Explainers

What Is a Stablecoin (And Are They Safe to Use)?

0
Image Credit: Jonathan Petersson/Pexels

Stablecoin projects are becoming more common in the cryptocurrency space. It seems like barely a day goes by without news of another stablecoin, but what exactly are they? How do they work, and are they worth your consideration? here’s everything you need to know.

What Is a Stablecoin?

Stablecoins are cryptocurrencies that are backed by something else or are “pegged” to another currency. Looking at fiat currencies, the gold standard is the pegging of a currency to physical gold reserves. If a country has five units of gold, they limit themselves to five units of currency (or an agreed denomination).

Stablecoins attempt to mimic this fiat currency backing. By backing each crypto-token with physical security, the logic is that the token’s price will remain stable, as it’s tied to a stable currency.

If a cryptocurrency is tied to gold, one or more dollars, or almost any other commodity, the price is unlikely to swing out of control, and speculators may remain out of the market as it’s difficult to make vast profits when the price remains the same every day.

If you can always exchange one stablecoin for one dollar, why would you ever pay more than one dollar for the coin? This keeps the price strong and stable.

Why Should You Use a Stablecoin?

The big draw of stablecoins is in the name—they are stable (in theory). Stablecoins represent an excellent way to store your funds in case of a crash or market disaster. Many trading pairs exist between stablecoins and other cryptocurrencies. It’s quick and easy to trade your cryptocurrency for a stablecoin, ride out the storm, and then trade back to your chosen crypto. It’s not quick to sell your cryptocurrencies for cold hard cash, and you may not want to.

Here’s an example. Suppose Gavin buys 25 Blocks Decoded Wobblers for $1 each. That’s a total of $25 (25 x $1). If the price starts crashing, he could trade those Blocks Decoded Wobblers for 25 Blocks Decoded Stablecoins. He now owns 25 Blocks Decoded Stablecoins worth $1 each, or $25 total. The price of a Blocks Decoded Wobbler is now $0.10. Had he remained in Blocks Decoded Wobblers, his total stack would be worth $2.50, yet his investment remains safe at his buy-in price of $25.

He could now buy 250 Blocks Decoded Wobblers with his $25. This is a very simplified example, but stablecoins exist to keep their price rock-solid stable, which can help out in times of crisis or market fluctuations.

How Do Stablecoins Work?

Stablecoins are almost always tied to an asset class. This can be fiat, a commodity, or even another cryptocurrency.

Fiat-backed stablecoins are backed by fiat at a fixed ratio. This is often the US dollar, but the Euro and Swiss Franc are becoming more popular. For every fiat-backed stablecoin, there is a real fiat currency held in custody. These stablecoins are redeemable for the fiat currency at the specified ratio, but only from specified issuers such as the creators. As fiat is involved with these stablecoins, issuers often have to follow all local currency rules and regulations. No cryptocurrency transaction happens to convert between the two. The conversion happens off-chain.

Commodity-backed stablecoins are pegged to almost any asset class. This could be gold, silver, anything at all. These stablecoins are redeemable at the specified ratio by anyone. There are no regulations on who can issue these, and very few laws to follow, but the volume of these stablecoins often reflects the volume of the commodity in some way.

Finally, cryptocurrency-backed stable coins are tied to another cryptocurrency. This links each stablecoin to cryptocurrency collateral. While like fiat-backed stablecoins, cryptocurrency-backed stablecoins work over crypto smart contracts. All the trades happen on-chain, and so there could be as many as three different cryptocurrencies involved: the stablecoin, the collateral, and the underlying smart contract.

There is one final type of stablecoin. This is a Seignorage-style backed coin. These stablecoins are less common than the other types and use on-chain algorithms to maintain a stable price. Often, this involves increasing or reducing the total available supply and letting the laws of supply and demand stabilize the price. There is no collateral or fiat/commodity backing these coins.

Are Stablecoins Risky?

Stablecoins are not always risky or unsafe, but there are still some areas to consider before dropping a significant amount of money on any stablecoin.

Stablecoins are as risky as their backing. As they are tied to commodities or fiat currency, they can experience the same price fluctuations as the asset itself. If the price of silver or gold goes up, so does the value of your stablecoin. Should the price go down, so will your stablecoin’s value. It’s that simple.

The other consideration is that of the blockchain itself. There are plenty of scams, thefts, hacks, and fraud within cryptocurrency projects, and stablecoins are not immune to these problems. Storing your stablecoins on an exchange for an extended period of time introduces an increased risk into your holdings. Get your funds off the exchanges and protect your private keys.

Finally, stablecoins are not without their share of controversy. Projects such as Tether may be heading for trouble in the near future.

Disclaimer: This is not investment advice. Bitcoin and other cryptocurrencies are highly speculative. Nothing is guaranteed in cryptocurrency. Always perform your own research before investing and never commit more money than you are comfortable losing.

Start Using Stablecoins Today!

Now you know what stablecoins are, will you start using them? Do you prefer fiat or commodity-backed stablecoins, or what about a cryptocurrency backed or even a seignorage-style backed project?

Whatever you choose, the benefits can be massive. A stable price with good trading pairs which enable easy trading in and out of the market at almost a moment’s notice. Now go study Dan’s piece about the best trading papers to combine with your stablecoin of choice.

We earn commission if you purchase items using an affiliate link. We only recommend products we trust. See our affiliate disclosure.

Joe Coburn
Joe is a senior software developer with a degree in computer science from the University of Lincoln, UK. He is currently a Senior Writer for Blocks Decoded. Formerly, he was on the editorial team. As a writer at MakeUseOf, Joe has seen his work shared by Adobe, the Arduino Foundation, and Lifehacker. He has collaborated with Anker, BenQ, iStock, Ledger, Ultimate Ears, and many more. Joe loves all aspects of blockchain and cryptocurrencies, particularly the technical details.
Advertisement

Comments

Leave a reply

Your email address will not be published. Required fields are marked *

You may also like

Advertisement