Stablecoins are digital currencies that reflect the value of another asset. These are usually fiat currencies, such as euros or US dollars. A stablecoin can therefore mirror the value of another currency. In principle, a stablecoin can represent any asset. However, stablecoins typically represent assets with low volatility. This makes them relatively stable in value compared to other cryptocurrencies (just as stable as the value to which they are linked).
Do you want to know more about stablecoins? Then take a look at the relevant BTC-ECHO ACADEMY entry.
This stability makes stablecoins particularly suitable for trading cryptocurrencies such as Bitcoin. The advantage: exchanging stablecoins for cryptocurrencies is much easier than going through a bank account. Investors who want to buy or sell cryptocurrencies do not need to process transactions through their fiat bank account. This usually saves time and fees.
Stablecoins therefore act as a link between the crypto sector and the classic market. By being linked to “stable” values, they facilitate the trading and storage of crypto assets. One of the best-known stablecoins, for example, is Tether’s USDT. This would like to represent the US dollar at a ratio of 1:1.
How do stablecoins work?
The quality of a stablecoin is measured by how reliably it reflects the value of an asset. A stablecoin that represents the euro, for example, should have as few deviations as possible from the original in order to function as a solid currency and accounting unit. To achieve this, there are currently three different procedures:
- Hedging through classic assets
- Hedging through cryptocurrencies
- Algorithmic protection
Hedging through classic assets
With stablecoins of this type, classic assets are deposited as security. For example, if you want to buy a classically secured stablecoin that represents the US dollar at a ratio of 1:1, you must deposit a physical US dollar with the respective provider for each coin purchased. If it is resold, it can be exchanged back accordingly. This is intended to guarantee the value of the coin. However, the collateral does not have to be with fiat money. It is also conceivable to hedge with assets such as precious metals, such as gold.
Advantages of hedging with classic assets:
- Compared to the crypto market, classic assets such as precious metals and gold have lower liquidity. Stablecoins with such an underlying asset should therefore have similarly low volatility.
- Classic assets come from a regulated market environment.
Disadvantages of hedging with classic assets:
- There is no investor protection. If Tether goes bankrupt, there is no deposit protection.
- It cannot be guaranteed 100 percent whether the envisaged exchange ratio to the base asset will hold.
Hedging through cryptocurrencies
In addition to hedging with classic assets, there are also stablecoins that guarantee value stability using cryptocurrencies as collateral (in German Pfandbrief or security). This has the advantage of greater decentralization. Finally, the deposited deposit can be managed using a smart contract – a middleman like with Tether is therefore not necessary.
However, investors have to protect the high volatility of cryptocurrencies with a disproportionately high collateral. Due to the fluctuation in value of the security itself, situations are conceivable in which the required deposit is less than one US dollar. Investors have to compensate for this.
Advantages of hedging with cryptocurrencies:
- Decentralization is closer to the idea of peer-to-peer systems.
- Smart contracts eliminate the need for an intermediary – none Single point of failure.
- Strong transparency.
Disadvantages of hedging with cryptocurrencies:
- Over-collateralization necessary.
- Low acceptance, therefore low liquidity.
- Smart contracts are fallible.
Protection through an algorithm
In addition to hedging with assets such as fiat currencies, gold or crypto, a third option is used to create value parity with the base asset. The approach to algorithmic hedging is not to deposit collateral. Rather, automated buying and selling algorithms are intended to ensure price stability. In principle, this type of “stable cryptocurrencies” works similarly to a central bank – only automatically and decentrally. If the market pushes the price above the target base value, such as one US dollar, then the algorithm throws more coins onto the market and thus artificially increases the supply. As a result, the exchange rate should fall back to one US dollar.
Advantages of algorithmic hedging:
- Investors do not have to deposit any collateral.
- Transparent system.
- No intermediaries.
Disadvantages of algorithmic hedging:
- Price has been more volatile in previous attempts than in other systems.
- Algorithm is fallible.
- Low acceptance, low liquidity.
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