Stablecoins offer convenience, privacy, and security.
In thıs article, we explain the topics of cryptocurrency using analogies stories and examples. So today, we want to explain what stablecoins are and how you can best use them to leverage your crypto trades.
First, what is a stablecoin? A stablecoin is technically a utility token built upon another coin’s blockchain. If you don’t know the differences between a coin and a token is you should check out our previous article on that topic. But the entire goal of a stablecoin is to create a cryptocurrency that isn’t volatile and doesn’t change the price. Stablecoins offer the convenience, privacy, and security of crypto while offering the stability and trust of fiat money.
A stablecoin is pegged to the USD and should always equal 1 USD theoretically.
Bitcoin, the first cryptocurrency, was created to be used as a store of value. However, since it’s not widely adopted and there aren’t very many regulations on it, yet the price fluctuates a lot. So much so that it is classified as a speculative investment. So what if you want to store money using crypto technology, but you don’t want to risk your investment with the price fluctuations of crypto in today’s world. Well, you can use a trusted stablecoin. Before we get too deep in the stablecoins, you first need a refresher on the differences between a centralized exchange and a decentralized exchange.
A centralized exchange is an exchange that is owned by one entity, like Coinbase. But they allow you to buy and sell cryptocurrencies. Since they are a company, they are technically regulated by the government that the answer to. On the other hand, a decentralized exchange is an exchange that is not run by a company, instead, they are run by code. Changes to the exchange only happen when the code is changed, and due to their decentralized nature, a government cannot regulate control or even shut them down as they could do to Coinbase. Using stablecoins, you can trade back and forth from ethereum to a stablecoin from that stablecoin to bitcoin from that bitcoin back to another stablecoin. Whenever you want using a decentralized exchange. This way, you don’t have to pay as many fees, you don’t have to wait as long, or you don’t have to worry about the government tracking or canceling your transactions as if you would have to do it if you used a centralized exchange.
Now, this is a really good advantage of stablecoins. Let’s say you purchase 100 bitcoins for 100 USD. Bitcoin then goes up to 10 000 USD per coin. So, you sell 50 bitcoins for half a million dollars, so you trade 50 of those bitcoins to DAI or USDC, which are stablecoins for half a million dollars. And then you hold it when you can then buy back at a lower price. It’s almost like a cryptocurrency savings account. Stablecoins are also beneficial when investing on platforms like AAVE or COMPOUND, where you can earn interest on your crypto assets. Because you don’t have to worry about the price fluctuations. 20% apr and ethereum do not matter if ethereum drops by half. However, 20 APR on your USDC stablecoin is delicious.
Moving on, we’re gonna move into some technical stuff. How do stablecoins work?
Well, mainly they work in two different ways; collateralization or through algorithmic mechanisms, also known as smart contract manipulation. Those were a lot of big words, but we’re gonna break it down for you. First off, fiat collateralization means that each coin is backed by something. In most cases, that is one us dollar. In some thought, it’s other countries’ currencies like the euro or even gold. Tether is, in fact, one of the most major companies that release their USDT stablecoin using fiat collateralization.
The pros of a fiat collateralized stablecoin are that they are quite stable much more than the alternative. However, they do have problems. The first is that the money required to put up for each USDT cannot be invested. This could mean millions of dollars for that company that is not earning interest. Another problem is someone at the company could embezzle or steal a bunch of that collateral .and one last problem specifically that tether faces is that it’s very difficult to prove that you own the total amount of collateral.
Let’s move on to the second method. Because as an alternative to the fiat collateralization method, some stablecoins are controlled by smart contracts. Some people call these algorithmically pegged stablecoins. Now the benefit of this method is that it is very easy to audit. You just take a look at the smart contract code. Another benefit is that there are no physical assets to steal. However, some of the problems can seem much worse. Smart contract controlled stable stablecoins are usually much more volatile. Simply due to how they work. What they do is they must manipulate the supply of their coins to adjust the price.
Now the algorithm differs among each stablecoin, but there are three main algorithms. We may actually make an entire article about these three specific algorithms. One changes the amount of coin in your wallet each time that you check it. So that the value stays roughly the same, one dollar. The second system uses a money printer and a bond reward system to adjust the price to one dollar. A third is very similar to the second however it uses something called coupons. And how they work?
Moving on, though, how do you buy a stablecoin? In short, stablecoins are bought and sold on exchanges both centralized and decentralized. It’s very easy to buy tether or daı or USDC on a centralized exchange like Coinbase or Gemini. Another method is you could buy something like ethereum on Coinbase, transfer it to your private wallet, and then use a decentralized exchange like Uniswap and trade that eth into a stablecoin.
Now it’s time to be a little more pessimistic around the topic of stablecoins. While stablecoins do have good traits around them, there are a few things that you should think about before fully ditching your savings account and tossing all your savings into a stablecoin. First is the lack of insurance. When you put your money into a bank savings or checking account, it is insured by the government. At least if you’re in the USA. Some banks are FDIC insured, meaning they’ll repay up to 250 000 worth of money that is stolen or lost from the bank to you. Stablecoins do not have this advantage yet. If a company that started and is operating that stablecoin goes bankrupt, then you’ll most likely lose all of your investment and be left empty-handed.
Secondly, we have to bring back up the collateralization issue. Remember how we said that there were rumors that tether may actually not be backed by true cash. If they aren’t, and that scares people, the price could fluctuate a lot. It could even cause it to be unpegged to a dollar because tether is only worth what people think it is worth, and right now, that is one dollar. If the belief changes, then the value changes.
So concluding, stablecoins are a great advancement for cryptocurrencies at the current moment, and we’re excited to see where they go from here. If you’re putting your money into them, we recommend being cautious and, as always, do your research.