What is a Stablecoin? 

#Cryptocurrency #Stablecoins #Blockchain #Finance #Investing #CryptoEducation #MichaelGSantos #PrisonProfessors

Lesson 5: What is a Stablecoin?

Lesson Intro:

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5. What is a Stablecoin?

TL;DR 

What Is a Stablecoin?

Stablecoins are crypto assets pegged to stable assets like fiat currencies or precious metals, designed to avoid crypto market volatility. There are three types: fiat-backed, crypto-backed, and algorithmic. Stablecoins maintain value stability through different pegging mechanisms, providing benefits like stability for day-to-day payments and reduced investment risk. However, they can lose their peg, lack transparency, and be centralized. As their use and market cap grow, regulators are paying more attention. Despite the risks, stablecoins are essential in trading, investing, and making global transactions.

Key Takeaways

• A stablecoin is a cryptoasset pegged to another asset, such as fiat currencies or precious metals.
• Stablecoins are designed to maintain a relatively stable price so that users can avoid the volatility risks common in the crypto markets.
• There are three types of stablecoins: fiat-backed, crypto-backed, and algorithmic.
• Due to their practical use and large market capitalization, regulators are beginning to take a closer look at stablecoins.

Introduction

Cryptocurrencies aren’t all about volatility. In fact, stablecoins are specifically designed to maintain a fixed price. In an industry where coins and tokens can crash overnight, there is a massive demand for currencies that mix blockchain benefits with the ability to track a more stable asset. If you haven’t started using stablecoins while trading or investing, it’s worth learning more about them as well as the benefits and drawbacks they bring.

What Is a Stablecoin in Cryptocurrency?

Stablecoins are digital assets that track the value of fiat currencies or other assets. For example, you can purchase tokens pegged to the dollar, euro, yen, and even gold and oil. A stablecoin allows the holder to lock in profits and losses and transfer value at a stable price on peer-to-peer blockchain networks.

Bitcoin (BTC), Ether (ETH), and other altcoins have historically been volatile. While this provides many opportunities for speculation, it does have drawbacks. Volatility makes it challenging to use cryptocurrencies for day-to-day payments. For example, merchants may take $5 in BTC for a coffee one day but find that their BTC is worth 50% less the next. This makes it challenging to plan and operate a business that accepts crypto payments.

Before, crypto investors and traders had no way to lock in a profit or avoid volatility without converting crypto back into fiat. The creation of stablecoins provided a simple solution to these issues. Today, you can easily get in and out of crypto volatility using stablecoins like TrueUSD (TUSD).

How Do Stablecoins Work?

Creating a coin that tracks another asset’s price or value requires a pegging mechanism. There are multiple ways to do this, and most rely on another asset acting as collateral. Some methods have proved more successful than others, but there is still no such thing as a guaranteed peg.

Fiat-backed stablecoins

A fiat-backed stablecoin keeps a fiat currency, such as USD or GBP, in reserves. For example, each TUSD is backed by $1 held as collateral. Users can then convert their fiat to a stablecoin and vice versa at the pegged rate.

Crypto-backed stablecoins

Crypto-backed stablecoins work in a similar way to fiat-backed stablecoins. But instead of using dollars or another currency as reserve, we have cryptocurrencies acting as collateral. As the crypto market is highly volatile, crypto-backed stablecoins usually over-collateralize the reserves as a measure against price swings.

Crypto-backed stablecoins use smart contracts to manage minting and burning. This makes the process more reliable as users can independently audit the contracts. However, some crypto-backed stablecoins are run by Decentralized Autonomous Organizations (DAOs), where the community can vote for changes in the project. In this case, you can get involved or trust the DAO to make the best decisions.

Let’s look at an example. To mint 100 DAI pegged to USD, you will need to provide $150 of crypto as 1.5x collateral. Once you have your DAI, you can use it however you want. You could transfer it, invest it, or simply keep it as is. If you want your collateral back, you’ll need to pay back the 100 DAI. However, if your collateral drops below a certain collateral ratio or the loan’s value, it will be liquidated.When the stablecoin is below $1, incentives are created for holders to return their stablecoin for the collateral. This decreases the supply of the coin, causing the price to rise back to $1. When it’s above $1, users are incentivized to create the token, increasing its supply and lowering the price. DAI is just one example, but all crypto-backed stablecoins rely on a mix of game theory and on-chain algorithms to incentivize price stability.

