Volatile Markets: What You Need to Know About Stablecoins

On 22 May 2010, Laszlo Hanyecz made the first real-world cryptocurrency transaction by purchasing two pizzas from Papa Johns in Jacksonville, Florida for 10,000 BTC (Bitcoin). That was for around $25, with Bitcoin being valued at 0.0025 cents per coin. Fast forward to 2019. The same order could cost around $82M if purchased through Bitcoin! Thanks to Bitcoin’s massive change in valuation over the years, which stands at around $8200 per coin at present.

Volatility in markets is a cause of anxiety not only for investors in traditional financial instruments but also for emerging avenues such as cryptocurrencies. There is an abundance of literature and advice available for guidance around traditional investment options. However, expertise and reliable data to help decision-making when it comes to investment in cryptocurrencies is still very limited. The following section is an attempt to share information and insights related to Stablecoins.

What are Stablecoins?

Before understanding the concept of Stablecoins, it is important to have the basics in place with regards to the valuation of cryptocurrencies. The value of most cryptocurrencies fluctuates almost every day, similar to traditional financial instruments such as stocks, bonds, hedge funds and so on. This also means that while virtual currencies intend to enable secure transactions, their inherent values are based on speculation.

On the other hand, Stablecoins are increasingly gaining popularity as their value is much more fixed and reliable than traditional cryptocurrencies such as Bitcoin. Stablecoins derive their value from other assets to which they are attached, such as the US Dollar or gold.

As a result, Stablecoins provide investors with the advantage of all the key benefits of a cryptocurrency such as security, transparency, privacy and so on, without pushing them into the extreme volatility of traditional digital coins.

The primary motive behind creating Stablecoins was to provide cryptocurrencies that are stable, simple, secure and scalable means for transactions. This is the logical progression from traditionally volatile cryptocurrencies because there will be hardly any businesses interested in accepting a currency whose value tanks beyond imagination in a few weeks.

At the time of writing this post, there are around 57 stablecoins that have either been released or are known to be in development worldwide. Furthermore, there are two USD-backed Stablecoins approved and regulated by the New York State Department of Financial Services, namely the Paxos Standard (PAX) and the Gemini Dollar (GUSD).

Types of Stablecoins

Stablecoins are pegged to the value of an underlying asset. The exact asset in question may vary from coin to coin. The following section provides a cursory look into the various types of Stablecoins offered today:

• Fiat Currency-based Stablecoins: Several Stablecoins have been collateralized at 1:1 ratio with certain fiat currencies, such as the US Dollar, Sterling or the Euro. In these cases, real fiat currency is being held in bank accounts for each Stablecoin to provide a solid backup.

If anyone wishes to redeem cash with their coins, the entity managing the Stablecoin will withdraw the corresponding amount of fiat currency from their reserve and send the same to the person’s bank account. The corresponding amount of Stablecoins will then be destroyed or removed from circulation.

At present, Tether (USDT) is the most popular Stablecoin and the 9th largest cryptocurrency by market capitalization. It is the most frequently traded cryptocurrency after Bitcoin.

• Commodity-based Stablecoins: Several Stablecoins have been pegged to assets, such as gold or other precious metals. Some Stablecoins are even pegged to oil and real estate.

Holders of such commodity-backed Stablecoins hold an equivalent tangible asset that has real value. The value of such commodities usually appreciate over time, providing an increased incentive for individuals to hold and use these coins.

Digix Gold (DGX), for instance, is an ERC-20 token (developed on the Ethereum network) backed by gold, where 1 DGX represents 1 gram of physical gold. On the other hand, Tiberius Coin (TCX) is collateralized to a combination of 7 precious metals used in the manufacture of technology hardware. The value of TCX coins are expected to increase because these metals are used to make technology such as solar panels, electric cars and so on.

• Cryptocurrency-based Stablecoins: These Stablecoins are backed by other cryptocurrencies and intended to be much more decentralized than their fiat or commodity-backed counterparts, for all transactions are conducted on the blockchain. To shield against price volatility, these Stablecoins are often over-collateralized in order to absorb price fluctuations in the collateral. In the event of the price of the backup cryptocurrency dropping significantly low, the Stablecoins will be automatically be liquidated.

At present, Dai, developed by MakerDao, is the most popular cryptocurrency-based Stablecoin. Dai’s face-value is collateralized to the US Dollar, but in reality it is backed by Ether that is locked up in smart contracts.

• Non-collateralized Stablecoins: Non-collateralized Stablecoins are not pegged to any asset, which may contradict the underlying concept of Stablecoins. The idea of notional stability around the US Dollar can be applied to these Stablecoins. For many years, the US Dollar used to be backed by gold, a phenomenon that ceased decades ago. Nonetheless, US Dollars are still stable because people trust in their value.

Non-collateralized Stablecoins use complex algorithms to maintain the Stablecoin supply. With the increase in demand, new coins are created to roll the price back to the normal level. If the coin is trading too low, then existing coins in the market are bought to reduce the supply. Hence, it is expected that the prices of these stablecoins would remain stable because the are driven by the law of demand and supply.

One must, however, note that non-collateralized Stablecoins need continual growth to be successful. In the event of a crash, everyone’s money would be lost because of the absence of a collateral for liquidation. Basis is the [redominant example of a non-collateralized Stablecoin.

Stablecoins have undoubtedly offered a potential solution to not only guard against volatile cryptocurrency valuation trends but to weather crisis situations with local fiat currencies as well. The use cases for Stablecoins are still emerging and the stronger business cases will certainly bring significant benefits to a host of industries and individuals, thus transforming the entire cryptocurrency space.

Author Bio :

Akash Takyar

CEO LeewayHertz

Akash Takyar is the author of Blockchain Technology and Business book. He is the co-founder of LeewayHertz and is a consultant to fortune 500 companies including Siemens, 3M, Hershey’s and others. He has a Masters Degree in Computer Science. Akash’s experience of building over 100+ apps allows him to rapidly architect and design solutions. His ability to explain complex technologies in simple and practical ways has resulted in him becoming a popular speaker at colleges, universities, and conferences.