Stablecoins are touted as foolproof, fiat-backed coins, but are they as stable as you think?
Let’s get down to it and find out:
What is a Stablecoin ?
A Stablecoin is a utility token built upon another coin’s blockchain.
The goal of a stablecoin is to create a cryptocurrency that isn’t volatile and doesn’t change price.
As such, this means that while still being able to offer the convenience, the privacy, and the security of crypto, a stablecoin will also attempt to offer the same stability and trust fiat money has.
Looking at Bitcoin, for example, it was created to be used as a store of value.
However, since it is not widely adopted and lacks regulation, its price still fluctuates a lot.
On the other hand, a stablecoin which is pegged to the US Dollar, for example, should theoretically always equal one dollar, meaning that it does not share the speculative investment nature of Bitcoin, rather it works as a mean to store money using crypto technology and avoid price volatility altogether.
The differences between a centralized exchange and a decentralized exchange
A centralized exchange is owned by one entity.
They allow you to buy and sell cryptocurrencies but since they are a company, that means they are also regulated by the government that they answer to.
On the other hand, a decentralized exchange is run by code an the only changes you’ll experience are the ones done when the code itself changes, meaning that, as opposed to centralized exchanges, no government can single-handedly regulate, control, or even shut them down.
By using a decentralized exchange, one can trade his or her stablecoins back and forth from one crypto to another without having to pay a lot of fees, without waiting too long, and without having to be afraid that a governmental entity could track or cancel their transactions.
Stablecoins can work similarly to a crypto savings account, but they shine when invested in platforms in which you can earn interest on your crypto assets. By doing so, you don’t have to worry about any price fluctuations (earning 20% APR on a random coin won’t matter if that coin’s value drops, whereas 20% on a stablecoin will be a strong return on investment).
How do stablecoins work?
Mainly they work in two different ways: collateralization or through algorithmic mechanisms known as smart contracts.
Fiat collateralization means that each coin is backed by something.
This system, however, is far from being risk free as embezzlement and even stealing might happen in the companies which claim to have fiat collateralization for each single stablecoin.
As for smart contracts, or algorithmically pegged stablecoins, auditing them is a simple process as you can simply consult their smart contract code.
However, there are also some drawbacks to this system as smart contract controlled stablecoins are more volatile simply due to their nature.
This means that they must manipulate the supply of their coins to adjust the price.
To keep things in balance, there are three types of algorithms which differ in terms of manipulation (Rebase, Seigniorage Supply, and Fractionally Collateralized algorithms).
One, for example, will change the number of coins in your wallet as to keep the value the same ($1).
Another will use something similar to a money printer and a bond reward system, and so forth.
So, what exactly are the main issues with stablecoins?
- Insurance won’t come to the rescue:
It is important to know that by depositing your money into a bank, savings, or checking account, it will be insured up to a certain amount.
That means that your insured money if stolen, or lost from the bank, will be repaid to you.
If a company that is operating a stablecoin goes bankrupt, your investment will be lost and you will be left empty handed.
- Fiat collateralization is a trust exercise:
Collateralization claims are hard to prove and there are rumors that companies like companies like Tether might not actually be back by true cash.
If they aren’t and that scares people, the price can fluctuate a lot.
It can even cause it to be unpegged to a dollar, as Tether is only worth what people believe it to be worth. Right now, it’s $1 but if the belief changes, so will its value.
Stablecoins offer stability in the crypto universe but as far as security goes, they seem to be often reliant on their user’s trust. With the rapid growing crypto universe leaving no question on weather they can succeed or not, it will ultimately be up to the crypto community to ensure things keep running smoothly as possible.