Crypto assets are known for their high price volatility nature compared to other traditional asset classes, like stocks. Whereas crypto assets were actually created as alternative means of payment, this volatility blocked those dreams. This is where stablecoin comes in as a stable crypto asset which has a low price volatility.
Talking about cryptocurrency, many believe it always has a high price volatility. A crypto asset’s value can surge more than 100% while some others may drop as low as 99%. These cannot be avoided since crypto assets decentralization nature of crypto supply and demand. Many investors, retail or institutions want a stable way to hedge their investment. In order to tackle this problem and to attract more institutional investors, the stablecoin terms were created.
Eliminating the high price volatility nature, the stablecoin is created to track the value or price of another stable assets, such as real world currency or commodities. The stablecoin value is programmed to peg another stable value to maintain its low volatility price movement and maintain its fixed price nature, in contrast to another volatile crypto assets.
There are many varieties of crypto stablecoin, even though their names are stablecoin, some are created with different algorithms and different assets they are pegged to. For example, the stablecoin pegged to the currency value may be more stable compared to stablecoin pegged to the gold, because of the price movement of the gold commodity itself.
How Do Stablecoins Work?
Stablecoins are created to mimic the value of another assets. This can be programmed into two different collateralization methods. The first one is the Collateralized stablecoin and the second one is the Algorithmic stablecoin. To simplify these terms, the collateralized stablecoin is the stablecoin which its value is pegged to one other asset. While the algorithmic stablecoin is stablecoin which its value was being programmed to follow more than one of another assets or follow no other assets at all with its own set of rules.
Let’s understand each one of them below:
The Collateralized Stablecoin
- Cash Collateralized
This type of stablecoin is backed 1-to-1 or near 1-to-1 by government issued money. This real world currency has to be stored in a safe manner before the stablecoin issuer publishes their stablecoin in the blockchain network. This cash collateralized stablecoin operated by a centralized entity with another regulated parties to regularly audited the issuer stablecoin reserves.
- Crypto Collateralized
While still volatile, a crypto assets also serves as a collateral for some stablecoin. The only difference only the ratio must be over-collateralized in order to maintain the fixed price of stablecoin while its collateralized crypto is volatile. There are always more crypto collateral reserves compared to its stablecoin supply. This type of collateralization drives the stablecoin price out of its fixed price a little if the crypto collateral reserve fluctuates way too frequently.
- Commodity Collateralized
Commodity collateralized stablecoins are backed by other types of interchangeable assets, such as gold, diamond, oil, even real-estate inflation rate. This type of stablecoin’s value is tied to the price of the commodity they are pegged to or the fraction of commodity they are pegged to.
The Algorithmic Stablecoin
Algorithmic stablecoin are stablecoin with algorithm or stable crypto with self-assessment system to maintain its value without the need of centralized reserves and audit. Without the reserves balance, to maintain a fixed price or supply and demand, typically an algorithmic stablecoin runs on certain algorithm and smart contract rules.
- Rebasing algorithmic stablecoin
In order to maintain its peg, a rebase stablecoin will alter the existing supply. This model stabilized the price using a ‘rebasing’ of the stablecoin supply. When the peg price fluctuates, this rebase stablecoin increases or decreases in total supply, not the price. The more its supply increases, the more investors to sell, this rebased the stablecoin value back to normal. The less the token supply, more investors will buy, this also rebased the stablecoin value back to normal. Rebase stablecoins are often also referred to as elastic tokens because of its elastic token supply mechanism.
- Seigniorage algorithmic stablecoin
In traditional finance, seigniorage is the difference between the face value of a coin and its production cost. This model uses two or more scales of crypto assets, one for the fixed stablecoin value and one or more others as incentives assets. The fixed stablecoin supply either minted or burned depends on the incentives assets price, the incentives asset also either minted depends on its stablecoin price.
- Fractional algorithmic stablecoin
This type combines the features of a collateralized stablecoin and algorithmic stablecoin. These stablecoins avoid over-collateralization from collateralized mechanism and have less custodial risk. To maintain its stable value, the fractional stablecoin uses two methods called target collateral ratio (TCR) and Effective Collateral Ratio (ECR). TCR used for minting the stablecoin, ECR used to redeem the stablecoin. Fractional algorithmic stablecoin aims to maintain a tighter peg with a higher level of stability.
Example of Stablecoin
- USDT, USDC, BUSD for cash collateralized stablecoin
USDT, USDC and BUSD all stored the collateralized real world money, the US Dollar as reserves before issuing their stablecoin tokens. The more reserves they had, the more tokens they able to issue. Although this seems to be the most trusted way to issue the stablecoin, the control of this stablecoin is held by a central authority.
- DAI for crypto collateralized stablecoin
DAI is a stablecoin which tracks the price of one US Dollar, while pegged with crypto assets such as Bitcoin and Ethereum, not the US Dollar like the cash collateralized stablecoin.
- PAXG for commodity collateralized stablecoin
Paxos Gold pegged its value with real world commodity which is one fine troy ounce of a London Good Delivery gold bar, stored in trusted vault facilities custodian.
- Ampleforth (AMPL) for rebasing algorithmic stablecoin
Ampleforth is a stablecoin pegged to the CPI-adjusted 2019 US dollar. When the 2019 US Dollar increases above AMPL target, its total supply increases along with every token holding. This creates sell pressure and rebase the AMPL price. On the other hand, when the 2019 US Dollar decreases below AMPL target, its total supply decreases along with every token holding. This crates buy pressure and rebase the AMPL price
- BASIS Cash (BAC) for Seigniorage algorithmic
To maintain the peg of $1, the BASIS Cash protocol delegates BASIS Shares and BASIS Bonds to their holders in order to keep the pegged price. BASIS Shares distributed when BAC price increases above $1 and Basis Bonds distributed when BAC price decreases below $1
- FRAX for fractional algorithmic
FRAX using both collateralized and algorithmic stablecoin mechanisms. FRAX using USDC tokens and its own FRAX Shares (FXS). Depending on the FRAX price, typically 0.75 USDC and $0.25 (in FXS) are needed to maintain the value of one FRAX token.
Use Cases and Advantages of Stablecoin
|Can be used as day-to-day digital/crypto payments
|Stablecoins also a blockchain type assets, which easily trackable through the blockchain
|Used by many retail and institutional investors as hedge assets, especially during the crypto bearish period
|Serve as on-ramp assets, converting the fiat money to the crypto assets
|Allow investors to earn stable and expected rate of passive income
|As an investment of another countries currency or commodities as a hedge of their country currency
|Creates a liquidity within the blockchain and DeFi ecosystems
While it seems promising to become the future of digital currency, stablecoin is very young. Its utility as alternative stable digital currency is served, however the resistance of these technologies is yet to be proven. Many stablecoin projects already fail regardless of how advanced they are created and programmed. As of now, no single stablecoin is being regulated by any government as a legal tender, in fact world governments are exploring to create their own stablecoin called central bank digital currency or CBDCs.
How to Buy Stablecoins?
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