What are stablecoins and how do they work?

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James Hayward
March 3, 2023
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What are stablecoins and how do they work?

As cryptocurrencies continue to make headlines, there is one area that has seen particularly noticeable gains: stablecoins. With over 200 different global stablecoins in circulation and the top 10 currently valued at over $135 billion, stablecoins have become increasingly attractive to those looking for a less volatile way to interact with crypto markets.

In this article, Checkout.com explains:

  • What is a stablecoin
  • Types of stablecoin
  • How does a stablecoin work?
  • Stablecoin use cases
  • Why are stablecoins growing in popularity?
  • Benefits of stablecoins
  • Stablecoin: potential drawbacks
  • The future of stablecoin

What is a stablecoin?

Stablecoins are crypto tokens typically pegged to a fiat currency, like USD or EUR, so they can usually be exchanged one-to-one for the non-cryptocurrency in question. As swings in crypto prices occur, this feature allows businesses and consumers to use crypto for regular payments, allowing the value of goods exchanged to remain stable even as crypto prices fluctuate. At the same time, payments using stablecoins are still fast, transparent, and secured on the blockchain.

Simply put: stablecoins allow people to use crypto, without worrying about the extreme price volatility many cryptocurrencies incur.

Types of stablecoin

There are three main types of stablecoins–fiat-collateralized, crypto-collateralized and algorithmic–and each provide a unique mechanism to stabilize their value. As their name suggests, fiat-collateralized stablecoins are backed by a reserve of a fiat currency (or basket of currencies) while crypto-collateralized are backed by other cryptocurrencies. Algorithmic stablecoins do not necessarily hold reserve assets, instead maintaining their value by controlling its supply via an algorithm.

With over 42.8 billion coins in circulation, USD coin (USDC) is an example of a stablecoin. Given that stablecoins can be pegged to any fiat currency, some crypto companies offer more than one, such as the largest, Tether, whose currencies are pegged to the Euro (EURT) and the US Dollar (USDT), respectively.

List of top stablecoins by market capitalization:

  • Tether (USDT)
  • USD Coin (USDC)
  • Dai (DAI)
  • TrueUSD (TUSD)

How do stablecoins work?

At the most basic level, an exchange offering a fiat-backed stablecoin will deposit a dollar — or whichever currency its coin is pegged to — for every stablecoin it places in circulation. This is what pegs the stablecoin to that currency and theoretically enables holders of stablecoins to exchange their stablecoins for fiat currency at a one-to-one ratio.

While fiat-backed stablecoins make up most of the market capitalization, there are stablecoins in circulation that are pegged to other assets. These include:

  • Stablecoins pegged to gold and other precious metals, such as Digix Gold
  • Stablecoins pegged to other crypto assets. Dai is the best example
  • Algorithmic Stablecoins, also known as Non-Collateralized Stablecoins, such as the Ampleforth or AMPL token

Although there are differences in the mechanics that power different types of stablecoins, the result is the same: offering the stablecoin holder a high degree of certainty in the asset's value.

Stablecoin use cases

Stablecoin use cases continue to emerge as more people come to understand what the technology has to offer. These use cases range from trading, lending and escrow to financial access and payroll. However, here we explore the main use cases related to payments:

Stablecoin for payment: Payment presents the leading use case for stablecoins as companies that opt to accept stablecoin as payment benefit from lower transaction fees. For example, accepting stablecoin payment enables businesses to avoid the typical 2% to 3% processing fee that is charged by financial institutions on fiat transactions.

Stablecoin for settlement: Stablecoin settlements provide a major use case for entities working around the clock as they operate on the blockchain, which runs 24/7 and enables near instant settlements globally. Fiat settlements, on the other hand, are limited to banking hours or a centralized financial insitition's business hours.

Stablecoin for remittance: Given stablecoins’ inherent price stability, they provide a meaningful use case when it comes to global payments and remittances, especially for people who most need this type of price stability like overseas workers. Off-chain remitters also charge high fees to send money internationally, which presents a hindrance to these workers when sending money back home to loved ones.

Why are stablecoins growing in popularity?

Even before the pandemic, paying with digital cash was becoming more and more attractive. Now, after almost two years of living with the shifting regulations in the physical world, buying online using digital money is more popular than ever. But these trends have resulted in many different stores of digital money, which don't synchronize easily.

Take a Venmo balance, for example — what good is holding USD in a Venmo account if no one else is using Venmo? Stablecoins offer an alternative: a single form of digital currency that, since it's managed on the blockchain, will translate across payment systems, no matter which platform you want to pay on. Stablecoins also provide the added benefit of cross-border payments at greater speed and lower costs, among other advantages.

Benefits of stablecoin

The nature of stablecoins can bring additional benefits to consumers, businesses and governments alike because:

Stablecoins are low volatility assets: Because they're usually pegged to fiat currencies, their value doesn't fluctuate in the same way as other crypto assets. As a result, consumers and businesses can treat stablecoins much like traditional currencies.

Stablecoins enable fast and low-cost payments: With stablecoins, payments can easily be made cross-border, making it easier for vendors to sell to international clients in a globalized marketplace. These payments are also fast and lower-cost, making them much more attractive as a way for small businesses to accept payment.

Stablecoins can enable micropayments: Micropayments — where consumers pay incrementally for their use of content online — is a practice that is currently prohibitively expensive in traditional banking. As Circle’s CSO Dante Disparte told Associated Press, "If you could receive a streaming payment or an accrued payment, or a payment that is contractually obligated to you in software, and it costs no more to send $1, or a billion dollars, all of a sudden you’re unlocking quite a lot of economic activity."

For crypto investors, stablecoins are particularly attractive right now because the prices of all cryptocurrencies tend to be volatile. In this sense, stablecoins offer a 'safe haven' for those looking to avoid market volatility. Stablecoins can also be 'staked', allowing owners to earn yields on holdings while avoiding the ups and downs of crypto prices.

But in the future, stablecoins could also offer a way into digital payments for unbanked segments of the population, which are not served by traditional banking, according to economist Eswar Prasad. This could be particularly helpful, for example, for governments issuing stimulus payments and bringing new consumers into the world of digital payments.

Stablecoin: Potential drawbacks

As with all innovative technology, stablecoins do pose risks, especially as we wait for clear legislative guidance from regulating bodies and governments on their application in day-to-day payments. More so, given its appeal as a more stable alternative to its cryptocurrency counterparts, many stablecoins on the market claim to be more stable than they are when you look at the real-world asset reserves backing them. If a stablecoin’s reserves are stored with a bank or third party, we must also consider counterparty risk. These third-party entities have control over the reserve assets, creating the risk of inefficient use of capital and subsequent price volatility or instability.

The future of stablecoins

It’s currently not clear how governments will decide to regulate stablecoins, although there are signs that, in the U.S. at least, they might be subject to securities laws–a point recently contested by Circle CEO Jeremy Allaire.

The main question is whether stablecoin operators hold sufficient cash reserves to meet their promise of a one-to-one exchange of value with the dollar. For example, if everyone started taking their coins out at once, it could have devastating effects.

The benefits of stablecoins, however, are clear to governments too. Indeed, the Biden administration recently said that stablecoins could change how we pay for everything. As buying digitally becomes ever more embedded in our lives, stablecoins offer an affordable, stable, and easily accessible way for consumers and businesses to move value globally, today and in the future.

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March 3, 2023 7:53
March 3, 2023 12:07