A Comprehensive Guide On Stablecoin

Stablecoins are digital assets pegged to fiat currencies or precious metals. Stablecoins are intended to maintain a relatively stable price so that users can avoid the volatility risks that are prevalent in crypto markets.

Types of stablecoin security

Using this framework, stablecoins are available in a variety of flavours, and a variety of assets back collateralized stablecoins.

The most common collateral for stablecoins is fiat currency. Companies are looking towards stablecoins linked to various fiat currencies like the Turkish lira-pegged BiLira in addition to the most widely used fiat currency, the U.S. dollar.

Some cryptocurrencies are pegged to the price of precious metals such as gold and silver.

Some stablecoins even use other cryptocurrencies as collateral, such as ether, the native token of the Ethereum network.

Other expenditures: Tether's USDT was once intended to be backed 1:1 with dollars, but its collateral mix has shifted over time, and according to a breakdown provided by the company in 2021, nearly half of its reserves consist of commercial paper, a form of short-term corporate debt. It has not disclosed the issuers of this paper but claims it is all rated A-2 or above (A-2 is the second-highest grade available to corporate borrowers from credit rating agencies such as Standard & Poor's). In its monthly disclosures, Circle's USDC lists unspecified "approved investments" alongside accounts at federally insured banks (notably, it does not specify whether the accounts are insured).

What is a cryptocurrency stablecoin?

Stablecoins are digital assets whose value is pegged to that of fiat currencies or other assets. For instance, tokens pegged to the dollar, euro, yen, and even gold and oil can be purchased. A stablecoin enables the holder to lock in profits and losses and transfer value on peer-to-peer blockchain networks at a stable price.

Bitcoin (BTC), Ether (ETH), and alternative cryptocurrencies have always been historically volatile. This provides numerous opportunities for speculation, but it also has disadvantages. Volatility makes it difficult to use cryptocurrencies for everyday transactions. For instance, merchants may accept $5 in BTC for a cup of coffee one day but see the value of their BTC decrease by 50% the next. This makes business planning and operation challenges.

Previously, crypto investors and traders could not lock in a profit or avoid volatility without converting their holdings back into fiat currency. Stablecoins provided a straightforward solution to these two problems. Using stablecoins such as BUSD or USDC, it is now simple to enter and exit the crypto volatility market.

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Why are stablecoins so essential?

Companies are looking towards stablecoins linked to various fiat currencies like the Turkish lira-pegged BiLira in addition to the most widely used fiat currency, the U.S. dollar. An independent accounting firm attests (i.e., verifies publicly) these accounts.

Similar to numerous other stablecoins, USDC operates on the Ethereum blockchain. Stablecoins are immune to the volatility of cryptocurrencies that are not pegged while inheriting some of their most potent properties.

  • Stablecoins are accessible to anyone on the Internet, 24/7.
  • They can be transmitted quickly, affordably, and securely.
  • They are digitally native to the Internet and programmable.

What can stablecoins be used for?

  • Minimize volatility. Cryptocurrencies like Bitcoin and Ether can see wild price swings, sometimes even within a minute. Token holders can rest easy knowing the value of their tokens will not vary wildly if the asset is tied to a more stable currency.
  • Trade or save assets. Stablecoins are easy to send and receive and don't require a bank account to be retained. The value of stablecoins can be easily transferred around the world, including to regions where the U.S. dollar may be difficult to obtain or where the local currency is volatile.
  • Acquire interest: It's simple to earn interest on a stablecoin investment, and that income is usually higher than what you'd get from a bank.
  • Transfer funds affordably. One million dollars’ worth of USDC has been transferred with less than one dollar transfer fee.
  • International shipping. Stablecoins, such as USDC, are a good choice for sending money anywhere in the world due to their rapid processing and low transaction fees.

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What Types of Stablecoins Exist?

Given the widespread availability and acceptance of the U.S. dollar, some may argue that stablecoins are a solution seeking a problem. Many cryptocurrency supporters, on the other hand, believe the future belongs to central bank-independent digital currency. There are three distinct stablecoins based on the mechanism used to maintain their value stability.

  • Stablecoins Collateralized with Fiat
    To ensure their value, stablecoins backed by a reserve of a fiat currency (or currencies) like the U.S. dollar are used. Other forms of collateral include precious metals such as gold or silver, as well as commodities such as crude oil. Still, the majority of fiat-collateralized stablecoins are backed by U.S. dollars.
    These reserves are managed by independent custodians and audited frequently. Popular stablecoins Tether (USDT) and TrueUSD (TUSD) are backed by U.S. dollar reserves and pegged to the dollar.
  • Cryptocurrency-Backed Stablecoins
    Other cryptocurrencies back stablecoins that are crypto-collateralized. Due to the possibility that the reserve cryptocurrency is also subject to high volatility, such stablecoins are overcollateralized, i.e., the value of the reserve cryptocurrency exceeds the value of the stablecoins issued.
    A reserve of $2 million in cryptocurrency could be used to issue $1 million in a crypto-backed stablecoin, protecting against a 50% price decline in the reserve cryptocurrency. For instance, MakerDAO's Dai (DAI) stablecoin is pegged to the U.S. dollar while being backed by Ethereum (ETH) and other cryptocurrencies worth 150% of the circulating DAI stablecoin.
  • Stablecoins Based on Algorithm
    It is possible that algorithmic stablecoins do not hold reserve assets. Principally, stablecoins maintain their value by controlling their supply via an algorithm, essentially a computer program executing a predetermined formula.
    This is similar to central banks, which also do not rely on a reserve asset to maintain the stability of the currency they issue. Because of its standing as the issuer of legal cash, a central bank like the Federal Reserve in the United States can publicly set a monetary policy based on transparent standards.
    The issuers of algorithmic stablecoins cannot rely on such advantages during a crisis. The TerraUSD (UST) algorithmic stablecoin lost its peg to the U.S. dollar on May 11, 2022, as the price of the related Luna token, which was used to peg Terra, fell more than 80% overnight.

Consequences of Stablecoins

The most significant disadvantage of stablecoins is counterparty risk. Counterparty risk refers to the possibility that another party to an agreement will default. In this scenario, an issuer of stablecoins may not have the reserves they claim to have or may refuse to redeem tokens for their reserves.

Stablecoins that rely on centralized entities and auditors are susceptible to human error, as audits may miss inaccuracies and potential issues. In addition, stablecoins backed by fiat currencies are frequently held in commercial paper, a form of short-term unsecured debt. The use of commercial paper increases the counterparty risk, as the issuing company may default on its obligations.

Risk premiums may also result from periods of market turmoil or auditing failure. Risk premiums are the additional compensation investors receive for the increased risk of investing in a particular asset (i.e., stablecoins). The risk premiums reduce the value of stablecoins relative to their peg, making the purchase of cryptocurrencies with stablecoins marginally more costly than with fiat currencies.

Frequently, algorithmic stablecoins can lead to Ponzi schemes in which new tokens are created only when new users deposit collateral. Suppose you invest money in a Ponzi scam. In that case, you can lose your money rewards are paid to earlier investors with money contributed by new participants. This implies that the value of these assets can rapidly collapse if new users cease to arrive.

At the request of law enforcement, the central entities issuing tokens may be able to freeze them on addresses. Even during investigations involving money laundering, counterterrorism financing, or other illegal activities, law enforcement agencies may require that tokens be frozen.

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