New Era for Cryptocurrency
Stablecoins have emerged to counteract concerns surrounding the volatility of decentralized cryptocurrencies. Stablecoins address the desire for a solution that effectively bridges the gap between fiat currency and cryptocurrency. The goal of stablecoins is to evolve digital assets to better hold consistent values. This will further unlock the extensive utility in decentralized finance (DeFi) and the wider blockchain ecosystem. The main types of stablecoins are fiat-collateralized and crypto-collateralized, while algorithmically managed and commodity-collateralized stablecoins are also emerging and driving innovation.
Stablecoins also allow investors to move in and out of different cryptocurrencies while staying within the cryptocurrency realm. These coins offer the benefits of cryptocurrency, namely instant transfers and low fees, without the drawback of volatility. That means investors can hold them without worrying about wild swings in the value of their portfolios. International bank transfers are a prime example of one use. Conventionally, this would require foreign exchange (FX) conversions with multiple banks and intermediaries. The process would then involve a series of steps and various fees and often take a few business days to complete — as opposed to a stablecoin transfer which would be instant and come with low, or zero, fees.
Benefits of Stablecoins
Stablecoins are an alternative to Bitcoin and other altcoins. Stablecoins provide you with a coin that offers the best of both worlds — the instant processing and security of cryptocurrencies, as well as, from a price perspective, the volatility-free comfort of fiat currencies. Unlike other cryptocurrencies, stablecoins do not experience extreme volatility. It is digital money that tries to imitate traditional and stable currencies. They leverage cryptocurrencies’ qualities such as irreversibility, openness, encryption, rapid transfers, electronic wallet, confidentiality, and low transaction costs while retaining the trust and stability provided by fiat money. These distinguishing characteristics are behind the rapidly growing interest in stablecoin development.
Key benefits/features of stablecoins:
- Liquidity. Because stablecoins are underpinned by liquid funds and assets, more tokens can be created to preserve stability during price surges. Likewise, tokens can be removed from circulation during price drops to enhance stability. This is vastly different from other cryptos like Bitcoin, which have an absolute number of coins that will ever exist.
- Little or no volatility. Because stablecoins are asset-backed, they can readily withstand fluctuations in the monetary environment.
- Transparency. Given that stablecoins are blockchain-based, they are transparent, with all network members connecting directly to transactions.
- Borderless. Stablecoins retain the power of all cryptocurrencies to move without regard to national borders.
- Simplify trading and commerce. Stablecoins have widespread adoption and can be exchanged on a variety of exchanges. They enable unbanked businesses/people to send and receive money.
- Protect funds in between crypto investments. If you just made a big score on a run-up in the price of one or more cryptos, or if you want to exit your positions due to market instability, you can sell your other cryptos and move the money into a stablecoin.
Stablecoins provide many of the main benefits of cryptocurrencies — such as transparency, security, immutability, and decentralized control — without losing the guarantees and stability that come with using fiat currency. Stablecoins are created by linking to assets such as cryptocurrency, gold, and fiat currency and then controlling them with algorithms. This brings up the important point of centralized and decentralized stablecoins.
Centralized and Decentralized Stablecoins
A stablecoin is a blockchain-based digital currency that is meant to keep its price pegged at a specific level, most often $1. This successfully eliminates holders from market volatility while offering a secure and dependable method to hold value. Stablecoins serve as a bridge between retaining securities and exiting through the fiat system, or they are utilized to execute cross-border transfers more efficiently.
Centralized stablecoins are typically fiat collateralized off-chain. However, these are typically directly linked to third-party administrators, just like banks. Centralized stablecoins include Tether (USDT) and Coinbase’s USD Coin (USDC). These stablecoins require you to have faith that the third party holds the matching dollars. With most centralized stablecoins, stability is achieved via 1:1 backing of token liabilities with the corresponding asset (US dollar). You might think of these as IOUs held in a blockchain that can easily be traded back for the equivalent of the underlying asset. Centralized stablecoins balance the supply and demand via minting and redemption mechanisms. Under this model, users mint new stablecoins by depositing the equivalent fiat to the custodian. Redeeming the fiat requires burning the token version to retrieve the fiat back.
Decentralized stablecoins are completely transparent, non-custodial, and have no or only limited third-party control. Because the money is on a publicly certified blockchain, all collateral backing is transparent to everybody. No one person or entity controls decentralized stablecoins. Your ability to independently hold your own funds means no trust of others is required.
Also, all collateral backing is visible to everyone as funds are on a publicly verified blockchain.
Decentralized stablecoins are further classified into two more categories: crypto-collateralized and algorithmic. When necessary, collateralized stablecoins can manually raise or decrease supply by minting or burning. Algorithmic stablecoins use smart contracts, also known as algorithmic market operations controllers (AMOs), to regulate supply autonomously.
Decentralized Algorithmic and Crypto-collateralized Stablecoins
Decentralized stablecoins are further classified as crypto-collateralized and algorithmic. We’ve already examined centralized collateralization that is based on a fiat currency or other assets such as gold. Decentralized finance is a more complex and rapidly developing industry. It is about experimentation, innovation, and building on the philosophical and ideological foundations of a more efficient, control-resistant, and open financial system.
