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The fundament of the week: Stablecoins

Tether, TrueUSD, Dai, and many more. You probably know that these are the so-called Stablecoins. But do you have at least a basic idea of what these specific cryptocurrencies are for? This will be the topic for today’s article.

How stablecoin is created and what it is used for

Undoubtedly, the typical characteristic of cryptocurrencies is volatility. Upward and downward price movements ranging anywhere from percent to tens of percent are nothing special for Bitcoin and other cryptocurrencies. This aspect makes cryptocurrencies an attractive opportunity for speculation, but it also limits the possibility of their wider usage in the financial market.

To ensure at least partial market stability, it was necessary to come up with a solution whose exchange rate would be fixed on more stable fiat currencies or commodities. And so stablecoins were born. Unlike classical cryptocurrencies, their supply is usually backed by existing commodities. It ensures their stability and direct correlation with the bound commodity. In the vast majority of cases, the US dollar plays the role of the main backing cryptocurrency. Therefore, the price of one stablecoin usually corresponds to the price of one dollar.

Due to the fact that the value of stable cryptocurrencies is not prone to such high volatility, it serves as an ideal connection between classic fiat currencies and cryptocurrencies. Through them, it is possible to invest in cryptocurrencies without fear of devaluing the invested funds within a few days or even hours.

What are stablecoins backed with?

The mentioned backing up of stablecoins by another commodity is somewhat simplistic. In practice, there are 3 basic groups of stablecoins:

  • Collateralized (backed) by fiat currencies and commodities
  • Collateralized by other cryptocurrencies
  • Uncollateralized
  • Collateralized by fiat currencies or commodities

    By far the most popular is the simplest way to hedge currency - collateralization through the classic fiat currency or commodity. To successfully create a coin, you need to deposit the corresponding pegging currency/commodity (dollar, euro, yen, gold, silver, oil) into a tied bank account. It is possible to exchange between fiat and cryptocurrency in this way without much difficulty. This raises the aforementioned bridge between the two currency worlds. Whether this idea is in line with the first postulate of cryptocurrencies - decentralization - will be left up for discussion.

    Collateralized by cryptocurrency

    It may not be clear to you now how stablecoin can be collateralized by a cryptocurrency that is highly volatile. It is quite simple. Many companies are trying to deal with the massive movements of their projects by buying stablecoins and counterbalancing cryptocurrency at twice the value. So they will get a one-dollar worth of stablecoin for $ 2 worth of crypto. The main problem remains the high cost of this solution and the inevitable centralization of the cryptocurrency.

    Uncollateralized stablecoins

    Everything is possible in the 21st century, so it is not surprising that stablecoins can be formed without being pegged to any commodity or fiat/cryptocurrency. Special algorithms are used to calculate and maintain their value. Through them, the supply of stablecoins changes according to the fluctuation of the commodity to which it is virtually linked. This solution helps to partially solve the problem of insufficient decentralization because it works on the principle of smart contracts.

    stablecoin chart Figure 1: Comparative analysis of stablecoins

    Stablecoins are everywhere you look

    In recent years, there has been an influx of various stablecoins on the market. In addition to enthusiasts who are trying to resolve the biggest pain of the cryptomarket, banks and other financial institutions are trying to come up with their own solution too. Undoubtedly, they are attracted by the idea of establishing a functional system and gaining an access to a massive market with a large number of active investors through a functional system.

    Stablecoins and controversies

    Despite all the positives and their stability aspect, it cannot be said that stablecoins avoid controversy more than other projects. Probably the biggest focus in this field has been the stablecoin that currently comes in fourth in the terms of market capitalization - Tether. A study published in 2018 confirmed that the USDT was used to manipulate cryptocurrency prices during the massive growth in 2017. Throughout the same year, it was also speculated whether Tether had sufficient reserves in the accounts to cover all coins issued. The company behind Tether did not provide any guarantees to rebut this allegation and continued to "mint" new coins.

    Several failed projects that were not able to fulfill their ambitions are also worth mentioning. For example, NuBits. At the end of 2018, a similar fate befell the project of the uncollateralized stablecoin Basis, which justified the termination of its activities by doubts about the forthcoming regulations by the American authorities.

    What is the likely future of stablecoins?

    Let's try looking into the future now. What fate awaits stablecoins? Due to the planned cryptocurrency regulatory measures by governments and control institutions, stablecoins can be expected to become an inevitable solution. Their ability to maintain value even in turbulent times will certainly be appreciated by many large investors, as evidenced by the involvement of large banks and their announced plans of creating their own currencies.

    The mass spread of stablecoins can ultimately serve as a bridge for the subsequent development of cryptocurrencies. In an increasingly globalized world, stablecoins will serve as a universal currency, avoiding unnecessary fees for exchanging fiat currencies in traditional exchange offices or for transferring funds as part of international payments.

    Jakub is a crypto trader and founder of Trader 2.0 project, which helps hundreds of traders from central Europe to understand cryptocurrency trading and its challenges. Jakub not o...

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