Stablecoins. Connecting crypto to the real world.

Gepubliceerd op 9 januari 2022 om 10:00

The value of a cryptocurrency can be linked to the value of another product with a value. For example gold or fiat money (like Euro or the Dollar). What exactly are stablecoins, why do stablecoins exist and what are the different types of stablecoins? I will cover these questions and more in this blog.

What are stablecoins?

A stablecoin is a cryptocurrency that is linked to so-called 'fiat currency', such as the Euro or the dollar. A well-known cryptocurrency is Tether. Tether is a popular stablecoin and has the same value as a dollar or euro. Stablecoins are therefore linked to a fixed exchange rate and should provide value stability. It is important to note that stablecoins do not have to be linked only to the value of the Euro or dollar. Stablecoins can also be linked to the value of commodities, such as gold, silver, steel etc.

The value of cryptocurrency

As is known to most people, cryptocurrencies are unstable. The price of cryptocurrencies fluctuates greatly. For example, one day you could be +20% in the plus and the next day you could be -30% in the minus. Cryptocurrency - like bitcoin - is therefore volatile. The unstable factor of crypto also makes it very attractive to invest in cryptocurrencies. A bank transfer to another country can take days or weeks, but the cryptocurrency industry trades internationally and 24/7. You can therefore process transactions much faster and exchange stablecoins into dollars, euros or, for example, Russian rubles. Ideal for trading transactions.

Are stablecoins 'stable'?

The term stablecoin is named that for a reason. The word stable in stablecoin refers to the fact that the exchange rate of the Euro or dollar can be called stable compared to the lesser stable cryptocurrency. By linking the value of a cryptocurrency to the Euro or dollar, the volatile nature will be largely eliminated.

Governments have also discovered stablecoins. Increasingly, governments are already seeking digital currencies, like the so-called CBDCs (central bank digital currencies). In Europe, this is a digital euro and electronic form of central bank money. This is not quite the same as stablecoin, but it has similar advantages. Moreover, not all countries are yet open to the idea of CBDCs. In the European Union, there are already investigations going on to see if a CBDC (digital euro) can be introduced in the EU. I think it is a matter of time before the EU introduces a digital euro. Please note that it is not yet clear if the blockchain shall be used for the digital euro. 

Why do stablecoins exist?

Mitigate the volatile nature

One of the main arguments against cryptocurrencies is that the price is too volatile. Opponents of crypto-currencies such as bitcoin believe that cryptocurrencies therefore cannot be used for daily use. 

Stablecoins exist to mitigate the volatile character of cryptocurrencies. Stablecoins can make things like borrowing, saving and salary easier in the short term, or at least that's the promise. 

Mitigate price drops of cryptocurrencies

Stablecoins are mainly used on cryptocurrency exchanges. In fact, it can be a way to hedge against price fluctuations. Stablecoins works roughly like this:

Suppose the price of bitcoin is currently 40,000 euros. You expect the price to drop to 30,000 euros. At that point you can choose to trade bitcoin for a stablecoin such as Tether. Does the price then drop to 30,000 euros? Then you still have 40,000 euros in digital currency. If you expect bitcoin to rise again, you can then exchange the stablecoin for bitcoin again.

Types of stablecoins

Fiat-backed stablecoins

Tether is the most known example of a fiat-backed stablecoin (1:1). As discussed above, a core feature of this type of stablecoin is that it is always backed by a fiat currency such as the euro or the dollar. Thus, the value of the cryptocurrency follows the value of fiat money.

How does something like this work in practice? Suppose Alice wants to buy 10 Tether. You can do this on an exchange. Suppose you have bitcoin, then you can exchange that into Tether. For every Tether Alice buys, Tether has a dollar in reserve. So you can always exchange your Tether for dollars. If Alice decides to sell 10 Tether, Alice should receive (around) 10 dollar.

Suppose Alice has no access to the financial system in the country she lives (unbanked). Alice has discovered cryptocurrency and uses her local currency to buy 1 stablecoin that is linked to the dollar. When Alice sells her 1 stablecoin, Alice obtains, assumingly, 1 dollar in return. As a result, Alice has converted her local currency into the dollar. Is this a potential way to evade sanctions or tax evasion?

Crypto backed stablecoins

Another way is that the stablecoin is backed by another cryptocurrency. The disadvantage of a crypto-backed coin is that it is connected to the value of another cryptocurrency. In case the value of this cryptocurrency drops to zero, the value of the stablecoin is also zero. If you invest into a stablecoin, always check which cryptocurrency the stablecoin is connected to. 

Alghorithm based stablecoins

The way algorithm-backed stablecoins are regulated is somewhat similar to how the ECB regulates the Euro. When the price of a stablecoin becomes too high, the algorithm will automatically create new coins and put them into circulation. In the opposite way, when the price is too low, the algorithm buys the coins from the market.

Precious metal backed stablecoins

Commodity-backed stablecoins are backed by physical assets such as precious metals, oil and real estate. The most popular commodity to collateralize cryptocurrencies is gold. Tether Gold (XAUT) and Paxos Gold (PAXG) are two of the most liquid gold-backed stablecoins. It is important to note that these commodities can fluctuate in price. The same applies for crypto-backed stablecoins as mentioned above.

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