Algorithmic stablecoins

Algorithmic stablecoins take a different approach by removing the need for reserves. Instead, algorithms and smart contracts manage the supply of the tokens issued. This model is much rarer than crypto or fiat-backed stablecoins and more challenging to run successfully.

Essentially, an algorithmic stablecoin system will reduce the token supply if the price falls below the fiat currency it tracks. This could be done via locked staking, burning, or buy-backs. If the price surpasses the value of the fiat currency, new tokens enter into circulation to reduce the stablecoin’s value.

What Are the Advantages of Stablecoins?

Stablecoins are versatile and powerful tools for investors, traders, and cryptocurrency users. Their main strengths include the following: 

1. Stablecoins can be used for day-to-day payments. Businesses, and individuals value stability. Due to its volatility, cryptocurrencies haven’t achieved widespread use for day-to-day payments. Large stablecoins have a track record for maintaining their peg, making them suitable for daily use.
2. Stablecoins have the benefits of being blockchain-based. You can send a stablecoin to anyone globally who has a compatible crypto wallet (which can be created for free in seconds). Double-spending and false transactions are also almost impossible to run into. These qualities make stablecoins incredibly versatile.
3. Stablecoins can be used by traders and investors to hedge their portfolios. Allocating a certain percentage of a portfolio to stablecoins is an effective way to reduce overall risk. Your portfolio as a whole will be more resistant to market price swings, and you will also have funds on hand in case a good opportunity comes up. You can also sell crypto for stablecoins during a market downturn and repurchase them at a lower price (i.e., shorting). Stablecoins allow you to enter and exit positions conveniently, without the need to take money off-chain.

What Are the Disadvantages of Stablecoins?

Despite their potential to support widespread cryptocurrency adoption, stablecoins still have limitations: 

1. Stablecoins aren’t guaranteed to maintain their peg. While some large projects have a good track record, there have also been many projects that have failed. When a stablecoin has constant issues maintaining its peg, it can lose its value dramatically.
2. Lack of transparency. Not all stablecoins release full public audits and many provide only regular attestations. Private accountants carry these out on behalf of the stablecoin issuers.
3. Fiat-collateralized stablecoins are usually more centralized than other cryptocurrencies. A central entity holds the collateral and may also be subject to external financial regulation. This gives them significant control over the coin. You also need to trust that the issuer has the reserves they claim to have.
4. Crypto-collateralized and uncollateralized coins rely heavily on their community to function. It’s common to have open governance mechanisms in crypto projects, meaning that users get a say in the development and running of each project. As such, you need to get involved or trust the developers and community to run the project responsibly.

Examples of Stablecoins

Crypto-backed stablecoin: MakerDAO (DAI)

DAI is a crypto-backed stablecoins that tracks USD on Ethereum. The coin is managed by the MakerDAO community that holds the governance token MKR. You can use MKR to create and vote on proposals to change the project. DAI is over-collateralized to deal with the volatility of crypto, and users enter into Collateralized Debt Positions (CDPs) that manage their collateral. The whole process is run via smart contracts.

Fiat-backed stablecoin: TrueUSD (TUSD)

TUSD is an independently verifiable dollar-pegged stablecoin. It is the first stablecoin to programmatically control minting with instant on-chain verification of USD reserves held off-chain. TUSD’s reserves are monitored using Chainlink Proof of Reserve so that holders can autonomously verify that their TUSD is backed by USD held in reserves.

Are Stablecoins Regulated?

Stablecoins have caught regulators’ interest worldwide due to their unique mix of fiat and crypto. As they are designed to maintain a stable price, they are useful for reasons other than speculation. They can also facilitate high-speed transactions internationally at a low cost. Some countries are even experimenting with creating their own stablecoins. As a stablecoin is a type of cryptocurrency, it will likely fall under the same regulations as crypto in your local jurisdiction. Issuing stablecoins with fiat reserves may also need regulatory approval.

