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Understanding Stablecoins

By Owolabi Jeremy Aug22,2020 #stablecoin
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Last updated on August 30th, 2020 at 01:27 am

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What are Stablecoins?

A stablecoin is basically a cryptocurrency that’s designed to mimic the value of another currency (usually fiat). 

Basically speaking, fiat refers to government issued currencies (like the dollar, naira, or euro) issued by the government through a central bank and serving as the legal tender within the realm of the jurisdiction of that government. 

So, as we earlier established, the price of a stablecoin is usually pegged to that of another currency which is often fiat in most cases. But why do stablecoins exist?

Why Do Stablecoin Exist? 

The reason for the advent of stablecoins was to allow users to cheaply and rapidly make borderless transactions while maintaining price stability. 

Naturally, cryptocurrencies (e.g Bitcoin, Ethereum, Litecoin, EOS etc) are VOLATILE in nature. This means that they are prone to frequent fluctuations in price.

Now, these frequent fluctuations in the value of cryptocurrencies can be cumbersome when it comes to usability. 

You might wonder, “how does the volatility of crypto affect their usability?”. In some cases when transactions are made using cryptocurrencies, by the time the transaction is settled the transferred coins could already be worth significantly more or less than they were at the time they were sent or at which the transaction was initiated.

For example;

(A) buys $50 worth of Remycoin from (B). Let’s say this hypothetical remycoin (RMC) is trading at $5/RMC. This means that B would transfer 10 RMC to A for $50. 

But in the scenario that after he transfers the coin, the price drops drastically by say 20% all the way to around $4. That would mean A would have lost about $10 because he paid $50 for $40 worth of coins.

The obvious consequence of this high volatility is that it could lead to a party getting over-paid or under-paid. 

However, stablecoins were created to solve this problem. Stablecoins are designed to see negligible price movement and closely track the value of the underlying asset or fiat currency that they emulate or are pegged to. 

This makes them effectively serve as reliable safe haven assets amid the generally volatile cryptocurrency markets.

Types Of Stablecoins

Now, there are three different type of stablecoins, namely:

1. Fiat-backed

2. Crypto-backed 

3. Algorithm stablecoins

Fiat-Backed Stablecoins

But for the purpose of this article, I’ll only be speaking on Fiat-backed stablecoins since they’re the most common kind.

Now, a fiat-based stablecoin (also known as a fiat-collateralized stablecoin) is a stablecoin whose price is directly pegged to a fiat currency with a 1:1 ratio. It is called a Fiat-collateralised stablecoin because of the way it works. I’ll briefly go into details on this.

The way it works is that there is usually a central issuer (or a bank) who holds an amount of fiat currency in reserve and issues a proportionate amount of tokens. 

This means that if 1,000 units of the fiat are kept in reserve, 1,000 units of the stablecoin would be issued. 

For instance, if a cryptocurrency is pegged to the naira, 1million naira would be kept in reserve and 1 million units of that token would be released. 

Read Also: Understanding What is Stablecoin Like ABCD stablecoin Pegged to Naira and How It Works.

Explaining it more, let’s assume we have a hypothetical Naira based cryptocurrency called NNSD. To make this stablecoin work, there would be 1 million Naira in reserve with the issuer and that would translate to a 1 million NNSD token supply being issued to the public.

There are several fiat-backed stablecoins such as USD Tether (USDT), True USD (TUSD) and USD Coin (USDC) etc. You could buy any of these coins on cryptocurrency exchanges such as Binance. 

Binance also offers other stablecoins that are fiat-backed such as BUSD (a fiat-based stablecoin that’s pegged with the US dollar), BGBP (pegged to the British pound) as well as BKRW (South Korean WON pegged) and IDRT (Indonesian Rupiah pegged). 

If you are yet to open a binance account, you could sign up using this link . It’s a very resourceful platform for trading. 

Advantages Of Stablecoins

For starters, one of the major merits of stablecoins is their potential to provide a medium of exchange that complements cryptocurrencies. 

We earlier established that high levels of volatility is a phenomena associated with cryptocurrencies. This high volatility has been a stumbling block to cryptocurrency achieving widespread usage in everyday transactions.

But how do stablecoins solve this problem?

Stablecoins solve this ongoing problem by providing higher levels of predictability and stability. They effectively serve as a safeguard against volatility.

In a way, they actually integrate the cryptocurrency market with the traditional financial markets. 

On a normal day, these two markets (crypto vs traditional financial markets) exist as separate ecosystems with very little interaction. 

But with the advent of stablecoins, cryptocurrencies now see increased usage in loan and credit markets, a market that had been previously dominated exclusively by government-issued fiat.

Also, another merit of stablecoins is that they can be used by traders and investors to hedge their portfolios. Now this is something you might want to pay close attention to. 

By allocating a certain percentage of a portfolio to stablecoins, one can reduce his overall risk. At the same time, you’d be maintaining a store of value that can be used to buy other cryptocurrencies when prices drop. 

This can turn out to be an actually very effective strategy. You can use stablecoins to “lock in” the gains you make when prices of your assets rise. 

Basically, if I purchase OGN in bulk and then the price pumps by 25%. Now, instead of leaving my OGN with the risk of the price falling, I can just convert it to a stablecoin. This way, I’ve locked in my profit and can decide to sit by and watch the market before making my next decision.

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