The cryptocurrency exchange market is gaining momentum and popularity as it continues to grow. While relatively new to the investment scene, terms like Bitcoin and Ether are becoming as well-known as stocks and bonds.
However, the world of crypto can be a volatile market. New investors, especially, can quickly become gun shy when major peaks and major troughs are a constant norm.
Table of Contents
Peaks and Valleys of Crypto
All markets will have highs and lows, but when it comes to digital assets, those peaks and valleys can truly be terrifying. Like a wild theme park roller coaster, the value of crypto can fluctuate greatly. Even in recent months, and granted during a worldwide pandemic, the overall value of Bitcoin has been through so many high highs and low lows, it may need a sick bag.
As the pandemic set in during March of 2020, Bitcoin fell to a value of around $5,000. But, by April of 2021, the value had risen once more to nearly $65,000 total.
Not two months later, Bitcoin’s worth fell nearly half its value, plummeting to a $30,000 total in June 2021. By November, the price zipped back up to its $65,000 worth.
These are some major ups and downs for any investor. The traditional stock market does not often take such drastic terms, and certainly not in such quick timeframes.
But, that’s the online world of trading? Right? Some even focus on crypto because of this volatility. You can become rich overnight. You also risk losing your entire worth overnight, too. But for some, that thrill is all part of the game.
The roller coaster is not the ride for everyone, though, and some prefer to stick to the merry-go-round. There is a need for further stability, but don’t worry. The crypto exchange has come up with a solution.
Enter the Stablecoin
Technically speaking, stablecoin is a form of cryptocurrency. It derives value by being attached to another asset, for example, the US Dollar or the price of gold. The stablecoin is designed to hold a more stable market, allowing for investors to involve themselves in crypto, but not take on the major peaks and valleys of more typical cryptocurrencies.
How Value Is Derived In Traditional Crypto
Unlike typical crypto which is mined via blockchain, the stablecoin gets its price from the value of another asset. The stablecoin is pegged to another, the underlying asset.
Crypto like Bitcoin or Ether operates with a decentralized public ledger, known as the blockchain. Miners must use the distributed network of computers in order to either perform a series of complex puzzles or computations (a proof of work, or POW, blockchain) or to stake value as a sort of collateral for a randomized chance to mine or “win” a new block (proof of stake or POS blockchain).
In both cases (POW or POS), value is derived and tracked by a peer-to-peer network working as a team on a blockchain. The transactions are recorded in the public ledger, which is copied to all users on the network.
How Value Is Derived In Stablecoins
Instead of being mined by an open, public ledger (i.e. a blockchain), a stablecoin derives its price from the value of another asset. It takes on the model of the historic US Dollar. For example, until 1934, the US Dollar was backed by the value of gold. Until the 1960s, the dollar was backed by silver. Currency backed by an asset, and value represented by another asset, such as the former dollar, is more what the stablecoin of today represents.
Now, the dollar in the United States, however, is fiat currency. Today’s dollar is not represented by an asset.
Since that time, the US Dollar has been changed. It no longer represents a reserve of precious metals. It is simply backed by the government itself. The government says it is worth money and its citizens trust that that is true.
This is the definition of fiat currency, funds that are backed, not by another asset, but by the governmental entity.
Fiat Currencies vs. Stablecoins
Fiat money is basically the opposite of a stablecoin. While both have value and are considered worth something, how they are backed completely differs.
The fiat currency system operates on the word of a government, its laws, and its citizens respecting that authority. At the end of the day, a U.S. Dollar bill is simply a piece of paper. It is printed with green ink, official language, holograms, and serial numbers to confirm its authenticity. However, it is still a simple piece of paper.
It is only the government and that body’s society accepting that it has a value over say a coloring paper your child brought home from preschool. Why is a piece of paper valued more than another? Because, as a society, the American citizens have decided paper a dollar is printed on is a valuable asset, which can be used to purchase goods and services.
Stablecoins, however, much like the original American dollar, are backed by something in inherent value. It can represent things like the dollar itself, but also things such as solid gold. Gold has value due to its rarity. It is not a commonly found metal. It is bought, sold, and traded at high values.
Stablecoin’s Role in Digital Currency
As we’ve discussed, the point of having a product like a stablecoin is to provide for a less volatile (i.e. more stable) product on the exchange. Not everyone is ready to ride that rollercoaster, and cannot financially withstand such highs and lows.
Stablecoins play an important role in the cryptocurrency market. By having it pinned to an underlying asset, its future is less questionable. This backing allows investors to feel safer, knowing that something other than the mining of blockchains, is backing that crypto.
Something Like a Casino
At the end of the day, most markets of buying, selling, and trading, even the world’s stock markets, are a gamble. Investors put money into businesses or products. These items increase or decrease in value. Users make or lose money based on these changes.
While there is far more at play, computations being calculated, trends being monitored, and futures being predicted, in a typical stock market. But, in the end, it is still a risk.
Stablecoins are often compared to casino chips. In a casino, you take your money to the cashier. There, you change paper dollars into plastic chips. These chips represent the dollars you’ve exchanged. The chips don’t innately have a value, but they represent something that does.
Stablecoins are a type of cryptocurrency that is designed to have a constant value. Because they are just a “stand-in” of sorts, representing something guaranteed to have a value, they are not fluctuating in worth from day-to-day.
