The purpose of this article is to gain a better understanding of stablecoins and the terminology associated with them. To understand stablecoins, we first need to grasp knowledge about cryptocurrencies and blockchain. Cryptocurrency comes from cryptography and is a means of communication over a network. Cryptography uses various encryption algorithms which can only be decrypted with a particular code, ensuring the highest levels of security of the transmitted data. The technology that makes cryptocurrencies accessible is called the blockchain.
What are Stablecoins and their purpose?
If you are worried about making a digital transaction due to safety issues, cryptocurrency should be your go-to thing. A cryptocurrency is a decentralized form of currency that can be used in the place of any transaction that you make online; it will act just like a currency. Without the help of any middleman, they make it possible to make safe online payments. Stablecoins are a form of cryptocurrency with a valuation associated with some “stable” assets. If any cryptocurrency like Bitcoin is undergoing market instability, you can trade those with stablecoins to secure the valuation.
They can be used to give salaries to their employees, as it is more convenient to transfer money overseas. You can even lend money in the form of cryptocurrency to people and get interested; that is more than financial institutions like banks offer.
How do Stablecoins work?
As previously stated, stablecoins (cryptocurrencies) are decentralized; there is no governing body or agency to decide their valuation. This helps them to achieve autonomy.
Stablecoins connect traditional money and cryptocurrencies because they are associated with the currencies used by different nations—like the US dollar.
These are called fiat currencies. For example, if you are investing in a stablecoin backed by the US dollar, the algorithm will deposit 1 dollar for every stablecoin you place in circulation. Fiat-backed stablecoins are popular, but there are other assets with which the valuation of stablecoins is associated, like gold, crypto token, or algorithms.
The Importance of Stablecoins
Many people get confused with the introduction of stablecoins when popular cryptocurrencies like Bitcoin are already in the market. However, a significant drawback is their instability of valuation. The value of cryptocurrencies is inconsistent, and it often fluctuates dramatically.
People like to invest in something that will be profitable to them in the future. But they cannot predict any market valuation of such cryptocurrencies because they have an unstable market valuation, and it becomes almost impossible to use.
The bitcoin price in February 2021 skyrocketed to USD 58000 from USD 32,000 before plummeting sharply to roughly USD 34,000 in May.
Some alternatives had to be adapted to handle this instability, and stablecoins’ popularity began increasing. Stablecoins of all kinds exist to increase the reliability of cryptocurrencies. They are linked to the value of assets that are not volatile, for example, the US dollar or precious metals like gold or silver.
Note that their prices fluctuate too, but you can know the valuation it might have tomorrow.
Types of Stablecoins
Fiat-back Stablecoins
It is not a physical asset backed by the currencies of various nations and is the most commonly used stablecoin. Most of them get stored in a one-to-one ratio, which means one dollar invested in a fiat-backed stablecoin should be equivalent to one stablecoin.
Commodity-backed Stablecoins
As the name suggests, it is a stablecoin that is backed by precious metals like gold or silver and is a physical asset. One of the main advantages is that users can invest in these commodity-backed stablecoins without buying physical gold or precious metals, which provides a sense of security as these assets are often the target of thieves.
An example of a commodity-backed stablecoin is the DIGIX; Digix is a cryptocurrency network developed by DigixDAO that gets traded with gold. DigixDAO issues an Ethereum-based ERC-20 stablecoin token in place of actual gold bars. This form of stablecoin also works on a 1:1 ratio. One DGX currency was created to represent one gram of gold by Digix and is used to hold information on gold bars using Ethereum smart contracts.
Crypto-backed Stablecoins
We can also invest in stablecoins through the help of various cryptocurrencies. However, they are not precisely stored in a 1:1 ratio. Therefore, their market valuation is fragile, and crypto-currency has to overcompensate. For example, if we have $100 worth of crypto, it would get transferred as $75 worth of stablecoins. The remaining value is stored for market inflation to avoid any losses. An example is MakerDAO (DAI), which leverages Maker collateral vaults, a type of smart contract, to secure and generate DAI tokens. It is backed by Ethereum and sets its valuation at 150% of the actual stablecoins in use.
Algorithmic Stablecoins
They are a unique type of stablecoin with no collateral or backup of any physical or digital property. Instead, Algorithmic stablecoins are maintained by a set of instructions called algorithms – that monitors the market valuation and acts according to it. Let us take an example. When prices increase, we tend to be careful with our money and spend less. Algorithmic stablecoins work in the same way. Their algorithmic token circulation is lowered when there is a drop in market valuation and similarly increases as the valuation becomes stable and better. An algorithmic stablecoin example is Frax. Frax is currently deployed on Ethereum and is open-source and autonomous. You can also redeem or mint the stablecoins. Frax protocol aims to replace digital assets with a fixed supply, like Bitcoin, with highly scalable, decentralized, algorithmic money.
Hybrid Stablecoins
These stablecoins are more secure and protect against market fluctuations. However, this is a new addition that might confuse beginners.
Collateralized and non-collateralized stablecoins are combined to create hybrid stablecoins. They are backed by fiat, commodities, or crypto stablecoins and managed algorithmically.
Sovereign Stablecoins
A financial institution or governing body approves this stablecoin. Though their exact purpose may vary across geographies, many nations adopt sovereign stablecoins to cope with financial instabilities and market inflation.
Even though algorithmic stablecoins have proved more trustworthy, many factors must be decided before investing in them. First, we should store our money in such a place where we can retrieve the amount whenever we need it. The best way to determine the reliability is by checking what kind of scrutiny or audits were conducted and by which organizations. We should not invest in any source whose audit was not done by a trusted organization.
How to mint Stablecoins?
Let us first understand what minting means. When we buy any cryptocurrency, it generates new coins by verifying the details and storing the information on the blockchain. It is a way of exchanging your money or assets with cryptocurrencies so that they can be circulated online.
The MakerDAO project is currently the best example of using a digital asset as collateral and uses a decentralized method of a minting stablecoin. MakerDAO uses the market value of ether as a unit of valuation and mints stablecoin DAI, which is managed by smart contracts without the help of any governing organization. The disadvantage of this process is that it can only accept ether, which limits production and circulation.
Another way of minting stablecoins is through bitcoin; stablecoins will get minted according to the exchanged amount and market value of bitcoin. It is a much more secure way of minting because it is built on a high-level algorithm, which makes it impossible for hackers to steal information or assets.
The valuation of stablecoins has skyrocketed recently and reached a whopping value of around one hundred sixty billion US dollars in March ’22. Within that period, statistics show that their valuations increased thrice as much just within the span of half a year. This value excludes TerraUSD (UST), the algorithmic stablecoin linked to the LUNA cryptocurrency, which experienced a sharp fall some months ago.
As we saw in this article, the cryptocurrency market is volatile, and stablecoins are no exception. However, if we don’t be careful, we can lose all of our life’s savings in a day, and a beginner should not start this journey towards cryptocurrency all by themselves.
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