HOW TO STABLECOINS | How it works, types of coins, and how to invest with low risks?
Stablecoin — this word helps us forget about the volatility and unpredictability of the crypto market, get calm and breathe deeply. It's great that we can hold crypto without fear that its price will drop or increase while we sleep.
A secure analog of the dollar on your crypto wallet — no need for banks, accounts, or even cash! Nobody can steal or block it, and DeFi services provide many opportunities for low-risk investments. The HODL paradise, can you think, but…
When something sounds so good, we Instinctively look for a catch. Well, it's one here is. To understand the dangers, let's take a closer look at how stablecoins work.
A stablecoin — is a cryptocurrency with the same value as a fiat currency or other non-crypto asset. For example, we think that the crypto-dollar and the dollar are equal because we can buy or sell 1 crypto-dollar for 1 US dollar.
So, as stablecoins have the price of fiat currency, they are not volatile because the crypto market is measuring in fiat. It's the main reason stablecoins are widely used for «fiat-like» actions on the blockchain and long-term hold because crypto enthusiasts don't trust banks. Right?
And here we come to a deeper understanding of the essence of stablecoin. You must understand and remember that if you have 100 USDT (or any other currency) on your wallet, it is just 100 USDT, NOT 100 USD.
Seriously? Of course, it's not Benjamin Franklin in the pocket or even a USD debit card. Of course, it's run on a blockchain, but it's still a dollar.
Well, yes, but not really ©
The fact you have 100 tokens in your wallet that can be converted to 100 USD, and that's all. USDT (or any other stable) is not a dollar until the Fed breaks the law and financial system and cancels the US monopoly on USD emissions.
Why do we believe that 100 tokens can be exchanged for 100 USD? This is about securing.
Securing is a way to keep the token price stable in pair with the fiat analog.
But how it possible to do that?
Fiat-backing
Imagine a company with a bank account with N thousand dollars. Now the company can issue N thousand tokens, ensuring that they can exchange each token for 1 dollar when holders ask about that.
Market players are sure that 1 USDT = 1 USD because each token has the US dollar on the bank account. It's secure.
That method uses the main market stablecoin — Tether USD (USDT), as well as USD Circle (USDC), Gemini Dollar (GUSD), Paxos Dollar (PAX), and others.
The fiat-backed token is highly centralized and not transparent. The issuer company needs investors' trust (Stable must be REALLY secured). Thus, issuers use traditional mechanisms such as auditing and warranties. In general, that is why Nakamoto came up with Bitcoin.
It is simply a «gold standard» model on the blockchain, transformed into a «dollar standard» model. Even stablecoins baked with other assets, like CACHE gold (CACHE), Digix, PAXG, use the same backing mechanism.
Crypto-backing
The most famous example of a crypto-backed stablecoin is DAI. It's secure by ETH and a few other cryptocurrencies in the Ethereum network. The DAI runs as an answer to the problems of centralized, stablecoins.
The main advantage of DAI is that it is backing blocked on a smart contract, not in the bank, that is, transparent and not centrally managed.
But, there is one thing — because the crypto-assets are volatile, crypto-backed stablecoins like DAI must always stay overbacked. For example, to get 100 DAI, you will have to pay 150% of the received amount in ETH. The overbacking is called the collateral ratio. It ensures that the fiat value of the DAI will be stable even if the ETH (backing asset) price drops.
In addition, the DAI holders pay a stability fee, which reduces the efficiency of capital.
How is the DAI hold the stable price?
If DAI gets cheaper, the smart contract increases the stability fee, and so it's too expensive to keep the DAI, so you return it to a smart contract and take back your ETH. Returned DAI is burning to make a DAI deficit and raise the price.
If the DAI price goes up, the algorithm will make token minting more profitable (less stability fee) to increase the number of tokens in circulation.
By the way, you can buy DAI on the stock exchange, for example, Binance (remembering that it is a centralized exchange), or on DEX and keep on a decentralized wallet like Metamask.
Algorithmic stablecoins
Top of decentralized economy. To say it simply, a mathematical algorithm (seigniorage) ensures the stability of a token in this case.
If the price goes up, the algorithm will mint more tokens to increase the supply and reduce the price.
If the price is lowered, the algorithm will buyback and burn some tokens until the price becomes at its standard level.
Such stablecoins use more sophisticated security models based on a native token protocol (UST): partial backing of centralized and decentralized assets (such as FRAX) or multi-backing of a basket of cryptocurrencies.
By the way, there is an alternative of seigniorage — rebase. The algorithm adds or removes assets from users' wallets to stabilize the price. Ampleforth uses Rebase model, but this stablecoin is low-using. How would you like it if you bought 100 tokens for 100 USD and then found only 90 tokens in your wallet?
The most famous algorithmic stable is UST in the Terra network. Seigniorage is provided by arbitration trading: when the price of UST falls, the algorithm buys it, when it increases — sold. For backing is using a native Luna token.
Still, Terra is an exciting network, and maybe we may consider it in another article.
The main advantage of algorithmic assets is that they do not have an issuer company. That is, they are unregulated and are decentralized both in management and security.
Ugh, even I'm' a little boiled up with all this information, but trust me — the better and deeper you understand the market, the stronger your sleep. After all, these are your funds, and you have to manage them.
Non-financial recommendation
As you can see, none of the coins represented here is 100% Gem. Some are centralized, some are unpopular or can be hacked. To make yourself as safe as possible — diversify!
Let's say you have $1,000 that you want to convert into stablecoins. Buy at the same time USDT, USDC, DAI, and UST.
Store it on different exchanges and wallets, and when one of your tokens is hacked or locked, you don't lose all deposits. And if the hack is unlikely, many peoples are already faced with restrictions of access to their coins (hello sanctions).
Well, I hope this article was helpful, and you've learned something new. I wish you profit, stay in touch, there's still a lot to see there!