Stablecoins Explained
Stable coins are digital currencies that are tied to a stable reserve asset, such as the US dollar or gold.
A stable coin is designed to maintain a stable monetary value over time.
They differ from traditional cryptocurrencies, such as Bitcoin or Ethereum, in that they are less volatile and more reliable for daily transactions.
Stable coins can also be used to store wealth, make payments, and facilitate trading activities within the cryptocurrency market.
The idea of combining the stability of traditional assets with the flexibility of digital assets has been massive.
As a result, stable coins such as USD Coin (USDC) have attracted billions in value. They are now among the most popular methods for storing and trading value because they bridge the crypto world and everyday fiat currency.
Types of Stable Coins
There are a few different types of stable coins such as: fiat-backed, commodity-backed, crypto-backed, and non-collateralized (algorithms).
Fiat-backed Stable Coins
Fiat-backed stable coins are pegged to a national currency such as the US Dollar or the Euro. For every unit of the coin issued, an equivalent amount of the underlying fiat currency has been deposited into an escrow account and held by a third party such as a bank or another financial institution.
This approach provides stability against market volatility since its value remains linked to real-world assets.
Examples of fiat-backed stable coins include USD Coin (USDC) and Paxos Standard (PAX).
In my opinion, Tether (USDT) is not a real fiat-backed stable coin and it’s something that I’m unwilling to hold or keep my personal money in. Tether is not pegged to the US Dollar in the same way that its name and marketing suggest; instead, it is pegged to a portfolio of assets and its worth fluctuates based on what the market believes. This lack of stability was highlighted when Tether dropped to 0.96 cents, demonstrating how market forces can have an impact on the value of this type of cryptocurrency.
My preferred stable coin is USDC and this is why:
The company behind USDC, Circle, has implemented a number of measures to ensure the safety and security of its operations. First and foremost, all USD deposits backing USDC tokens are held in segregated accounts at FDIC-insured banks.
Additionally, Circle is regulated by the Financial Crimes Enforcement Network (FinCEN) as a money services business (MSB), which means they are subject to strict regulatory requirements and oversight.
Finally, USDC has insurance coverage provided by a consortium of insurance providers. This insurance policy is designed to protect against losses arising from theft or hack of the underlying assets that back USDC tokens.
Commodity-backed Stable Coins
These are backed by commodities such as gold, for example.
Gold-backed stable coins are cryptocurrencies that are pegged to the value of physical gold, meaning that for each token issued, there is a corresponding amount of gold held in reserve.
This provides stability to the price of the cryptocurrency, as the value of gold tends to be less volatile than other assets such as stocks or currencies.
The concept behind gold-backed stable coins is to offer investors a digital asset that combines the benefits of both traditional gold investments and cryptocurrencies.
My preferred gold-backed stable coin is PAXG:
PAX Gold (PAXG) is my favorite gold-backed stable coin because each PAXG token represents one fine troy ounce of a London Good Delivery gold bar, stored in professional vault facilities. The gold held in reserve to back PAXG tokens is audited by a third-party firm on a monthly basis to ensure that the amount of gold matches the number of tokens in circulation.
Additionally, Paxos Trust Company, the company behind PAXG, is regulated by the New York State Department of Financial Services and holds a trust charter. This means that they are subject to strict regulatory requirements and oversight, which helps to ensure the safety and security of their operations.
Finally, PAXG has insurance coverage provided by Lloyd’s of London, which insures against physical loss or damage of the underlying gold assets held in custody by Paxos.
Crypto-backed Stable Coins
Crypto-backed stable coins are backed by other cryptocurrencies such as Bitcoin or Ethereum, instead of fiat currencies.
This means that the value of the stable coin is collateralized by these underlying assets, which creates a form of price stability.
For example, MakerDAO’s Dai is backed by Ethereum tokens held in reserve in an Ethereum smart contract known as the Maker Vault. The Maker protocol offers a unique approach to decentralized finance by allowing users to lock in their ETH as collateral and mint DAI stable coins against it.
The collateral acts as insurance against price fluctuations so if the price of Dai goes down too much, Maker users can sell their Ether back into the market and get their Dai back at its original value.
Non-Collateralized Stable Coins
Non-collateralized stable coins do not have any backing assets, they instead rely on algorithmic mechanisms built into their protocol to maintain their stability.
These algorithms adjust the supply according to demand in order to keep the price steady, making it self-regulating. Non-collateralized stable coins rely on market confidence in their ability to maintain their peg to a certain value.
One such example is Basis, which utilizes a fixed supply of tokens and an algorithmic mechanism to achieve price stability. Through creating or destroying tokens based on market demand, Basis works similarly to how central banks adjust money supply to stabilize prices.
Ampleforth is another example but takes a different approach to maintain price stability. Unlike Basis which creates or destroys tokens, Ampleforth increases or decreases the number of tokens held by each user to maintain price stability.
Advantages Of Using A Stable Coin
Stable coins provide numerous benefits, such as being open, global, and available to anyone on the internet 24/7. They are also fast, cost-effective, and secure to transmit. Moreover, they are digitally native to the Internet and can be programmed according to specific requirements.
They can also be used for quick and reliable international payments. Merchants worldwide can accept instant crypto payments without having to worry about exchange rate fluctuations wiping out profits overnight.
This includes countries with unstable economies or troubled domestic political situations, which makes crypto ideal for individuals living abroad who need access to funds quickly and without worrying about exchange rate risks associated with local currencies in those countries.
Furthermore, decentralized stable coins have the added benefit of reducing risks associated with government intervention.
Additionally, a stable coin like PAXG could prevent a hedge against issues such as high inflation rates caused by governments printing out excessive amounts of money, leading to the devaluation of national currency units over time.
Finally, stable coins provide the amazing option of self-custody. This means people no longer have to hold money in banks. This reduces risk against bank runs (which have been happening around the world) and gives people 100% control over their money.
Users on Coinbase can earn 1.50% APY staking with $USDC. This is a great option for investors who are holding money on the side, waiting for great opportunities and black swan events to present themselves.
Disadvantages Of Using A Stable Coin
A potential downside of using stable coins is that this technology is relatively new and we’ve yet to see regulation or much government intervention.
Private companies that create stable coins may have issues with transparency, trustworthiness, and accountability. There also may be private companies that are publicly advertising a fraudulent digital dollar (In my opinion, this is USDT Tether).
There are concerns that private entities could be less reliable than governments in terms of maintaining the currency’s backing or pegging it to a reserve asset; this could lead to investors losing money should an issuer be unreliable or dishonest.
These risks can be mitigated with strong regulatory oversight, though this may vary significantly depending on geographic location and jurisdiction.
Conclusion
In conclusion, stable coins provide greater safety, transparency, reliability, and decentralization compared to traditional forms of currency. They provide the bridge between the world of blockchain and crypto, to that of everyday fiat currency.
For investors, stable coins provide instant liquidy and allow them to be nimble if needed, but also provide a safety net to store hard-earned money with self-custody.
Stable coins also remove risk factors involved in government intervention and gold-backed stablecoins may also provide a hedge against inflation which many countries are currently suffering from.
I believe we will see regulation around stable coins in the very near future and I’m excited to see how things unfold.