If you’ve dipped your toe into cryptocurrencies for any length of time, stablecoins are bound to have come up across your radar. They’ve become an integral part of the crypto ecosystem and account for billions of dollars of transactions every day. But what exactly are they? What problem do they try and solve? And what can you do with them? Let’s take a look.
What are stablecoins?
Stablecoins refer to a type of cryptocurrency that try to offer price stability. This is usually achieved by being backed by a reserve asset but can also be achieved by the usage of computer algorithms. We’ll go more in depth about what exactly this means a little later. First, though, it’s worth going over why an asset like this is even needed.
Why are stablecoins so popular?
Participation in the world of digital currencies has many potential upsides, but its also fraught with well-documented instability.
Enter stablecoins.
By providing a digital currency with a stable price, stablecoin issuers try to offer people and institutions the best of both worlds: exposure to digital asset markets without the volatility that is inherent in cryptocurrencies such as Ether or Bitcoin. It’s an elegant solution that has broad appeal. Hence the widespread adoption.
How do stablecoins work?
Stablecoin issuers try to maintain price stability in three main ways:
- Backing their coin by fiat currency or fiat-denominated assets,
- Collateralizing their coin with other cryptocurrency,
- Using computer algorithms.
An example of the first type of cryptocurrency, known as off-chain collateralized stablecoins, would be a USD-pegged coin like USDC. One USDC has a value equivalent to that of $1US. This price remains stable because USDC’s issuer only mints as much USDC as they have actual USD in their bank reserves.
Then there’s cryptocurrency-backed stablecoins, which are known as on-chain collateralized stablecoins. For these, a cryptocurrency or a selection of crypto is used to peg the price of the coin. However, the main difference is that these coins are usually overcollateralized to account for the volatility of many cryptocurrencies. For example, a coin collateralized by Ethereum (ETH) might hold $2 of ETH for every $1 of stablecoins it mints. This helps it maintain its price even if ETH’s value dropped by 50%.
Finally, algorithmic stablecoins use computer code to maintain a stable price. Think of these algorithms as the coin’s “central bank.” They will restrict or increase the supply of these stablecoins to the market in order to achieve a consistent price.
What are stablecoins used for?
So, that’s a rough breakdown of what stablecoins are and how they work, but what are they actually used for? As digitally native assets, stablecoins can be used in any variety of ways that other cryptocurrencies can. However, there are a few use cases that are particularly popular.
For starters, you can earn interest on your stablecoins. This option has proven very popular among retail investors as well as institutions. The last several years has seen an ever-increasing expansion of crypto banking services—think traditional savings accounts but for your crypto. You deposit funds. The funds are lent out by the bank. The bank pays you interest.
The difference, though, is that because cryptocurrency markets are highly unsaturated compared with traditional finance, and highly volatile, these services can pay returns to customers that average 8-11%. (1) Numbers that are unthinkable in the current low-interest rate climate of traditional banks.
Stablecoins are also being used to transfer value over great distances without friction and with very low fees. If you want to send any sum of money across international borders with a bank it can take days or weeks and cost a significant amount of money. In contrast, with stablecoins, you can send millions of dollars from one digital wallet to another, anywhere in the world, for negligible costs. This is useful for companies or traders trying to arbitrage on different international cryptocurrency exchanges. But it’s just as useful for the migrant worker sending a remittance to their family back home.
Saving is also a very important component to stablecoin usage. In developed countries with strong economies and stable national currencies, it’s often taken for granted that when you get your paycheque every two weeks, that money will maintain its purchasing power for the days and weeks ahead. It’s easy to forget that this is not the case in many developing countries where hyperinflation and political instability could mean that the nice-looking paycheque you got yesterday might not be able to buy you much of anything tomorrow.
However, in countries like Nigeria, Turkey, and Lebanon, which have all experienced recent bouts of extreme inflation, thousands of young, digitally fluent citizens, have been purchasing cryptocurrencies as stores of values. (2)
While stablecoins have their detractors and are bound to face increased scrutiny from regulators and governments, they have proven to be an important part of the cryptocurrency ecosystem and will likely continue to be for the foreseeable future.
–Haan Palcu-Chang, Crypto Content Specialist
Sources
- “10% Yield on your USD Stablecoins? Here are the top 4 options!,” Data Driven Investor: https://medium.datadriveninvestor.com/10-yield-on-your-usd-stablecoins-here-are-the-top-4-options-96771a4a39c3
- “Stablecoins find a use case in Africa’s most volatile markets,” Rest Of World: https://restofworld.org/2021/stablecoins-find-a-use-case-in-africas-most-volatile-markets/
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