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Stablecoins, Explained
They have been touted as the silver bullet for eliminating crypto price volatility. But what are stablecoins, how do they work, and what are their downsides?
As the name suggests, stablecoins are designed to have a consistent price or value over time.
There are three different ways of achieving this — delivering a happy medium between offering the stability of fiat currencies and the decentralized benefits that virtual currencies provide. Without stablecoins, taking out a loan while using crypto as collateral can be risky, as the assets used to secure your borrowing can be rendered worthless in a short space of time. Likewise, imagine what getting your salary in crypto would be like if prices were to tumble unexpectedly. In the real world, it would be like suddenly finding out that milk has ballooned in price from $1 to $3, meaning your money goes a lot less further.
The first type of stablecoin is collateralized by fiat. For every single stablecoin issued, $1 is kept safely by a central custodian such as a bank. This means that, in theory, you should be able to exchange between the two effortlessly without great expense. In other cases, commodities have been touted as a way of collateralizing crypto, with Venezuela’s government unveiling plans to launch the petro — a coin that’s value was to be tied to one barrel of oil. Alas, the petro’s launch was long delayed and, as Cointelegraph reported, it faced mixed success.
Next, you have stablecoins collateralized by crypto. “But wait!” I hear you cry. “Doesn’t this mean that price volatility is still possible?!” To an extent, yes — but some providers try to tackle this issue by “overcollateralization,” meaning $2 worth of crypto is deposited with a custodian for every $1 of a stablecoin. This can help to keep decentralization alive, with crypto reserves absorbing the impact of any fluctuations, but a downside is that huge amounts of capital can be required to get them off the ground.
Last, there are noncollateralized stablecoins, which do away with the idea of having reserves altogether. These types of assets see smart contracts take on a role not too dissimilar to a reserve bank. They monitor supply and demand — buying circulating coins when prices are too low and issuing new ones when prices are becoming too high. The ultimate goal is to keep prices in line with that of a pegged asset such as the U.S. dollar.
No matter what type of method is used, it is worth noting that stability is more of an aim than an inseparable feature.
