Stablecoins: Definition & Four Types Explained

Jul 07, 2020
13:07
2 min reading

Choise.com team

It’s no secret that the crypto realm isn’t yet perfect. The main inconveniences that skeptics tend to bring up include long transaction confirmations, high fees, and unpredictable volatility.

These issues have discouraged people and businesses from incorporating blockchain-based payment methods into their daily lives and operations.

Stablecoins were introduced as a way to deal with all those matters, and allow everyone to enjoy a true digital experience. In this article, you will learn what stablecoins are, why they are so important in today’s world, and which types of stablecoins are out there.

What is a stablecoin?

A stablecoin is a cryptocurrency whose value has been pegged to a collection of fiat currencies, or a single national fiat currency. Stablecoins can also be alternatively defined as cryptocurrencies whose value has been pegged to the worth of one or more financial assets that have individual or collective stable value.

So, how do these stablecoins manage to maintain the same course of value? Well, since the whole process includes pairing the value of stablecoins to collateralized real-world assets, it means the value of a stablecoin should never exceed the collateral in reserve and thus can be exchanged to the asset it is pegged to at any time.

Also, you must note that stablecoins are neither pre-mined nor minable. Instead, the total supply of stablecoins is constantly changing and reacting to the movement in the market.

To make sure inflation is under control, every stable coin exchanged to the pegged asset gets burned automatically. Likewise, after a new asset gets collateralized, new stablecoins enter the market.

Types of stablecoins

Fiat-collateralized stablecoins

Just as their name suggests, these fiat-backed stablecoins have been pegged to fiat currencies like the US dollar (USD) or the euro (EUR). They are more like digital versions of these fiat currencies.

The fundamental framework of these types of stablecoins is that their value is similar to that of the traditional (fiat) currency. And this backing implies that if the underlying value of fiat currency is equal to $2, the stablecoin will have the same value. The two coins stay at a 1:1 ratio.

That said, the biggest problem with this sort of stablecoins is that they depend on centralized systems. These stablecoins are backed by real money stored in bank accounts.

In regards to how fiat-backed stablecoins work, it’s rather simple. Third-party organizations manage the flow of the fiat currency and token. Simply put, they are responsible for accepting fiat currencies and issuing the same amount of stable coins into the blockchain network.

This is the most famous type of stablecoin. The world’s leading stablecoins like USDT or USDC belong to this category.

Commodity-collateralized stablecoins

Commodity-collateralized stablecoins have been pegged to the value of things such as valuable metals, gas, and gold. So since these underlying commodities have a stable value, the stablecoins will have the same.

That said, note that the concept of commodity-collateralized stablecoins isn’t as straightforward as fiat-collateralized stablecoins. The company’s behind these tokens have to keep the physical assets in custody, or hire third-parties to do so. Yes, banks could work too.

One important aspect about this type of stablecoin is that the price of the token will reflect the value of the underlying asset. Therefore, if the price of gold goes up, the token will increase in value. In this case, stability refers to the accuarate representation of the asset value rather than price stability.

Crypto-collateralized stablecoins

This type of stablecoins is backed by another cryptocurrency or group of different coins. The stability of these stablecoins depends on a series of complex processes that regulate the demand, supply, and governance of the underlying assets.

The most famous crypto-collateralized stablecoin is DAI by MakerDAO. This stablecoin originates from something called “Collateralized Debt Positions (CDPs)”. In plain English, a CDP is nothing more than a smart contract that regulates the process of creation and distruction of DAI.

Let’s imagine that you hold Ethereum. Crypto-collateralized stablecoins allow you to lock part of your holdings as collateral and get a stablecoin until you return the funds. That’s right. It works pretty much as a loan.

Non-collateralized stablecoins

There is a fourth type of stablecoin we haven’t discussed yet, and it’s called non-collateralized stablecoins (aka algorithmic coins.) These are not backed by anything at all.

Such coins are governed by complex algorithms, so if the demand of the cryptocurrency assets increases, a new supply of stablecoins is instantly created (and vice versa).

A great (but non-related) example of this type of stablecoins is the US dollar. Until a few decades ago, the currency was backed by gold. And regardless of that coming to an end, the dollar remains stable because everyone believes in its value. Non-collateralized stablecoins work the same way.

Why use a stablecoin?

A day-to-day currency

The main allure of stablecoins is their ability to provide a reliable medium of exchange, unlike cryptocurrencies. Due to their unpredictable levels of volatility, cryptocurrencies haven’t been able to attain widespread use in day to day applications like payment processing.

So by providing a higher level of stability and predictability, these stablecoins solve this ongoing problem.

By acting as safeguards against high levels of volatility, stablecoins may also play a major role in integrating traditional financial markets with the cryptocurrency industry. As it currently stands, the two markets exist in extremely separate ecosystems.

Streamlining recurring and P2P payments

As noted before, stablecoins’ transactions are traceable, irreversible, and most importantly, transparent. This makes them ideal for rent payments, subscriptions, loan repayments, and even salary payments.

If an employer has employees all over the world, paying everyone at the same time will be easier if he/she deploys smart contracts that automatically transfer stablecoins at the end of each month.

Besides, note that using this method eliminates the long process and high fees associated with mass payouts.

Fast and affordable remittance

For migrant workers who want to send money internationally to their family and friends, using stablecoins can help them beat current methods such as Western Union that take days and charge an average transaction fee of up to 7.45 percent.

Today, people can send money back home with digital currencies instantly and for free. For example, the Crypterium Wallet allows you to transfer money internationally without fees and immediate delivery. Oh, and the receipients don’t even need to have a Crypterium account. All you need to send them money is a mobile number. That’s it!

Protection from local currency

Stablecoins offer the sort of predictability that most nations struggle to attain with their national currencies. In countries like Argentina or Venezuela, where hyperinflation dilutes the people’s life savings, stablecoins present an excellent choice to safeguard money.

Improved crypto trading

Part of the success of stablecoins can be attributed to how crypto exchanges (the primary point of access for most traders and investors) have started embracing technology and raising awareness.

OKEx, one of the largest exchanges, announced that it was working on launching its own stablecoin. And Binance, the largest crypto exchange in the world, has also been aggressively expanding the stablecoin trading pairs it already offers.

Limitations of stablecoins

Centralized control

Despite their widespread support and adoption, stablecoins also have to deal with some limitations. The main one for most cryptocurrency enthusiasts is the fact fiat-collateralized stablecoins are way less decentralized compared to ordinary cryptocurrencies because a central entity is required to hold the underlying assets.

Fees to buy and cash out

While stablecoin transactions are faster and more affordable compared to using traditional financial institutions like banks, getting stablecoins in the first place can be expensive.

In the light of this situation, Crypterium has recently achieved the lowest purchase fee on the industry — 1% for purchases above 100 EUR.

Cashing out is also a tricky part if you’re not working with the right providers. With Crypterium, you can withdraw stablecoins straight to your bank card with instant delivery and, yes, a super low 2.5% fee.

Limited retail adoption

Even if stablecoins offer the same stability as cash, not all retailers are keen on accepting them as a payment method. Hopefully, nowadays cryptocurrency users can easily spend assets with crypto cards.

The Crypterium Card is a great example. Available in more than 180+ countries, this global cryptocurrency card connects your digital assets to any merchant, online or physical.

Conclusion

Stablecoins are relatively new in the realm of cryptocurrencies, so we’re yet to see their full potential and use cases.

While we are already reaping the benefits of the currently operating stablecoins, we can rest assured we will see a broader variety of them emerge over the next couple of years.