Stablecoins represent digital actives that hold a steady store of value with respect to the external conventional asset class that is pegged to them. These assets were created to mitigate price volatility as their value is backed by traditional assets such as a combination of fiat currencies, a separate fiat currency, gold and others.
Due to the support from traditional investments, the market is confident in their price, so stablecoins are often the preferred option for residential and commercial customers of cryptocurrencies. In this article, we will explain the operating models of stablecoins and review the types of stable coins available on the market.
Benefits of stablecoins
Many investors view conventional cryptocurrencies, that are short on long-term and short-term sustainability, as risky. Cryptocurrencies cannot serve as a direct substitute for fiat currencies because of their unstable nature, price volatility threatens the purchasing power of cryptocurrency holders.
Stablecoin owners don’t have to worry about price volatility. Here is a short list of advantages that the stablecoin market offers:
Virtually no volatility in price
In order to see the unstable nature of cryptocurrencies, you only need to look at the oldest of them all, which is Bitcoin. Ever since its creation, Bitcoin has experienced a number of ups and downs. For example, BTC reached a historic maximum of $64,000 in early 2021, but fell below the $30,000 level by the summer of that year. By November 2021, the coin’s price had risen again to $68,000, but by January 2022, it had fallen back to around $35,000. At the end of 2023, the price of BTC is on the rise again.
Users see stable coins as a more palatable type of digital currency because their prices are not as volatile as BTC or ETH.
Cross-border payments and wire transfers
Financial institutions such as Wells Fargo and JP Morgan see stablecoins as an effective solution for settlement of global transactions. Cross-border payments with stablecoins are quicker, lower cost and more effective than the costly and slow conventional methods of SWIFT or Western Union.
Coins make the process easier and faster. For example, Chinese entrepreneurs and workers have recently sent millions of dollars in Tether (USDT) stablecoins from Russia to the PRC.
Leading bank of South Korea — Shinhan Bank — has partnered with Hedera to use stablecoins in international money transfers. In 2021, the largest bank in Africa by assets, Standard Bank Group, also entered into a partnership with Hedera. The utilization of a distributed public record by Hedera facilitates cross-border trading and provides full transparency for all parties.
Protecting crypto traders
Stablecoins protect investors during periods of market volatility.In a bear market, traders can convert their BTC, ETH or another crypto asset to stablecoins in a fraction of a second.
The kinds of stablecoins
There are 4 basic categories of stablecoins:
Fiat-backed
The most common type, which is backed by physical currency (EUR, USD, GBP, etc.) in a 1:1 ratio, i.e. one stablecoin may be traded for one piece of currency. Each existing stable coin is backed by a single unit of fiat money stored in a special vault (treasury).
While this category is the simplest, it is also the most centralized. The central authority acts as the custodian of the paper money reserve and manages the issuance of fiat currency-backed tokens and the generation of further fiscal reserves.
Cryptocurrency-backed
A coin backed by cryptocurrency works in the same way as one backed by paper money. However rather than fiat money, cryptocurrencies are used as collateral.
The token utilized to support a stablecoin provides a «security deposit» to offset price swings. Because the token cannot hold its peg, there is no 1:1 ratio. For example, a cryptocurrency token pegged to the U.S. dollar would have a peg of approximately $2 for each stablecoin issued.
Unbacked
These are algorithmic coins that have no backing. The price resistance is ensured by algorithm-generated smart contracts that manage the increase in the total number of stablecoins and their sales if the price deviates from the declared level.
Commodity-backed
Unlike algorithmic stablecoins, coins of this type are backed by fungible activities like precious metals. The most widely used product is gold.
Some issuers (Daxos Gold, Kitco Gold, etc.), have created their own stablecoins to cash coins with gold bullion. Other assets of this type are collateralized by property, petroleum, or precious metals. The underlying asset is often held in the vault of a trusted custodian. Such coins give the buyer the right to redeem the coin for the commodity.
The future of stablecoins
The mission of stablecoins goes beyond a simple financial contract. They are an evolution of both traditional pay systems and conventional unstable cryptocurrencies.
They are managed algorithmic instead of by a central entity, and also offer the similar perks as fiat currencies. As stable assets, they facilitate the mainstream acceptance of digital assets in daily life.
At the same time, because of the risks inherent in stablecoins, authorities in various countries are considering new forms of regulation. For example, in 2022, the US presidential administration said it hoped to regulate similar banking institutions.
In this case, issuers of stablecoins will have to insure their collateral reserves similar to the way traditional depository institutions do. Thus, dealers would be safeguarded not just against price volatility, but also against collateral theft or issuer bankruptcy. These would be federally regulated and audited as well.
Stablecoins have great promise to transform the worldwide payment environment. As stablecoins begin to «stabilize» and continue to gain public confidence, the means by which digital assets are used by the financial sector will expand.