At the close of 2021, stablecoin represented a market cap of $154 billion. This makes up for seven percent of the total ecosystem, which is a significant figure!
The stablecoin also makes up for 80 percent of all virtual currency transactional volume each and every day. This is a large majority.
The Most Popular Stablecoins
Just like other forms of cryptocurrency, stablecoins used in crypto exchanges vary by companies, networks, and markets. There is a wide variety out there on the market. Some of the most popular include:
- USD Coin (USDC)
- Binance USD
Thus far, Tether is the most popular of the stablecoin “brands.” It is most often in the top five of the highest market caps for cryptocurrency. This is the largest stablecoin on the exchange presently.
USDC is an open-source project, which is currently being operated by a consortium called Centre.
The largest crypto exchange in the world, Binance, has its own stablecoin called the Binance USD. Each of these stablecoins typically hovers around the $1 (one US Dollar) value. While the value of the dollar slightly lowers and raises over time, so does then the value of the stablecoin. But, like the U.S. dollar, this is not a major fluctuation of value.
Ironically, this means that these units are technically speaking fiat-backed stablecoins. Regulated financial institutions determine the value of a dollar (in the United States’ case, the government). In an attempt to dive into crypto trading, the fiat-backed stablecoins came into play to give investors peace of mind.
Benefits of the Stablecoin
There are many pros, beyond price stability, that stablecoins represent.
Typically the most beloved and discussed positive of a stablecoin is that it maintains a stable price. It maintains purchase power. It has the lowest possible inflation.
Buy Stablecoins Directly With No Fees
Another major pro of stablecoins is there are nearly never any transaction fees. How many financial system movements can you say that about in today’s world? How many things at all can you say that about in today’s world?
Exchanges do not charge to change a U.S. Dollar to a stablecoin. The values mirror one another. Those seeking to get into the crypto exchange world can now use stablecoin to purchase cryptocurrencies such as Bitcoin or Ether.
Abandon Ship Quickly
With the expected highs and lows of the ever-changing crypto exchange, many users seek a way to change currency quickly. No one wants to wait days, pay major penalties, or lose money by the minute when things are volatile.
Those seeking to quickly liquidate tokens like Bitcoin or Ether immediately to a set value can do so by changing it into stablecoins. Fees are not charged in this transaction, and it is done efficiently and effectively.
This process, free of charge and done immediately, allows for any investors seeking a quick change to go so smoothly.
Moving Money Over Borders
When you exchange a U.S. Dollar for a Euro, you will pay a fee to do so. If you move a Yen from Japan to a Mexican peso, you will pay a fee to do so. If you want to send your mother in Northern Ireland a few pounds, you will need to make not only an exchange fee from dollars to pounds, but also pay a fee to send the money in one way or another.
With stablecoins, many are using the process to avoid these costs. For example, Peru, which operates on a currency called the “sol,” launched its own stablecoin exchange dubbed Sol Digital. Instead of incurring the fees of sending a US Dollar to a Peruvian relative, changing a dollar to a stablecoin for free, then changing that stablecoin to a sol for free, means you avoid those costly fees.
Avoid Rapid Currency Inflations
Other countries often suffer from a fluctuation in currency value. If governments are unstable, if there is war or coups occurring, or if there is simply not a stable economy, stablecoin can step in to lend relief to those citizens.
Instead of hanging onto the currency inflating, it is possible to change that money over into stablecoin. That coin then can maintain its value, as backed by its pegged-to asset, and not ride the ups and downs of an unpredictable economy.
The stablecoin, in short, can provide a space for money to be protected until a country’s inflation has subsided.
Types of Stablecoins
Besides the companies backing a stablecoin (such as Tether, USDC, or Binance), there are different types of stablecoins. These categories breakdown into three main buckets.
1. Fiat-Collateralized Stablecoin
Thus far, the examples we have discussed have been the fiat-based stablecoin. The value of the stablecoin is backed by the value of a stable currency, typically the U.S. Dollar. These fiat-based items can also include things like precious metals and oil, but most often are used in conjunction with the dollar.
Reserves are maintained by independent custodians, and the users of the stablecoin entrust these entities to have the actual dollars to back the coins. Tether and TrueUSD are examples of these types of coins.
2. Crypto-Collateralized Stablecoin
This type of coin is backed by a reserve of another cryptocurrency. This seems counterintuitive since a cryptocurrency and its volatile nature is theoretically what we are trying to avoid. This reality is counterbalanced by forcing far more crypto to be on hand than coin.
For example, one dollar is equal to one stablecoin in the fiat-collateralized model. But, if you have one crypto-collateralized coin, it may take twice as much (or sometimes more) crypto to be on hand to back it up. Let’s assume you have $200 of stablecoin in this model. The platform may need to have $400 worth of crypto to account for the potential for drastic changes in value.
3. Non-Collateralized (Algorithm) Stablecoin
Non-collateralized stablecoin does not have any reserve. Instead, a working mechanism is used to retain a stable price. This could be compared to a country’s bank system. If a central bank needs to print more banknotes to maintain the value of its fiat currency, it can do so.
These systems typically operate via smart contracts. These are decentralized systems that can run autonomously to create streamlined and rapid change.