What is a Stablecoin? Here’s all you need to know.
We all know how volatile cryptocurrencies could be. In March 2021, Bitcoin reached a peak of $58,734. Come may, the value plunged to $35, 749. On the other hand, a ‘Stablecoin’ is a type of cryptocurrency where the price of the coin is determined by connecting the value of an outside asset to the value of the cryptocurrency. Such an asset can be the U.S. Dollar ($), gold, any precious metals, or industrial metals. The creators of a stablecoin attempt to keep its value stable by pegging it to fiat security (government-backed).
When was the term ‘Stablecoin’ first used?
The term Stablecoin was first introduced in the year 2014 by BitUSD and NuBits. These two cryptocurrencies were not collateralized (something which is pegged in the form of security for the value of a liability) by a fiat asset but were linked to other cryptocurrencies. The world’s first Stablecoin was BitUSD. It was released on 21st July 2014 and issued to the general public in the form of a token on the Bitshares blockchain. BitUSD was securitized by crypto and backed by Bitshares token, BTS. However, BitUSD soon lost its equal value to the USD in 2018 and is currently floating at 80 cents to the dollar.
The next Stablecoin was released in September 2014 – NuBits. In its whole lifetime, NuBits crashed twice, once in 2016 and once in 2018. Due to the severe pump in the Bitcoin, it rose over $1.20 to a dollar. The investors were struggling to convert their NuBits into a fiat profitably. At present NuBits is running at $0.058 to a dollar.
Crypto enthusiasts and traders initially targeted stablecoin. However, it is now used for payments, remittances, and as a vehicle for banks, asset management institutions, and other financial institutions to trade in crypto.
Why is a Stablecoin immune from market volatilities?
Cryptocurrencies have proved to be sensitive to market events, but Stablecoins are exactly the opposite. They tend to be less affected by volatile market conditions.
Stablecoins are essentially a form of cryptocurrency that has a fixed price. It faces less volatility in pricing due to market forces because its value is dependent on the underlying asset rather than pure demand and supply.
Pros & Cons of a Stablecoin
Stable: The perk of an asset-backed cryptocurrency is that the value of coins is stabilized by the underlying assets. Any changes in the underlying assets happen outside of the cryptocurrency market. Therefore, the value of Stablecoin is decided by value fluctuations in the underlying asset rather than the volatility afflicting the crypto market itself.
Providing stability to the overall Market: Bitcoins and other cryptocurrencies are highly interlinked so that the artificial currency holders cannot ignore the heavy price changes in the market. They can hedge their risk by investing in asset-backed Stablecoins.
Safe investment: Stablecoins are cryptocurrencies that are securitized by an asset, most often a country’s currency. As currencies are risk-free assets especially reserve currencies, stablecoins are as good as monetary instruments for investment.
Now let’s look at its disadvantages.
Trusting a third party: It requires a third party to purchase a Stablecoin, and also requires trust from an entity. While trusting the Central Bank of a country is easier, trusting a third party is not.
Audits: Stablecoins require frequent external audits just to ensure that all the assets are accounted for.
Low risk, low reward: The returns on Stablecoins are not much as compared to other cryptocurrencies and users in this market expect high returns due to the risk factor.
Back to square one: As it is a fiat-regulated currency, there would be involvement of the central govt norms and rules, hence involving the processes of the Central Banks, something which the blockchain envisions to abolish.
What are the types of Stablecoin?
We can distinguish Stablecoins into 3 different types:
Fiat-collateralized: This is the most simplified version, with every Stablecoin securitized by currency. The burden of producing and securitizing the coin is on the issuer of the coin. E.g. Tether- USDT.
Two primary reasons for the price stability of fiat currencies are:
1) There are defined authorities that back currency reserves and make adjustments in case of any volatility, like the RBI.
2) The net value of a currency is immune from market swings since they are linked to an asset such as gold or forex reserves, which in turn ensures the stability of Stablecoin.
Crypto-collateralized: This type of Stablecoin uses other cryptocurrencies (ex: Ethereum) as collateral for the Stablecoins. However, the crypto values themselves are subject to market volatility, and these Stablecoins need to ensure that they limit themselves within some prescribed set of protocols to make sure that the price of the Stablecoin issued remains at $1.
Let’s assume we purchase ETH worth Rs. 200 to receive Rs.100 of Stablecoins in return. The Stablecoins are now 200% securitized. This implies that if the price of Ethereum falls by 25%, the Stablecoins can still keep its price as it is, as there are still Rs.150 worth in Ethereum security backing the original value of the Stablecoin. E.g. Havven.
Non- Collateralized Stablecoins: This is a very unique model to Stablecoins for no security/ asset backs it. It operates in the way national currencies work i.e., through central policies. E.g. Carbon
Stablecoins may look like a perfect alternative for many traders of and investors in cryptocurrency. However, they must consider the ease of manipulating the value of any cryptocurrency. When a market influencer such as Elon Musk issues a statement or tweets an opinion on crypto, it can positively or adversely affect the market. This can cause a significant blow to or otherwise inflate the price of cryptocurrency. Hence, we cannot say that Stablecoins are a risk-free financial investment even though they are more ‘stable’ than other cryptocurrencies.
Although it would be safe to suggest that stablecoins are an obstacle to rising prices of cryptocurrency. Small traders or investors, switching to Stablecoin will not affect its market price. But investment or disinvestment of large whales has the power to drive the entire market bullish or bearish.
This article was co-authored by Medha Gupta.
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