We are all familiar with cryptocurrencies that derive their value from their utility as a store of value like Bitcoin or as a token representing access to computing resources. Stablecoins don’t derive their utility from anything intrinsic to the coin itself. Rather, the value of a stablecoin comes from the asset that backs it.
What are Stablecoins?
Stablecoins are a type of cryptocurrency whose value is pegged to another asset or basket of assets. As the name implies, the concept of stablecoins is to provide stability to their value and to serve as an asset that is not correlated to Bitcoin and altcoins. Bitcoin and altcoins are highly correlated with each other, so stablecoins offer a way to avoid exposure to them when they are experiencing volatility.
Types of Stablecoins
If you like this article, read and find out how Bitcoin protects you from Inflation: Is Bitcoin A Safe Haven in Times of Crisis? By Aaron Koenig.
The most common type of stablecoin is one which is backed by another asset. The assets which are used to back stablecoins include commodities, such as gold and silver; fiat currency, like the U.S. dollar; or other cryptocurrencies.
Perth Mint Gold Token (PMGT) is an example of a gold-backed cryptocurrency. Digital gold certificates back each PMGT token at a 1:1 ratio. DigixGlobal (DGX) is another gold-backed cryptocurrency with each token being backed by 1 gram of gold. These tokens represent a fixed amount of gold that represents the value of that asset. Physical gold, by contrast, can be very expensive to transport and store. These tokens allow their holders the benefit of owning gold without the headaches that go along with having to deal with physical gold.
Fiat-backed cryptocurrencies bring the value of those fiat currencies into the cryptocurrency market. If you expect Bitcoin to fall in price as compared to the U.S. dollar, you might sell your Bitcoin for one of the U.S. dollar-backed cryptocurrencies. This reduces your exposure to the volatility of the Bitcoin market. TrueUSD (TUSD) and USD Coin (USDC) are examples of this type of cryptocurrency.
Stablecoins that are pegged to a cryptocurrency or portfolio of cryptocurrencies often have their supply managed in a blockchain itself through the use of smart contracts. Unlike fiat currency and physical assets, the backing for the cryptocurrency-backed stablecoin doesn’t require any maintenance outside of the blockchain. How do cryptocurrency-backed stablecoins maintain their stability if they are backed by a volatile asset? Well, various cryptocurrency-backed stablecoins have different methods of addressing this problem. The stablecoin Dai is effectively pegged to the U.S. dollar through Ether tokens locked up in smart contracts. When the value of Dai veers away from that of the U.S. dollar, smart contract mechanisms are in place to ensure that the value returns to normal.
Why Use Stablecoins?
Stablecoins are designed to be a stable alternative to the volatility that is inherent in Bitcoin and altcoins in general. There are many times when this is desirable.
When you feel it’s time to close a position in cryptocurrencies, you may want to sell it for a fiat-backed cryptocurrency like USD Coin (USDC). This is effectively the same as selling it for U.S. dollars but still keeps your funds in the cryptocurrency market where it can be used again to re-enter the fray if Bitcoin or altcoins begin to become attractive again.
Gold-backed and silver-backed cryptocurrencies may be attractive for the value of the asset that backs the coin. During inflationary periods, the immense effort that is required to mine gold and silver give it a natural scarcity that strictly limits the new supply of these assets. This is in contrast to fiat currency, which can be printed at the stroke of a pen at any time. The strict limit of supply in gold and silver can make stablecoins backed by these metals a popular investment or safe haven when fiat currencies are falling in value.
There is some question as to whether stablecoins really fit in with cryptocurrency’s ideal of decentralization. For example, a stablecoin backed by the U.S. dollar must necessarily be dependent upon the Federal Reserve—the Central Bank of the United States. However, the practical cryptocurrency enthusiast sees these stablecoins for the tools that they are—serving a particular purpose in the course of trading and investing.
One common concern when evaluating a stablecoin is whether the assets backing the cryptocurrency are truly held in reserve. If the cryptocurrency is fully redeemable in return for the asset, that should put any questions to rest. The company behind the cryptocurrency Tether had at one time claimed to be a stablecoin and stated that each token was backed by one U.S. dollar. However, the company would go on to say that tokens could not be redeemed for dollars. Despite promising an audit proving that the company held sufficient reserves to back the tokens, no such audit was ever presented. In spite of these concerns, Tether continues to hold a value of around 1 USD. So, as long as the market has faith in the value of a token, it may not be as big a concern as you might think.
Stablecoins are different from most cryptocurrencies in that their value is pegged to another asset. These assets are typically commodities, fiat currencies, or other cryptocurrencies. Stablecoins offer an escape from the volatility that often appears in cryptocurrency markets by representing the value of assets outside the cryptocurrency market.