What are Stablecoins? Are they Solution to Cryptocurrency Problems?

by Mark Tencaten Mark Tencaten - Co-Founder and owner at NGS Group

Mark Tencaten explains that the utility of Bitcoin (BTC) and other virtual currencies as a means of exchange has been constrained by price volatility, which is why stablecoins, a more recent breed of cryptocurrency, are becoming more and more popular.

The list of stablecoins has expanded since Tether (USDT) became the first one in 2014. In addition to Tether (USDT), Havven's Nomin, True USD (USDT), Paxos Standard, USD Coin (USDC), Digix Gold, and Binance USD.

What are Stablecoins?

A currency is most helpful when it serves as a means of exchange and a store of value, regardless of whether it is the U.S. dollar or Dogecoin. For those activities, price stability is essential. Because of this, authorities work to maintain a general level of stability in the prices of traditional national currencies. A daily movement of 2% in the forex market of fiat currencies is a massive shift.

Mark Tencaten says that this does not happen in the Bitcoin world. During mid-November and mid-December of 2017, Bitcoin, the most well-known cryptocurrency in the world, soared from less than 6,000 dollars to more than 19,000 dollars before dropping to roughly 6,900 dollars by early February 2018. More recently, it increased from 5,000 dollars in March 2020 to 44,000 dollars by August 2021, a significant increase. It is not unusual to see cryptocurrencies increase or decrease by 10% over the course of a day, even on an intraday basis.

Such large swings are not indicative of a stable currency. This has raised significant concerns about whether well-known cryptocurrencies serve any purpose other than speculation.

Stablecoins are a new type of cryptocurrency that intends to offer the price stability needed to promote widespread use. The best of both worlds is what stablecoins promise bitcoin supporters: stable valuation without the centralized control associated with cash.

How do stablecoins maintain their value?

Stablecoins aims to reduce volatility by fixing their price to the U.S. dollar and securing the worth of their units with liquid sources of collateral.

Mark Tencaten explains that stablecoins can be split into three categories based on how they decide to pursue price stability.

1. Stablecoins with fiat collateral: The valuation of these stablecoins is supported by fiat money, such as the U.S. dollar. Precious metals like gold and silver, as well as commodities like crude oil, can also be used as collateral. To ensure that the stablecoin tokens are redeemed, collateral needs to be stored by a custodian and constantly audited.

Popular stablecoins Tether and TrueUSD are supported by dollar reserves and are linked at par with the U.S. dollar.

2. Stablecoins with crypto collateral: Stablecoins that are crypto-collateralized are comparable to those that are fiat-backed, but their underlying collateral is a different cryptocurrency or a collection of cryptocurrencies rather than a fiat currency or a physical good.

Stablecoins backed by other cryptocurrencies are typically "over-collateralized," which means the value of the collateral exceeds the value of the tokens issued by a certain ratio to account for the negative effect of the collateral cryptocurrency's volatility.

The collateral for the Dai stablecoin is a collection of digital assets valued at 150 percent of the token value. It is tied to the value of the dollar.

It's a flawed system. The stablecoin's value will crash, contradicting its purpose; if the collateral cryptocurrency entirely fails, there are procedural problems with the auditing procedure, or demands for further top-ups of collateral are not delivered on schedule.

3. Algorithmic stablecoins: Algorithmic stablecoins, whether collateralized or not, depend on an algorithm, or a system of rules, to regulate the supply of tokens and maintain their value.

An algorithmic stablecoin might, for instance, rely on a rule requiring adjustments to the token supply necessary to preserve the stablecoin's value. This is comparable to a central bank's responsibility to change interest rates to maintain price stability. The key distinction is that central banks, such as the U.S. Federal Reserve, establish a monetary system based on generally accepted guidelines and support it with an infinite supply of legal money. Such benefits are absent with algorithmic stablecoins like Basis and TerraUSD.