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What are stablecoins?

Stablecoins are digital assets that mimic the value of fiat currencies such as the dollar or euro. They allow users to transfer values worldwide cheaply and quickly while maintaining price stability.

Cryptocurrencies such as Bitcoin and Ethereum are known for their volatility compared to fiat currencies. This was expected since blockchain technology is still very new, and the cryptocurrency markets are relatively small. The fact that the value of the cryptocurrency is not tied to any asset is interesting from the point of view of the free market but can be burdensome from the point of view of usability.

As a medium of exchange, cryptocurrencies are excellent from a technological point of view. However, fluctuations in their value eventually made them very risky investments and not ideal for making payments. By the time of the transaction, the coins may be worth significantly more or less than they were at sending.

But stablecoins do not have such a problem. These assets see a slight price movement and closely monitor the value of the underlying asset or fiat currency that they mimic. Thus, they serve as safe-haven assets in unstable markets.

There are several ways in which a stablecoin can maintain its stability. Next, we will look at this in more detail and detail.

How do stablecoins work?

There are several categories of stablecoins, each of which is tied to its units in its way. Below are some of the most common types of stablecoins.

Fiat-backed Stablecoins

The most popular type of stablecoin is the one that is directly backed by a fiat currency with a ratio of 1:1. We also call these secured coins fiat stablecoins. The central issuer (or bank) holds a certain amount of fiat currency in reserve and issues a proportional number of tokens.

For example, an issuer can own one million dollars and distribute one million tokens worth one dollar each. Users can freely trade them as if they were dealing with tokens or cryptocurrencies, and holders can exchange them for the equivalent in US dollars at any time.

There is a high degree of counterparty risk here, which cannot be reduced: in the end, the issuer must be trusted. The user cannot determine with certainty whether the issuer has funds in reserve. At best, the issuing company can try to be as transparent as possible when publishing audit results, but the system is far from hopeless.

Stablecoins backed by cryptocurrency

Stablecoins supported by cryptocurrency reflects their counterparts supported by fiat currencies, with the main difference being that the cryptocurrency is used as collateral. But since the cryptocurrency is digital, smart contracts handle the issue of units.

Cryptocurrency-backed stablecoins have minimal credibility, but it should be noted that voters determine monetary policy as part of their governance systems. This means that you do not trust any issuer, but you are sure that all network participants will always act in users' interests.

To purchase this type of stablecoin, users fix their cryptocurrency in a contract that issues a token. Later, to get their collateral back, they pay the stablecoins back into the same contract (along with any interest).

The specific mechanisms that enforce binding vary depending on the design of each system. Suffice it to say that the combination of game theory and network algorithms encourages participants to maintain a stable price.

Algorithmic stablecoins

Algorithmic stablecoins are not supported by fiat or cryptocurrency. Instead, their binding is entirely provided by algorithms and smart contracts that manage the supply of issued tokens. Functionally, their monetary policy accurately reflects the approach used by central banks to manage national currencies.

You may have heard that this category of tokens is called unsecured stable coins. This is technically incorrect since collateral is secured, although not the same way as the previous two types of coins. In a black swan event, algorithmic stablecoins may have some pool of collateral to handle exceptionally volatile market movements.

Scenarios for using stablecoins

Secured stablecoins are by far the most common in practice. Examples of these coins include USD Tether (USDT), True USD (TUSD), Paxos Standard (PAX), USD Coin (USDC), and Binance USD (BUSD). However, copies of the other two categories above are also available. Bitshares USD and DAI are cryptocurrency-backed coins, while Carbon and the (now defunct) Basis are examples of algorithmic variants.

This list is far from exhaustive. The market for stable digital currencies is vast, as evidenced by the proliferation of hundreds of stable coin projects.

Pros and cons of Stablecoins

The main advantage of stablecoins is their ability to provide a medium of exchange that complements cryptocurrencies. Due to the high level of volatility, cryptocurrencies have not been able to find widespread use in everyday applications, such as payment processing. These stabilized currencies solve this ongoing problem by providing a higher level of predictability and stability.

Acting as protection against volatility, stablecoins can also play a role in integrating cryptocurrencies with traditional financial markets. Currently, these two markets exist as separate ecosystems with very little interaction. In the presence of a more stable form of digital currency, cryptocurrencies will likely be used more often in credit and loan markets, which have been dominated exclusively by fiat currencies issued by the state.

In addition to their usefulness in financial transactions, stablecoins can be used by traders and investors to hedge their portfolios. Allocating a certain percentage of the portfolio to stabilized coins effectively reduces the overall risk. At the same time, preserving the value that can be used to buy other cryptocurrencies when prices fall can be an effective strategy. In the same way, these coins can be used to "fix" the profits received when prices rise without cashing out the money.

Despite their potential to support the widespread adoption of cryptocurrencies, stablecoins still have limitations. Fiat-backed options are less decentralized than conventional cryptocurrencies since a central entity must store supporting assets. As for cryptocurrencies and unsecured coins, users need to trust the broader community (and the source code) to ensure the longevity of the systems. These are still new technologies, so it will take time to mature.

Final thoughts

Despite some disadvantages, stablecoins are an essential component of cryptocurrency markets. These digital currencies can remain more or less stable through various mechanisms at set prices. This allows them to be reliably used as a means of exchange and as a haven for traders and investors.

Although they were initially designed to provide traders with an effective risk management tool, it is evident that the use of stablecoins goes far beyond trading. It is a powerful tool that can strengthen the cryptocurrency space, serving in cases where unstable alternatives are not ideal.

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