What Are Stablecoins?

Oct 22, 2020

Stablecoins are a type of cryptocurrency. Unlike most crypto coins, stablecoins aim to sustain a consistent trading price and stable valuation. To do so, they are backed by relatively stable external assets or collateral, like the U.S. dollar (USD) or gold.

Why Were Stablecoins Created?

During the 2008 financial crisis, crypto innovators began creating financial instruments controlled by a decentralized network of computers, rather than a government entity.

By 2009, developer Satoshi Nakamoto launched Bitcoin, the first cryptocurrency, along with the blockchain, the coin’s distributed transaction database. In 2013, 19-year old programmer Vitalik Buterin introduced the cryptocurrency Ethereum and a new, more flexible blockchain called the Ethereum network. Buterin’s network has since become a platform for building and operating decentralized finance (DeFi) applications, like smart contracts.

Although Bitcoin and Ethereum remain two of the world’s most popular cryptocurrencies, severe daily price swings have limited their use across global payment and exchange systems.

For example, in May 2010, Lazlo Hanyecz, a Florida-based computer programmer, ordered two pizzas with 10,000 Bitcoins. The delivery order set Hanyecz back $30 at the time, with Bitcoin trading at 30 cents.

Exactly ten years later, on May 22, 2020, Bitcoin traded above $9,100. Unfortunately for Hanyecz, his 2010 pizza order cost him more than $91 million just a decade later, due to the appreciation in Bitcoin’s trading price.

Clearly, Bitcoin’s fluctuating price can have a major impact on consumer purchases and payments. Instead, some investors have used Bitcoin and Ethereum as store-of-value investments, like gold, to protect against inflation.

For a currency to act as an effective medium of exchange, its price must remain relatively stable over long periods to safeguard purchasing power. The wild price swings of cryptocurrencies drove market demand for more stable coins.

Tether (USDT), the world’s first stablecoin, was launched from Southern California in 2014. Many new stablecoins, backed by a variety of collateral, have since followed.

How Do Stablecoins Work?

Stablecoins are cryptocurrencies designed to minimize price volatility on a day-to-day basis. In this way, they aspire to work like traditional or fiat currencies. In order to maintain a consistent price, stablecoins are backed by or tied to relatively stable external assets, such as traditional currencies or precious metals.

The most popular stablecoins are backed by fiat currencies, like the U.S. dollar (USD), the euro (EUR), or the Japanese yen (JPY). Known as fiat-collateralized stablecoins, these cryptocurrencies are backed at a 1:1 ratio, which means that one stablecoin is intended to equal one unit of currency.

For example, a central issuer for USD stablecoins, such as Tether (USDT) or USD Coin (USDC), holds real U.S. dollars in a reserve bank account in proportion to the number of stablecoins issued.

Despite being backed by other assets, investing in stablecoins, as any currency, still comes with risk. Consumers must always ensure they have proper risk management plans in place.

While stablecoins have their benefits and risks, they are a critical component of cryptocurrency markets. Through a variety of mechanisms, they aim to consistently trade at steady or set day-to-day prices. This enables them to be used reliably as mediums of exchange, and also as potential lower volatility safe havens for traders and investors.

How Are Stablecoins Used?

Although initially designed to provide traders with a tool to manage price fluctuations, it’s clear that the applications of stablecoins extend far beyond trading. They’re a powerful tool that could strengthen the cryptocurrency space as a whole, serving investors where volatile alternatives are not ideal.

Stablecoins seek to reduce price volatility, while providing many of the typical crypto coin benefits, like 24-7 accessibility and cost-efficiency. Due to their price stability, investors primarily use stablecoins for value transfers between crypto exchanges.

They are also useful for global payments, foreign exchange, earning interest, portfolio diversification, and long-term investments. While not free from risk, stablecoins add a variety of potential benefits to the marketplace.

The crypto markets have made considerable headway over the years since stablecoins were introduced. Imagine if Lazlo Hanyecz had not placed his crypto pizza order – his life might be much different today if he had seen his bitcoin appreciate to $91 million.

Three Takeaways

  • Backed or tied to external assets, stablecoins attempt to provide price and value stability.
  • Investors often use stablecoins for value transfers between cryptocurrency exchanges.
  • Stablecoins are also utilized for global payments, foreign exchange, earned interest, and more.

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