Stablecoins: what are they and what do they do?
So-called ‘stable cryptocurrencies’, also known as stablecoins, such as Tether and DAI have emerged in response to the volatility of virtual currencies such as bitcoin and ether.
As a result of the high volatility, the use of these cryptocurrencies and investments in these currencies are restricted to a high-risk financial area, which lacks any kind of guarantees. In this context, these blockchain-associated financial instruments are in a constant state of development. The aim is to identify solutions to the challenges that technology still faces. Stablecoins have emerged as a result of recent efforts to reduce the volatility of virtual currencies.
This new type of cryptocurrency is based on tokens that are linked to the value of a fiat currency such as the dollar or the euro, to tangible assets such as gold or property, or to another cryptocurrency. There are also stablecoins that are not pegged to other currencies but are rather guided by algorithms to keep their prices stable. The main reason for creating a stablecoin is to protect investors in times of volatility.
Types of stablecoins
There are two different types of stablecoins that use different strategies to reduce volatility. Firstly, there are “collateralized” or “backed” cryptocurrencies, which are tied to an external value (be it a fiat currency, another cryptocurrency or other assets), which in theory provides stability.
Within the first group we find three categories:
Both Tether and TrueCoin fall into this category. They are backed by the US dollar and managed by several companies acting as a central institution. Tether is one of the biggest success stories. Created in 2014 on open blockchain technology, Tether currently has a total value close to $2.6 billion.
To use it, customers access the platform to exchange US dollars for the company token, called USDT, which can be used like any other cryptocurrency, whether in exchange for goods on the digital platforms that accept them or as an investment.
The companies behind Tether claim it has sufficient dollars “in reserve” that serve as a deposit guarantee for the platform’s customers. The idea is that customers will be able to return their USDT and receive dollars whenever they want, without being affected by price fluctuations typical of other cryptocurrencies, as USDT is virtually “pegged” to the dollar.
Despite this, the uncertainty surrounding the company has been raised as there is no concrete evidence that they have enough dollars to cover the token supply now in circulation.
Backed by cryptocurrencies
The most controversial stablecoins fall into this category because they use other cryptocurrencies to keep their own value stable. Various mechanisms are used to achieve this.
One example is DAI, a cryptocurrency that uses the Etherum platform and the value of the ether to keep its cryptocurrency pegged to the dollar. In this case, users do not directly buy DAI, instead they “generate” it in exchange for ethers, which are exchanged on the platform through a deposit.
Stablecoin avoids volatility caused by ether price fluctuations because users have to deposit more ethers than necessary. This mechanism is called over-collateralization and involves pledging excess collateral in exchange for funding to reduce risk. This is how users could “protect themselves” from a possible decrease in crypto value.
Asset support (gold, property, etc.)
In these models, cryptocurrencies link their value to an external asset such as gold to keep their value stable. G-Coin is one such case. It is a token-based platform where each token is equivalent to one gram of physical gold. The company claims that the gold backing their token is safely stored and that they use blockchain to ensure that the metal comes from conflict-free zones. According to the company, their tokens can be exchanged for physical gold, can be used as a long-term investment, or can be used like other cryptocurrencies to make digital payments.
Controlled by algorithms
The second main group of stablecoins are those without collateral, those that are unbacked, meaning they are not linked to any external value but rather use algorithms to avoid price fluctuations. In these models, it is the blockchain itself that controls currency changes by using algorithms and smart contracts.
An example from this group is USDX, which uses algorithms to keep the price of its tokens pegged to the dollar to control its stability. In this model, the system is decentralized because it is governed by smart contracts.
Basecoin, on the other hand, provides evidence that cryptocurrencies are not yet compliant with certain government regulations. Its stablecoin, called Basis, relied on both smart contracts and a set of algorithms that replicated the central bank’s monetary policy. However, on December 13, 2019, the founders were forced to announce the end of their venture and returned $133 million of raised capital to investors, as they were aware that they would not be able to overcome the significant hurdles presented in U.S. regulation.
Given that, stablecoins are still in a nascent stage and therefore not a safe enough investment tool. Over time, and with greater refinement of the various models, they could still raise more capital than currently represented by bitcoin or ripple.
Agustín Carstens, General Manager of the Bank of International Settlements (BIS), said. “New technology is not the same as better, or more efficient technology.” However, you don’t have to be a techno-optimist to recognize that the evolution of technology is unstoppable and improvements can be expected to address things like the volatility of cryptocurrencies. In fact, solutions are already being considered for this problem, such as stable digital currency, or “stablecoins”.
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