims to create pegged currencies without any collateral at all. Instead, developers use algorithmic code to ensure the peg remains active. The code is responsible for balancing the available supply depending on external circumstances. Such an approach can lead to tokens being minted and burned when necessary.

Whether this latter option will ever gain significant traction remains unclear. It sounds like a good idea on paper, yet there is nothing to give the stablecoin its face value.

A Solid Concept, But Drawbacks Remain

Creating new financial instruments out of thin air is always a dangerous game. While stablecoins provide a new form of exchanging and transferring value globally, competing with fiat currencies and digital payments will pose challenges. As such, it remains unlikely that these assets can gain broader adoption in the future. 

That said, stablecoins can still fulfill the role of providing a more accessible gateway into cryptocurrencies. The current onramps for fiat currency require thorough verification procedures, further eroding user privacy. With stablecoins – especially those backed by crypto assets or a coded peg – there are no intermediaries involved. Whether that will drive broader adoption of Bitcoin and Ethereum remains unclear.

Fiat-backed stablecoins, on the other hand, have a certain degree of centralization and a high trust requirement. Moreover, they will only be successful if sufficient people are willing to part with their dollars or euros. A few of these assets exist, but most people tend to flock to the same offering. That situation is far from ideal, especially if one firmly believes in decentralization. 

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