Stablecoins are cryptocurrencies whose value is pegged, or tied, to that of another currency, commodity, or financial instrument. Stablecoins’ purpose is to provide an alternative to the high volatility of the most popular cryptocurrencies, including Bitcoin (BTC), which has made crypto investments less suitable for common transactions.
What Is the Purpose of Stablecoin?
Stablecoins’ purpose is to provide an alternative to the high volatility of popular cryptocurrencies, including Bitcoin (BTC), which can make cryptocurrency less suitable for common transactions.
Say you were a Chinese business owner who wanted to pay an invoice to a client in Japan who also had subcontractors in Europe.
“You’d need to have a Chinese bank account, a Japanese bank account, and a European bank account,” explains William Quigley, co-founder of the WAX blockchain and one of the founders of USDT issuer Tether. “If somebody wants to send you euros or yen or RMB, the intermediaries who can hold those accounts swap out those currencies for the currency you can hold and send it to your bank. And along the way, they’ve skimmed a lot of money off the top for that.”
We can’t all have 50 different bank accounts in 50 different countries, says Quigley. But with stablecoins, there’s no need.
How do stablecoins work?
Stablecoins generally work the same across the board: They are cryptocurrencies minted on a blockchain that users can buy, sell and trade on an exchange just like any other crypto coin.
To have integrity, most stablecoins are linked to a reserve of external assets of some kind, whether it be a stash of fiat currency, commodities like gold, or debt instruments like commercial paper. In most cases, the company or entity that develops the stablecoin owns reserves equal to the number of stablecoins it has in circulation. This is such that any stablecoin holder should be able to redeem one stablecoin token for one dollar at any time.
The four types of stablecoins
There are four different types of stablecoins, each with its way of fixing the value of the tokens to a stable figure.
The most popular stablecoins in the market are ones backed by fiat currency. USD coin (USDC), for instance, is fiat-backed and pegged to the U.S. dollar (USD) at a 1:1 ratio. Other stablecoins are linked to the euro, the British pound, the Japanese yen, and the Chinese RMB.
Without getting too meta, crypto-backed stablecoins are cryptocurrencies pegged to the value of another more established cryptocurrency. For instance, MakerDAO is one of the most popular crypto-backed stablecoins. It uses a smart contract – a type of self-executing, code-based contract – alongside the Ethereum blockchain to pool enough ether (ETH) to use as collateral for its stablecoin. Then, once the amount of collateral reaches a certain level in the smart contract, users can mint DAI – the MakerDAO stablecoin.
As the name describes, commodity-backed stablecoins are pegged to the value of commodities like precious metals, industrial metals, oil, or real estate. Commodity investors love the option of commodity-backed stablecoins because it allows them to invest in gold without the hassle of sourcing and storing it. Tether gold (XAUT) is an example of a commodity-backed stablecoin. The currency is backed by a reserve of gold kept inside a vault in Switzerland. One ounce of gold is equal to one XAUT.
Not backed by any “real-world” commodities, you can think of an algorithmic stablecoin as a bucket of water left outside with a water level marked on the inside. To keep the water inside the bucket at the same level, you set up a mechanism that adds or removes water depending on how far the water level has deviated from the mark. This is controlled by a computer algorithm such that if it rains and the bucket begins to fill up, the algorithm instructs the mechanism to release water out of the bottom of the bucket until it reaches the water level mark. Conversely, if it’s a hot day and water evaporates out of the bucket, the computer algorithm would instruct the mechanism to add more water to the bucket until the correct level is regained.
There’s been a lot of trial and error in the quest to successfully introduce algorithmic stablecoins to the crypto ecosystem, and the failure of Terra’s UST stablecoin shows just how badly things can go if the algorithm isn’t able to keep up with dramatic swings.
Conclusively, stablecoin plays an important role in exchanges, though exchanges can exist without stablecoins by trading with other digital assets, but it will come with many demerits and risks.