📚 How to crypto Investor | Stablecoins and how they work
Stablecoin — this word helps us forget about the volatility and unpredictability of the crypto market, get calm and breathe deeply. Isn't it great that we can hold crypto without worrying about its price dropping or rising while we sleep?
A safe alternative to the dollar — without banks, accounts, or even cash! Nobody can steal or block it, and DeFi services offer numerous low-risk investment opportunities. Investor's paradise, can you think, but…
We instinctively look for a catch when something sounds so good, but to understand the risks, we must first understand how stablecoins work.
What are stablecoins?
A stablecoin is a cryptocurrency with the same value as a fiat currency or other non-crypto asset. For example, any crypto-dollar and the dollar are equivalent because we can buy or sell one crypto-dollar for one US dollar. They are not volatile because they are pegged to fiat currencies. It is the primary reason stablecoins are widely used for "fiat-like" blockchain operations and long-term investment.
And this is where we get a better understanding of the essence of stablecoins. You must understand and keep in mind that if you have 100 USDT (or any other token) in your wallet, it is only 100 USDT, NOT 100 USD.
The truth is that you have 100 tokens in your wallet that can be converted to 100 USD. USDT (or any other stablecoin) is not a dollar until the Fed breaks the law and financial system and cancels the US monopoly on the dollar issue.
How do stablecoins maintain their stability?
Why do we believe that 100 tokens can be exchanged for 100 USD? That is about peg and backing - mechanisms that help keep prices stable.
Fiat collateralization
Let's say that a company has N thousand dollars in a bank. That company can issue N thousand tokens, ensuring they can exchange each token for 1 dollar from their bank account when token holders ask about that.
Fiat-backed token holders are confident that 1 USDT = 1 USD because each token is backed by a US dollar in the bank. It's secure.
Fiat collateralization is used by Tether USD (USDT), USD Circle (USDC), Gemini Dollar (GUSD), Paxos Dollar (PAX), and other market stablecoins to maintain a fiat peg.
It's really secure, but it's not about cryptocurrency. The fiat-backed token is highly centralized and not transparent. To gain investors' trust, the issuer company must rely on traditional mechanisms such as auditing and warranties.
It is a blockchain-based "gold standard" model that has been converted into a "dollar standard" model. Even stablecoins backed by other assets, such as CACHE gold (CACHE), Digix, and PAXG, use the exact peg mechanism.
Crypto collateralization
DAI is the most well-known example of a crypto-backed stablecoin. It is collateralized by ETH and a few other cryptocurrencies on the Ethereum network. The DAI was created to answer the problems of centralized, stablecoins.
The main advantage of DAI is that collateralization is blocked on a smart contract, not in the bank, so it is transparent and not centrally managed.
However, because crypto-assets are volatile, crypto-backed stablecoins like DAI must always be overcollateralized.
For example, to obtain 100 DAI, you must pay 150% of the received amount in ETH. The overbacking is called the collateral ratio. It ensures that the DAI's fiat value remains stable even if the price of ETH (backing asset) falls. Furthermore, DAI holders pay a stability fee, reducing capital efficiency.
How does the DAI keep its price stable?
- If DAI becomes cheaper, the smart contract raises the stability fee, making it too expensive to keep the DAI, so holders burn it and return their ETH. DAI burning reduces DAI supply and raises the price.
- If the DAI price rises, the algorithm will make token issues more profitable and cost-effective (by lowering the stability fee) to increase token supply.
Algorithmic peg
Simply put, it is based on a mathematical algorithm (seigniorage) that ensures a token's stability. It works in the following way:
Some stablecoins employ more advanced security models based on a native token (USDD and TRX), partial backing of centralized and decentralized assets (FRAX), or multi-backing of a basket of cryptocurrencies.
By the way, there is an alternative of seigniorage — rebase. This mechanism adds or removes assets from users' wallets to keep the price stable. Ampleforth uses the Rebase model, but it is not very popular. Why? How would you feel if you paid $100 for 100 tokens and found only 90 in your wallet?
The main benefit of algorithmic assets is that there is no issuer company. In other words, they are unregulated and decentralized regarding management and security. It's a theory. As you can see from the UST and Terra examples, the reality is not so rosy.
Non-financial council
As you can see, there are no 100% secure and effective stablecoins. Some are centralized, while others are unpopular or vulnerable to hacking. To make yourself as safe as possible — diversify!
If you have $1,000 and want to convert it to stablecoins, split it into USDT, USDC, DAI, and UST. Store it on multiple exchanges and wallets so that you don't lose all of your funds if one of your tokens is hacked or locked.
Hope this article was helpful and you learned something new. Keep in touch; there's still plenty to see!