Stablecoins, A Basic Overview – Sagecoins
In this post we discuss what “stablecoins” are and broadly break down the different ways in which these currencies function.
In basic terms, a stablecoin is a digital currency that endeavours to keep its price consistent. There are currencies that attempt to do this through manipulation, which we will discuss, but the more popular strategies rely on the stablecoin’s market price being pegged (linked) to another “more stable” asset.
The creation of these types of currency are being promoted by their supporters as a solution to the volatility of cryptocurrencies. The supporters of stablecoins argue that the reduction of volatility will enable easier transactions and wider adoption. Stablecoins have also become a utility for many currency traders and investors. These parties utilize stablecoins as a way to trade in more commonly used digital currencies during down markets, while not having to trade directly back into government backed fiat currency itself.
So How Do Stablecoins Work?
Considering that the way in which stablecoins work is varied, and many employ unique strategies, we will break down three general categories:
Fiat and Asset-collateralized coins, Crypto-collateralized coins, Non-collateralized coins.
Fiat and Asset Collateralized Coins
If you have come across a stablecoin, chances are that it was from this first category as it is the most common. This type of digital currency is backed by something that has a recognized or perceived consistent value. This often comes in the form of real-world government issued fiat currency like the US dollar. The digital currency is “backed” through a stock of collateral. This is stored in a bank account or other means of safekeeping depending on the asset used. Therefore, the currency is issued on a consistent ratio.
Using the example of USD, the digital currency could be issued on a 1:1 level and be worth 1 American dollar. When a holder wants to exchange their stablecoin they can trade in their stablecoin and then receive a USD. However, as mentioned this can take many forms and instead of fiat currency, the collateralized asset could be gold or a share of another asset.
In theory this process is relatively simple and price stable. This method also means, in many cases, that no collateral is held on the blockchain which makes it less vulnerable to virtual attack. The nature of these stablecoins are centralized. This is a turnoff to many who use digital currencies because they are decentralized. Stablecoins in general require a certain amount of trust in the custodial party who manages the store of fiat. If the account was closed or some other negative events occurred, the holders of the coins could be caught with worthless currency.
This risk necessitates the use of audits from third parties to ensure transparency and confirm that the appropriate amount of collateral is being stored for the amount issued. This can help mitigate risks of trust but often is an expensive process, resulting in the cost keeping the currency running high.
Digital Currency Collateralized Stablecoins
Instead of being fixed to fiat or physical assets some stablecoins are instead backed by another cryptocurrency. This allows the currency to be completely on the blockchain and decentralized. These stablecoins can be based upon one currency or can be backed by multiple currencies to lessen risk.
Unlike fiat backed stablecoins, digital currency backed stablecoins are often not backed on a 1:1 ratio with the collateral currency. The reason for this being, that if it was backed 1:1 it would be equally as volatile as its collateral currency. The digital currency collateralized currency often has a collateral store much bigger than the number of coins issued to ensure that even if the price drops the investors will not lose their value.
One of the main hurdles of this form of stablecoin is due to the over collateralization necessary. Only a percentage of the capital that is put into the currency can be taken out, making it inefficient. Also, should the health of the currency the stablecoin is linked to crash it may be difficult to recover value.
Some types of stablecoins take a different route to stabilization. These offerings find ways to keep the value consistent through manipulation of the currency. Some stablecoins allow the price to be held at a certain level through the automated issuance of new currency and its destruction based on demand. In other words, coins are created when the price of the currency goes up and coins are bought back and destroyed when the price goes down. This method is more decentralized and independent than any solutions mentioned so far as there is no need to trust a holder of the coins’ collateral. However, unlike the collateral-based coins, this option is more vulnerable to crashes as there is no way to liquidate value on a sharp decline.
The use of stablecoins in all their different forms is a contentious topic for many. Many believe them to be a perfect next step in the evolution of money as they mimic some of the characteristics of legal tender, for better or worse, while ditching much of the regulation and oversight. Others conversely believe that the very makeup of what they are goes against what digital currencies aim to accomplish. Either way, stablecoins add to the variety of currency options that are available to the public in a constantly evolving industry.