Today’s post is a sequel to this post – ‘Stablecoins: What Are They And How Do They Work?‘
Stablecoins are cryptocurrencies that maintain a stable value.
In this post, you will learn how stablecoins maintain their stability amongst other things.
Let’s get started.
Stablecoins Explained
As mentioned earlier, Stablecoins are cryptocurrencies that maintain a stable value.
They usually have their value directly tied to fiat currencies like the Dollar, Euro, Yen, NGN, and others, with the Dollar being the most popular.
This tie is called a peg and it ensures that they are not affected by the ups and downs of the crypto market.
Usually, cryptocurrencies like Bitcoin and Ethereum are referred to as volatile assets.
What does that mean?
It means that their prices can go up and down as a result of the effect of supply and demand.
One day, they can be worth a lot, and the next day, they could lose a big chunk of their value.
For example, Bitcoin rapidly went up to $60,000 in 2021, but it went down to $16,000 in 2022.
This can be risky, and that’s why stablecoins were created as a safer alternative for investors.
This is what I mean:
When the crypto market starts to dip or show a sharp decline, smart traders will quickly convert their crypto to stablecoins to protect their investments.
Examples of stablecoins include USDT, USDC, DAI, and a host of others. You can find a list of stablecoins here.
But why do we need stablecoins when we can just use fiat?
Read about that below.
Why Do We Need Stablecoins?
The simple answer: They are easier and faster!
What do I mean?
If I want to send dollars from the US to Nigeria, I would have to go through the bank.
I will fill out some forms and wait 2 to 5 days to receive them at the other end.
But when I send Bitcoin, it is received instantly no matter where the recipient is in the world.
No permission is needed and no middleman is needed.
The same is true for stablecoins.
You just spend minutes to hours carrying out your transactions!
Stablecoins are very important in crypto. It makes DeFi and crypto trading possible.
But they are not without risks.
The crypto market is volatile and open to the forces of supply and demand.
So how do we make a coin in this market stable?
Read about how stablecoins maintain their stability right below.
How Do Stablecoins Maintain Their Stability?
There are 3 methods.
- Reserve,
- Collateralization, and
- Algorithmic
Details below.
1. Reserve
The Reserve method backs each stablecoin with real-world assets in a bank.
So, if you have ten dollars worth of stablecoins, this means there are ten real dollars stored in the bank.
Major stablecoins like USDT, BUSD, and USDC use this method to keep their value stable.
You can always exchange these coins for real dollars.
Next is, Collateralization.
2. Collateralization
The collateralization method backs each stablecoin with other cryptocurrencies instead of fiat.
But the secret is that the backing cryptocurrency has much more value than the stablecoin most time to the ratio of 2:1.
This is called over-collateralization.
This way, if the value of the cryptocurrencies backing the stablecoin goes down, there is still enough value left to keep the stablecoin safe.
Imagine we have stablecoins backed by shiny diamonds locked somewhere.
The value of these stablecoins stays stable as long as the diamond’s value remains steady and above the value of the coin.
However, if the diamond’s value falls, we can lock up more shiny diamonds to ensure the stablecoin remains stable.
MakerDAO’s DAI stablecoin is pegged to the U.S. dollar, but it is backed by Ethereum (ETH) and other cryptocurrencies worth 150% of the DAI stablecoin in circulation.
That means that if the value of ETH goes down by 50%, there is still enough value in the other cryptocurrencies backing DAI to keep it worth $1.
3. Algorithmic
The Algorithmic method is a bit more complex.
Coins are either burned or created to constantly adjust the supply of stablecoins to maintain their value.
There are two components in this method:
- The stablecoin and
- The non stablecoin
The aim of the non stablecoin is to make sure that the stablecoin is stable.
When the non stablecoin is burnt, more of the stablecoin is automatically minted.
And when the stablecoin is burnt, more of the non stablecoin is automaticlly minted.
This is the algorithmic nature.
For this to make more sense to you, we can all agree that the supply and demand determines the price of an asset.
When supply exceeds demand, price falls, and when demand exceeds supply, price rises.
So the stablecoin is pegged at 1 dollar.
When the price begins to rise above $1, i.e demand exceeding supply, some of the non stablecoin is automatically burnt to increase the supply of the stablecoin.
That is, more supply to bring demand to equilibrium and thus, bringing price back to $1.
On the other hand:
If the stablecoin’s price begins to drop below $1, the algorithm will burn some of the stablecoins to make it scarce and raise price back to $1.
So, it is like osmosis or diffusion i.e the movement of molecules from a region of higher concentration to lower concentration to bring the ecosystem to equilibrium.
Example is UST.
Read more: Algorithmic Stablecoins Explained in Simple Terms
Stablecoins are meant to be stable but they can fail, especially if the method used to achieve this stability is faulty and open to attack.
Below, I listed some factors that affect stablecoins stability.
Keep reading.
Factors that Affect the Stability of Stablecoins
The stability of a stablecoin can be influenced by various factors as listed below:
1.Underlying Asset or Collateral:
Many stablecoins are backed by real-world assets such as fiat currency, commodities, or other cryptocurrencies.
The stability of the stablecoin often depends on the value and stability of the underlying assets.
So anything that affects the underlying asset indirectly affects the stablecoin tied to it.
2. Reserve Management:
The way the issuer manages the reserves backing the stablecoin is crucial.
Transparent and responsible management helps ensure stability.
3. Auditing and Transparency:
Regular third-party audits of the stablecoin’s reserves can provide assurance about its value and stability.
4. Market Demand and Supply:
Like any other asset, stablecoins are subject to the laws of supply and demand.
If the demand for a stablecoin increases significantly, it can lead to its value exceeding its peg.
Or if the supply is too high, it might drop below its peg.
5. Regulatory Environment:
Changes in regulations or legal challenges can impact the stability of a stablecoin, especially if they affect the issuer’s ability to operate or maintain reserves.
6. Issuer Reputation:
The credibility and reputation of the organization or entity issuing the stablecoin can affect investor confidence and its stability.
7. Smart Contract Risks:
If a stablecoin is built on a blockchain platform using smart contracts, vulnerabilities or bugs in the code could be exploited, potentially affecting its stability.
8. Market Liquidity:
A lack of liquidity in trading pairs or markets where the stablecoin is traded can lead to price deviations from the peg.
9. Market Manipulation:
Like any financial instrument, stablecoins can be subject to market manipulation, which could lead to temporary instability.
Other factors include:
- Competing innovations
- Technological risks
- Cross border issues`
- Market sentiments, etc.
However, it’s important to note that no stablecoin is completely immune to fluctuations.
Maintaining stability is an ongoing challenge that requires careful consideration of these and other relevant factors.
Conclusion
Here, we draw the curtains on today’s post. Hope it’s worth your time.
While stablecoins help to keep the crypto market stable, they also have some downsides.
You can navigate through these hiccups and still use stablecoins by acquiring the knowledge of digital currencies.
If you want to learn how to trade with digital currencies and learn more about crypto and DeFi, create a Bybit account.
You can also join us on Telegram where we hold live sessions 3 times a week.
So long, dear reader… See you in my next post!
0 Comments