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Stablecoins explained: What they are, how they work, and common types

By Connor Freitas
September 30, 2019, 10:26 AM GMT
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    Can they unlock the elusive mass adoption that everyone is talking about?

    Cryptocurrencies have struggled to gain traction in the mainstream economy because of volatility. Bitcoin prices can jump up by 15% in a matter of hours — and suffer double-digit losses in minutes. As a result, these coins are regarded by some critics as speculative investments rather than a medium of exchange.

    But although the likes of BTC might not be an ideal payment method for groceries, many still believe that blockchain technology has plenty of potential — especially when it comes to eliminating countless issues blighting the global economy. Privacy for consumers is a concern, and some are frustrated by our collective reliance on centralized financial institutions such as banks and regulators. The speed of fiat transactions also comes in for frequent criticism, not to mention the exorbitant fees charged to those who need to send money internationally.

    For years, crypto enthusiasts have been seeking a compromise — a digital currency that minimizes volatility, is practical for daily use, and addresses fiat industry flaws that hit consumers in the wallet. Stablecoins have been touted as the answer, and they have exploded in popularity over recent years. Here, we’ll look at common types of stablecoins, examine how they achieve stability, and try to answer the question of whether they can unlock the elusive mass adoption that everyone is talking about.

    Stablecoins explained

    So… how do stablecoins work? Well, the value of these cryptocurrencies is pegged to another asset. Usually, this is a fiat currency such as the dollar, euro or pound. As a result, one unit of the stablecoin may be equal to $1, €1 or £1. Stability is achieved through collateralization — with a reserve fund ensuring that every stablecoin is backed by an equivalent amount of the pegged asset. So, if there are two million units of a stablecoin pegged to the euro out in circulation, there should be €2 million sitting pretty in a bank account.

    Although they are less common, there are other methods that can be used to achieve collateralization. Stablecoins can be pegged to precious metals such as gold and silver for instance, and pegging to another cryptocurrency is even possible. Alas, there is a reason why these assets are rarely used as a reserve, something we’ll explain in detail a little later.

    Algorithmic stablecoins are another approach. Here, no collateralization is required — instead, prices are regulated by mathematically adjusting supply in keeping with demand. This may seem like a cutting-edge method, but it isn’t too dissimilar to the tactics that central banks use to minimize inflation in their fiat currencies.

    The benefits of stablecoins

    First and foremost, stablecoins are touted as a way of making cryptocurrencies usable in everyday life. Their value is easy to understand thanks to how they are tied to another asset. Let’s imagine David, who lives in the US, wants to send money to his friend Medha in India. At present, the process of making a transfer can get very expensive, very fast. David will be charged commission fees through the remittance service he uses, and Medha will likely face an unsavory exchange rate when she is trying to change the dollars into rupees. Stablecoins eliminate this problem because the transfer can take place immediately and with minimum fees — and Medha will suffer fewer fees if she then decides to convert her crypto in rupees.

    Stablecoins also deliver much-needed predictability and reliability for consumers. They won’t have to worry about their coins suddenly declining in value, meaning their money won’t go as far.

    The downsides of stablecoins

    Critics of stablecoins argue that they undermine what crypto was designed for in the first place: to achieve independence from central banks and fiat currencies. A bigger concern surrounds collateralization. One of the biggest stablecoin operators, Tether, has faced allegations that it doesn’t have enough dollars in reserve to back the coins it has in circulation — despite saying it is “100% backed” by USD.

    As promised, let’s also examine a major flaw that occurs when stablecoins are backed by other cryptos: the risk of volatility in a product that was designed to eliminate volatility. This issue is normally resolved through overcollateralization — meaning that the value of crypto in reserve is substantially more than the value of the stablecoins in circulation. Although this sounds sensible, it can become financially unworkable as a brand’s popularity grows.

    Stablecoins in the mainstream

    There is a very real prospect that stablecoins could enter the mainstream consciousness far faster than you think. Facebook is considering launching its own digital currency, Libra, so its users can make cross-border payments to friends and purchase everyday goods. The stablecoin would be backed by a basket of major fiat currencies rather than just one. Unfortunately, the plans have been met with some resistance — and the launch has been delayed while politicians in the US investigate whether it could undermine the dollar.

    Tokenised securities are complex instruments and come with a high risk of losing money rapidly due to leverage. You should consider whether you understand how tokenised securities and leverage work and whether you can afford to take the high risk of losing your money. Nothing in the above article should be regarded as a recommendation to trade generally, to trade on a particular platform or to trade in a particular asset. Asset prices can go down as well as up and past performance is not a guide to future performance. Investors and traders should thoroughly research an asset or strategy before making any trading or investment decision and if necessary seek professional advice.

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