The topic of how do stablecoins work has gained the interest of many crypto fanatics within the cryptocurrency ecosystem. Throughout this crypto guide, we’re going to discuss what are stablecoins, the different types of stablecoins as well as an overview of use cases.
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One of the biggest obstacles facing cryptocurrencies is their extreme volatility. During one flash crash episode, Bitcoin price collapsed almost 50% from $6,500 to around $3,200. Resolving this challenge will open the door for the blockchain technology to be widely accepted.
The digital money industry is booming and stabelcoins can provide much-needed stability. If you haven’t heard about stablecoins, you probably have heard about Tether coin, which is the most widely recognized stablecoin.
Throughout this guide to stablecoin you’ll learn what are stablecoins, how do stablecoins work, the different types of stablecoins and their importance.
What are Stablecoins?
At its core, a stablecoin is a cryptocurrency or a crypto token that matches the value of a real-world asset. In many cases, it’s an asset that has a predictable value and purchasing power.
A common example of a stablecoin, or asset that might be pegged to a stable state, is the US dollar. Or, it can be something like a commodity like gold or silver. Usually, it’s something that we can have relative predictability on.
In other words, the stablecoin price is pegged to another stable asset like the US dollar. So, 1 unit of cryptocurrency stable coin is equal to 1 USD (so, both of these currency ratios will always stay at 1:1).
The idea is very simple. As the name suggests, a stablecoin's price is stable.
The advantage of stable coins is that they offer much more stable value than the standard crypto coins. This is good if you want to use cryptocurrencies as a mean to store value and transfer value.
Now that we understand what stablecoins are, it’s important to also understand the different types of stablecoins that exist. There are some decent stablecoins variations.
List of stablecoins:
The three major topics that we’re going to outline are:
- Peg stablecoins or fiat-backed stablecoins
- Collateral stablecoins.
- Centralized stablecoins.
Let’s go ahead and break down what are peg stablecoins in a way which is easy to understand.
Peg stablecoins or fiat-backed stablecoins can be very easily understood. A peg stablecoin is when we have one type of token or crypto and they mask a pegged asset that is backed behind it. So, if you have one US dollar crypto coin, we know that there is a dollar backing it in some way shape or form.
Tether made stablecoins really popular. They have been around since 2014 and is the first pegged stablecoin.
Tether Limited is the company that issued the tether tokens. This company has millions of dollars in reserve in banks across the world that back a certain amount of tether coins that are on crypto exchanges.
Top fiat-backed stablecoins examples:
Collateralized stablecoins operate in the same way as fiat backed stablecoins. The only difference is that they are backed with reserves of another cryptocurrency as opposed to the fiat currency.
Collateralized stablecoins have a set of collateral or a set of assets that are backing behind the newly created stablecoins. The main advantage of crypto-collateralized stablecoins is that the entire ecosystem can live on the blockchain.
DAI stablecoin and Maker are the two most prominent examples of a crypto-collateralized stablecoin.
DAI stablecoin mainly uses Ethereum tokens as collateral.
However, over time they intend to use a mixture of assets to back DAI stablecoin.
The second advantage of collateralized stablecoins, is that they are fully decentralized. This means they can benefit from the inherent virtues of the blockchain. They can also be liquidated very fast and with a reduced cost. The entire ecosystem is transparent because all transactions are stored publicly.
The biggest challenge of collateralized stablecoin is volatility. In essence, they are not that stable as the fiat backed coins.
The algorithmic stablecoins don’t use any collateral or peg. The question is, how do they make sure one coin is equal to 1 US dollar?
The way algorithm stablecoins accomplish this is by adjusting the supply based on demand. As we all know from basic economics: supply and demand meet at an equilibrium point. If you want to change the price of something, you can alter the supply. Altering the supply will move the equilibrium point, thus ultimately changing the price.
These stablecoins don’t rely on banks, are truly decentralized, and have no collateral required. There is also a complete separation from the fiat currency system.
Top algorithmic stablecoins examples: Basis, Carbon, Reserve.
Now that we understand that there is a little bit of variation between these different stablecoins, we’re going to outline what some of the use cases for stablecoins are. So, how do stablecoins work?
How do Stablecoins work?
We already gave a short explanation of how stablecoins work depending on each type. But we want to go a little bit deeper and use DAI stablecoin for a more indepth explanation.
DAI stablecoin is a cryptocurrency created through borrowing on the Maker platform. DAI is also pegged against the world’s primary reserve currency, the US dollar.
Let’s imagine you’re a businessman that needs money to grow your business.
You can borrow DAI stablecoins by locking currency into a collateralized debt position. You can reclaim that collateral at any time by returning the borrowed DAI stablecoins. In addition to this, you’ll also be charged an additional fee for the transfer.
How are DAI stablecoins created?
Every time a DAI coin is created you have to pay for a Maker cryptocurrency which is burned. You also have to put some collateral. Right now, the collateral is Ethereum.
The main idea is that in order to create the DAI stablecoin you need to burn some Maker. So, the more popular you think the DAI is going to be in the future the more Maker is going to be burned. This means that Maker will most likely be more expensive in the future.
Here is how the process of creating DAI stablecoins works:
In order to create 100 DAI you need to give $150 worth of ETH to a smart contract. These smart contracts are called collateralized debt positions.
If you want to get your $150 worth of ETH back, you’ll have to return your 100 DAI stablecoins. When you do that, you’re going to have to pay a small fee in Maker. As we mentioned earlier, this process leads to burning some Maker.
Let’s now explain how DAI stablecoin price remains stable at $1.
Let’s assume DAI decreases below $1 and trades at $0.80. This will make it cheaper to obtain the 100 DAI and you’re going to buy more DAI at a cheaper price to get your 150 ETH back. If DAI is cheaper, this will drive the demand up and in time it’s going to increase the DAI price until this arbitrage is no longer able to take advantage of.
The same process works in reverse if DAI stablecoin price increases above $1.
This is a self-stabilizing mechanism that is going to revolve around this soft peg $1.
There are many use cases of stablecoins but most predominantly the many stablecoins advantages will explain why we even need them:
- They allow people to cash out cheaply and fast.
- They have practical use due to their low volatility.
- Increase global access to a stable currency. This is huge!
- The ability to use stablecoins for collateral. Peer to peer lending is a great example.
Conclusion – DAI Stablecoin
Stablecoins can be the icebreaker for cryptocurrency real-world adoption. Once you understand how stablecoins work and how they can help businesses to pay someone a salary in Bitcoin, you begin to see their value.
Stablecoins have been a very dominant trend in 2019 and many crypto fanatics are eagerly waiting to see what the future holds in store for this innovative cryptocurrency. But, in the crypto world we know that hype around cryptocurrency doesn’t pan out very well. You need to be very tactical in your approach to the future of stablecoins.
If we’re ever going to see global crypto adoption, DAI stablecoin is definitely going to be part of the progress.
Thank you for reading! Be sure to check out our guide on the best cryptocurrency investments for 2019.
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