Crypto-collateralized stablecoins seek to remain decentralized while adding security and stability. As the name suggests, crypto-collateralized stablecoins are backed by cryptocurrencies (usually ETH), rather than fiat currencies. Instead of relying on a central issuer to store the reserve, crypto-backed stables use smart contracts to secure assets as collateral. To account for the unpredictable volatility of the cryptocurrency market, many decentralized crypto-backed stablecoins are over-collateralized. Many require a 200% collateralized ratio. For example, every $100 of a crypto-backed stablecoin must be backed with $200 worth of ETH. This allows the stablecoin to maintain its stability even during times of intense market volatility.
Crypto-backed stablecoins are evolving into a key element of the decentralized economy. These stablecoins over-collateralize an existing digital asset to allow for the dynamic maintenance of a consistent market price.
Algorithmic stablecoins are another cutting-edge in the cryptocurrency evolution. Algorithms are based on a combination of monetary economics, financial markets, mathematics, and technology. With this in mind, algorithmic stablecoins use math and incentive mechanisms to maintain their fiat peg. Algorithmic stablecoins use smart contracts, also known as algorithmic market operations controllers (AMOs). These autonomously manage the collateral ratio, supply, scalability, decentralization, and transparency of stablecoins.
These algorithms manipulate circulating supply so that any given coin’s price should be stable — in theory. A key way these algorithms work is by minting (adding) or burning (removing) supply from circulation to maintain the coin’s position relative to the US dollar. If the coin price is more than $1, the algorithm mints coins. If the coin price is less than $1, the algorithm burns coins. Coins are minted into or burned from coin holders’ wallets.
Stablecoins as a Functional Currency
In the exploding realm of cryptocurrencies, stablecoins seek to provide the best of both worlds: the stability of a traditional government-backed currency as well as the privacy and convenience offered by crypto transactions to be the bridge between fiat currencies and cryptocurrencies.
At the very least, their stability allows stablecoins to be used as a functional currency within a crypto brokerage. For example, traders might convert Bitcoin into a stablecoin such as Tether rather than into dollars. Additionally, stablecoins are available 24/7/365, making access to large sums of money more accessible than cash obtained through the banking system, which is closed overnight and on weekends. With instant access, you can also transfer funds anywhere in the world without the need to involve a bank or other financial institutions.
All of this and more makes stablecoins useful as an everyday currency. Bitcoin as an investment has made countless millionaires, but its volatility makes it harder to use as a currency. You know that your daily latte should cost about $3. On Monday, it might cost the equivalent of $3 in Bitcoin, but on Wednesday, it could cost $6 or $1 in Bitcoin. Pegging cryptocurrencies to a fixed exchange rate relative to the U.S. dollar, as stablecoins attempt to do, makes them more useful as a currency.
Is Stablecoin an Investment in a Stable Future?
Stablecoins are not likely to replace other cryptocurrencies, nor is that the intention. The most likely scenario is that stablecoins serve as another financial vehicle in the digital transformation of money. Stablecoins provide liquidity to markets of exchange, serve as a medium of exchange for risk-averse investors, and protect physical assets in the digital realm.
Stablecoins point the way toward integrating traditional financial markets with the quickly evolving decentralized finance industry. As a force for market stability, stablecoins present a primary vehicle for cryptocurrency adoption in loan, credit, and other financial markets, while inheriting much of the utility previously reserved for only fiat currency.
Exactly how stablecoins will evolve is not yet entirely clear, and you can only build on what is known today. At this stage, stablecoins perform an important function by protecting against hyperinflation and volatility of the crypto market and reducing risks for investors to increase confidence in cryptocurrencies.
Investors can enjoy the opportunity to trade, invest, buy, or simply hold crypto assets with the help of stablecoins. Transactions with stable tokens take only a few minutes and are carried out 24/7/365, unlike through financial institutions like banks. In most cases, transaction costs for such coins are minimal or non-existent, such as between Tether wallets. Plus, many exchanges do not accept fiat, but they do accept stablecoins.
In simple words, people are calling stablecoins the crypto equivalent of fiat money, and many are embracing it. While they do not provide the opportunity to get rich quickly as original cryptocurrencies did, their main function is to store value and allow the user to make predictable financial decisions.
Let Nabers Group Help You Stay On Top of The Crypto Industry
We’ve been investing in bitcoin since April 2013. Nabers Group is by far the most experienced IRS-approved Crypto Self Directed 401k provider in the industry, helping you to compliantly structure your retirement account so you can purchase not only crypto but also hold your own keys. That means you’re in charge of what types of coins you want to buy and how much, and you don’t have to compromise safety by handing over your private keys to a stranger.
Read more about what we share to educate clients with this educational series.
- Crypto Education Series: Part I – Bitcoin Basics
- Crypto Education Series: Part II – Bitcoin In Your Retirement Account
- Crypto Education Series: Part III – Grow Your Gains Tax-Free with a Roth account
- Crypto Education Series: Bonus – Bitcoin FAQ
Nabers Group also makes it possible and easy to hold crypto in other tax-advantaged retirement accounts. A Solo 401k enables you to contribute the maximum each year towards your retirement. Both the Roth Crypto Self Directed IRA and the Roth Solo 401k allow holding crypto in a retirement account that allows you to withdraw your wealth tax-free during retirement.
Set Up Your Self-Directed Retirement Plan and Start Investing In Alternatives
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Setting up a Solo 401k retirement plan is easy and allows for tax-deductible contributions much larger than an IRA or employer 401k. Importantly, it puts you in control with access to a world of alternative investment options.