Crypto 101: Stablecoins in a Nutshell
If you are still getting accustomed to the crypto world and you caught yourself wondering what is a stablecoin after reading some news about it, don’t worry – we’ve got you covered! This article will break down the definition of stablecoins, and explain the difference between them and other coins you might be more familiar with.
How it works
A stablecoin is a type of cryptocurrency that attempts to always offer price stability and which is backed by a reserve asset. These coins have gained popularity as they promise to deliver the best of both worlds; on one hand, the instant processing and security of payments that cryptocurrencies are known for, and on the other, the stability and lack of volatility of fiat currencies.
Since one of the main problems brought up by skeptics when debating cryptocurrencies is that their volatility makes them unable to act as what we know as currency, stablecoins try to solve this issue. They do so by representing a medium of exchanging goods, and a unit of account as well. Therefore, stablecoins are able to offer the stability of fiat currency, combined with the borderless nature and transparency of cryptocurrencies.
Even though Bitcoin maintains its crypto dominance, it is no secret that it often suffers from high volatility. For example, it rose from around $5,000 in March of 2020 to over $65,000 in November of 2021. Moreover, it is not uncommon to see the coin moving on average about 10% in either direction within the same day.
Being at risk of short-term volatility means Bitcoin and other dominant cryptocurrencies are sometimes deemed unsuitable for everyday use by the public. Traditionally, a currency acts as a medium of goods and services exchange and a way to store monetary value, which should remain relatively stable. Most people will refrain from switching to cryptocurrencies when they are not sure of their purchasing power tomorrow.
The main factor behind the stability of national fiat currencies is the fact they are backed by reserves and that their controlling authorities such as central banks take timely market actions, making it so that the currency remains free from crazy price swings.
Different types of stablecoins
All the information above can be summarised in one sentence: the key property of a Stablecoin is stability. Stablecoins may use different ways to achieve stability, which is why there are four broad categories:
1. Fiat collateral-based
This type of stablecoins maintains a fiat currency reserve as collateral in order to issue a proper number of coins. Collateral can be precious metals such as gold, as well as commodities like oil. However, most of today’s fiat collateral-based stablecoins use US dollar reserves.
2. Crypto collateral-based
Crypto-collateralized stablecoins (or Crypto collateral-based) are stablecoins backed by other cryptocurrencies. Since the reserve cryptocurrency is likely to be prone to high volatility as well, these stablecoins are over-collateralized, meaning that a larger number of cryptocurrency coins is needed as a reserve when issuing a lower number of stablecoins.
3. Algorithmic-based seigniorage
Non-collateralized stablecoins (also referred to as algorithmic-based seigniorage) do not actually use any reserve to maintain stability. Instead, these coins try to closely copy the mechanisms behind the classic central bank model, using smart contracts instead.
As opposed to collateralized coins, no asset can be redeemed. Therefore, value is maintained by the promise that the system will be able to upkeep the stablecoin’s stability.
4. Central Bank Digital Currencies (CBDCs)
CBDCs can be considered the odd one out. They are not cryptocurrencies, nor are they stablecoins; however, they include elements of both. The stability comes from the fact that a CBDC is a reenvisioned form of a traditional national currency that also has some of the key features that make cryptocurrencies so attractive – for example, the use of a distributed ledger system (such as a blockchain) to keep a single ledger of transactions.
Unlike other cryptocurrencies, both the supply and the regulations are most likely under the full control of the currency’s national, not too different from fiat currencies today, and would allow direct control by the central bank. Similar to the previously mentioned non-collateralized stablecoins, there are no assets that can be redeemed or traded, and the value derives from how well the system will perform.