Closing Thoughts

It’s hard to find an investor or trader nowadays who hasn’t held a stablecoin at some point. Stablecoins are often held in crypto exchanges so that traders can quickly capitalize on new market opportunities. They’re also very useful to enter and exit positions without having to cash out into fiat. Apart from trading and investing, stablecoins can be used for making payments and international transfers.

Even though they are an integral part of crypto and have enabled the creation of a new financial system, you shouldn’t underestimate the risks. We’ve seen stablecoin projects with failing pegs, missing reserves, and lawsuits. So while stablecoins are incredibly versatile tools, do bear in mind that they’re still cryptocurrencies and hold similar risks. You can mitigate risks by diversifying your portfolio, but make sure to do your own research before investing or trading, and don’t invest more than you can afford to lose.

Critical Thinking Questions

1. How do stablecoins address the issue of volatility in the cryptocurrency market, and what mechanisms do they use to maintain their value?
2. What are the potential benefits and drawbacks of using fiat-backed stablecoins compared to crypto-backed and algorithmic stablecoins?
3. How can the transparency and decentralization of crypto-backed stablecoins influence their adoption and trust among users?
4. In what ways can stablecoins facilitate international transactions and day-to-day payments, and what challenges might they face in achieving widespread adoption?
5. What role do regulators play in the stablecoin market, and how might increased regulatory attention impact the future development and use of stablecoins?

Advocacy Initiative:

We encourage participants to begin memorializing the ways they are using time in prison to prepare for success upon release. I encourage participants to create a personal profile by:

1. Writing a simple biography
2. Writing a daily journal to show all that you’re learning
3. Writing book reports that memorialize the books you read
4. Writing a release plan to show the ways you’re preparing for success upon release

These strategies helped me immensely once I got out. By using my time wisely inside, I was able to raise capital, build businesses, and succeed in ways that few people would think are possible for someone who served multiple decades in prison. Anyone can do the same—if they prepare first.

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My name is xxx, and I am in prison. I would like to begin showing the strategies I am using to prepare for success upon release. Please send me a Release Plan Workbook, and any other books that will help me prepare for the job market. After receiving those workbooks, I will begin building my profile to show others how I am using my time inside to prepare for success outside.  

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Glossary

• Algorithm (noun): A step-by-step procedure or formula for solving a problem or performing a task.
• Bitcoin (noun): A decentralized digital currency that uses cryptography for secure transactions on a blockchain.
• Block (noun): A unit of data containing transaction information, which is added to a blockchain.
• Blockchain (noun): A decentralized digital ledger that securely records transaction data across many specialized computers on the network.
• Collision (noun): The occurrence when two different inputs produce the same hash output.
• Cryptographic Hash Function (noun): A hash function that uses cryptographic techniques to ensure data integrity and security.
• Data Integrity (noun): The accuracy and consistency of data over its lifecycle.
• Deterministic (adjective): Producing the same output from the same input every time.
• Hash (noun): The fixed-size output generated from input data using a hash function.
• Hash Function (noun): A mathematical formula that converts input data into a fixed-size output (hash).
• Hash Rate (noun): The measure of computational power used in cryptocurrency mining.
• Immutability (noun): The characteristic of being unchangeable once recorded.
• Merkle Tree (noun): A data structure used in blockchain to efficiently verify the integrity of data.
• Mining (noun): The process of performing complex calculations to validate transactions and add them to a blockchain.
• One-way Function (noun): A function that is easy to compute in one direction but difficult to reverse.
• Output Size (noun): The fixed size of the hash produced by a specific hash function.
• Preimage (noun): The original input data that is hashed to produce a specific hash.
• Resistance (noun): The difficulty of performing a certain action, such as reversing a hash function.
• SHA-256 (noun): A cryptographic hash function that produces a 256-bit hash, used in Bitcoin.
• Zero (noun): The leading character in a hash that meets the difficulty criteria in Bitcoin mining.