What are Stablecoins?

17 Jun 2021  Read 809 Views

The last few years are remarkable as many investors left Wall St. and Dalal Street big handed by minting enormous returns by their new found strategy, Bitcoins and Cryptocurrencies. While the debate between its boon and bane never failed to hold a separate place in the daily headlines, many investors were quick enough to jump on the new train. 

Stablecoins, which follow their lineage, is yet another new addition, which was made popular by 2015 and in no time got an important place in our day-to-day conversations.

So, today we'll dive deep into the roots of the very tree called 'Stablecoins' and decode the various elements. Are you all set? 

Stablecoins - An Overview

Stablecoins, in general, are connected to an underlying asset or collateral. They are usually pegged to fiat, commodities or algorithms. And what's the value proposition, you ask?

You see, Bitcoins and cryptocurrency surely did grasp the investor attention. But one issue prevailed in this mode of investment which left a considerable portion worried - Volatility!

We only prefer to invest in those securities or instruments which will offer us the time value of the money. Along with that, we would expect to know the state of returns 5 years from now or at any given future date (at least an approximate figure). But, Bitcoins and Cryptos lacked this feature, and this made many fear its consequences. In short, the high volatility which they carried along made the future uncertain, raising doubts about the future returns. 

And that is where stablecoins make a grand entry. Aiming to cull out this fear, Stablecoins, as the name itself suggests, offers stability over volatility. And how does it do that? 

Let us assume you purchase a Stablecoin backed by the US dollar. For every coin, the underlying worth of collateral is held as a reserve. Thus, they offer security and stability to the decentralized financial institution, which is booming to be the new way of investing.

The increasing interest for these coins can be deduced from the fact that news covering of Stablecoins has leapfrogged like anything since 2018 -

(Source: CB Insights Research)

Types of Stablecoins

Having got an idea behind the working of the Stablecoins, let's understand their classification.

Fiat-collateralized Stablecoins 

Here the Stablecoins have fiat currencies as collateral, which is the US dollars. This is used as a measure to introduce the right number of coins. Apart from this, coins may also be tied to commodities like gold, silver, oil, real estate, etc. Assume an issuer has $100 as collateral. In such a case, he will be issuing 100 Stablecoins. However, there is increased counterparty risk in these investments. 

Some examples of the same include Tether, which is tied to the US dollars and Binance GBP-BGBP, which are backed by the British Pound. 

Crypto-backed Stablecoins

Here, the coins use another cryptocurrency as a collateral. But these are claimed to be excessively collateralized. As the cryptocurrencies are volatile, a larger number of such coins are to be held as a reserve for issuing just a handful of coins. This is done to lower the risk involved in the same. For instance, Ethereum is used as a collateral to generate DAI. So for every unit of DAI, an investor will have to provide a relatively higher value of Ethereum as collateral. 

Here the users agree to a contract where they surrender their crypto coins (underlying security) to secure the required Stablecoins. And can later reclaim the same on surrender of the Stablecoins. 

Algorithm-backed Stablecoins

Here there is no collateral, but instead, they hold a decentralized autonomous software that totally relies on a smart contract to maintain stability. It increases and decreases the tokens based on the price movement prevailing without creating disruption. In other words, the supply of new Stablecoins is increased if the price to which it is pegged to witnesses a fall and vice versa.

Advantages of Stablecoins 

Some of the features that stand as advantages of the Stablecoins are as follows, 

  • These coins can very easily be used to fulfil global transactions as they are relatively more stable than their counterparts. They can address the payment requirements arising from any part of the world within seconds. 
  • You can, if wanted, get back your collateral as and when the need arises. This makes it trustworthy. 
  • They act as a wonderful hedging option. A proportion of capital in the form of Stablecoins will help you ultimately in minimizing the risk. 

And that's the reason the Stablecoins market has been growing at a rapid rate -

(Source: Coin Metrics)

Drawbacks

Everything has two sides, and Stablecoins are no exception. Any issue arising on the underlying asset itself could hit the stability of the coins. Further, there is a lot of doubt prevailing with regard to the reserves of the underlying assets. While they claim to possess a specific amount of dollars or gold, the reality of the same is unverifiable. 

The entire idea of bitcoins and cryptocurrency is to promote a decentralized financial system (Defi). But by offering control to those issuing parties, who will be holding the collateral assets, the very idea is defeated. 

Conclusion 

With several big corporations jumping in to explore the newfound way of investment, it is easy to attract anyone's attention. But before you jump in, it's essential to analyze the need for the same in your portfolio. While allotting a small portion would do little harm, diving deep might leave you stranded with losses.

Give your fair share in understanding the features and working on each one before investing because, unlike the regular instruments, these are entirely different.

And this goes for all digital currencies... if you can't stand a 10-15% unexpected single-day drop in your portfolio, this is certainly not your game. Sorry, you better -

Invest in what you know

About the Author: Varishika Dinesh | 136 Post(s)

Varishika is on the verge of successfully completing B.Com. Nothing excites her more than reading books and watching movies. Business, finance, economy? You have her attention.

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