What is Stablecoin? | Stablecoins explained
Stablecoins have grown in popularity in recent years as they are known to offer the security, instant processing and privacy of cryptocurrencies with the stable valuations of fiat currencies.
Generally considered to be less volatile than other cryptocurrencies such as Bitcoin, Stablecoins are often pegged to a currency such as the US dollar or to the price of a commodity such as gold. This helps protect Stablecoins from wild swings in their valuations and makes them a less risky investment option for investors and traders.
How Stablecoin Works
Stablecoins can be backed by multiple sources including fiat currencies, other cryptocurrencies, commodities such as precious metals, and algorithmic functions. The level of stability of a Stablecoin is usually determined by the asset it is backed against.
For example, fiat backed stablecoins are considered the most stable and therefore the least risky because they are tied to a centralized financial system such as the US dollar and the central bank can intervene to control prices when valuations are volatile.
At the opposite end of the scale are cryptocurrency-backed Stablecoins, such as those backed by Bitcoin. These are considered a higher risk because no regulatory body controls the asset to which the Stablecoin is linked.
Let’s take a closer look at each of the sources that can be traced to Stablecoin:
Stablecoins supported by Fiat: Backed by a fiat currency such as the US dollar. Investors use dollars to buy Stablecoins which can be exchanged for the original currency in the future. Fiat backed Stablecoins aim to have very small price fluctuations.
Cryptocurrency-backed stablecoins: These are backed by other cryptocurrencies such as Bitcoin or Ethereum. It should be noted that these can be more volatile due to the volatility of the asset they are backed by.
Precious Metal Backed Stablecoins: Gold, silver, and other precious metals can be used to support these types of Stablecoins. This type of Stablecoin protects against volatility but is considered centralized which can be a disadvantage for some investors and traders.
Algorithmic stablecoins: These are not technically backed by an asset, but instead use a computer algorithm to keep the coin’s value from fluctuating too much. The algorithm is designed to control the number of coins available to help manage the price. For example, if the price goes too high, more coins are released, but if it drops too low, the supply is limited.
Benefits of Stablecoins
The benefits of Stablecoins include:
Less risky cryptocurrency
Choosing to invest in a fiat currency or precious metal backed Stablecoin can help investors limit their exposure to risk. However, as with all investments, an element of risk will always exist and if the cryptocurrency market collapses, investors could suffer huge losses.
Decentralized investment instrument
As many Stablecoins are decentralized, they are an attractive option for investors looking to diversify their portfolio with a mix of centralized and decentralized investments. The processing and transaction costs of decentralized investments are often lower than those of centralized investments.
Disadvantages of Stablecoin
The disadvantages of Stablecoins include:
Lack of transparency
Stablecoins have come under intense scrutiny from regulators and demand more transparency and oversight. In October 2021, the International Organization of Securities Commissions (IOSCO) declared that Stablecoins should be regulated as financial market infrastructures such as payment systems and clearing houses.
Not all stablecoins are decentralized
Stablecoins backed by currencies and precious metals are technically centralized, just like the asset to which they are attached is centralized. This may be of concern for some investors, especially those looking to diversify their portfolios with decentralized investments.