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Explained- How Stablecoins are really stable?

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Pavan A Follow


Jun, 22 2021

Jun, 22 2021

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With the unprecedented boom in its value since 2020, stablecoin has been highly valued by its investors due to its backing from traditional financial investment tool. 

The market cap of stablecoins has expanded over the years, the stablecoin market has seen tremendous growth. The market grew from $5B in 2020 to crossing $50B. There are 37 stablecoins that are officially listed, of which 6 have market values north of $1 billion. Tether is by far the largest with a market capitalization of $62.63 billion, as of June.

The most popular stablecoins include Tether (USDT), Binance USD (BUSD),

USD Coin (USDC), Paxos Standard, (PAX)True USD (TUSD), etc


What Is a Stablecoin?

Stablecoins are virtual currencies, but behave somewhat like fiat money for stable price and to avoid volatility, unlike other Cryptocurrencies whose valve change often. When all other virtual currencies are avoidance of fiat currencies, stablecoin relies on fiat currency like US dollars and strive to narrow the gap between traditional and cryptocurrencies.


It is categorized based on its working mechanism:


1) Fiat-Collateralized 

This is the most common stablecoin having the simplest structure, which is backed or collateralized by fiat currency like USD, EUR, or GBP. The coin will not fluctuate until the economy of the country remains stable.


Fiat-collateralized stablecoins are backed at a 1:1 ratio, that's 1 stablecoin is equal to 1 unit of currency--For every coin, there is real currency (like USD, EUR, or GBP) to back it up and is being held in a bank account.


So, if someone wants to exchange their coins for cash, the authority managing the coins will send the same amount of traditional currency from their reserve to the person's bank account, the equivalent Stablecoins are taken out of circulation.



2) Crypto-Collateralized:

These are backed by Cryptocurrencies. Since most Cryptocurrencies are highly volatile in nature, the stablecoins are over-collateralized, that is a larger number of virtual currency token are held in the reserves for issuing a lower number of coins. This is done to withstand the price fluctuations of underlying cryptocurrencies.


3) Non-Collateralized (algorithmic) :

Non-collateralized stablecoins run in an autonomous manner, where there is a working mechanism without using any reserves backing it. To retain stability in its valves, it includes a working mechanism just like the central banking system. It increases or decreases the supply of tokens depending upon the market needs, similar to a central bank printing traditional currency to maintain the valuation.


4) Commodity-backed:

Commodity-backed coins are backed by some amount of non-currency assets like precious metals like gold. In this, each token will have one gram of gold to backed it to avoid wide fluctuations in its price. If coins are worth $100, and you can actually exchange your coins for the same amount of gold. 


How are Stablecoins created?

Stablecoins are a type of cryptocurrency that is backed by fiat currency or physical assets. Its value is based on the value of the currency or precious metal to which it's pegged. Unlike traditional currency, it’s not controlled by any nation or company.


The amount of stablecoins released every year is controlled by a set of publicly known mathematical algorithms. The coins can be earned by keeping track of all the transactions occurring on the network through a process called mining.


How Stablecoins remain stable?

Stablecoins manage to remain stable as they are driven by market supply and demand. It mostly relies on US dollars or on a commodity's price such as gold. They have either backing (collateralization) or algorithmic mechanisms of buying and selling the reference asset or its derivatives to make it highly stable.


Even though Cryptocurrencies like bitcoin and ethereum are popular and in high demand, they lack stability in their valuations. This instability in its market valve makes bitcoin and other Cryptocurrencies unsuitable for the general public.


If compared with the traditional currency (fiat currency), its stability lies in two major reasons, one being the backing by the reserves and the other is the control by the Central Bank of any country to maintain its market value. The traditional currency is pegged to underlying financial assets like forex reserves and gold, whose market valve remains highly stable.


If there is a situation where the value of the traditional currency changes drastically, to maintain price stability, the demand and supply of currency are maintained by the controlling authority. So, it's highly unlikely for any cases related to price volatility to arise. Whereas, other cryptocurrencies lack reserve backing its valuation and no central authority to control price fluctuations.


How Stablecoins make money?

Stablecoins are mostly tied to a physical asset like gold or fiat currency, hence profits are nowhere near highly volatile cryptocurrencies like bitcoin and ethereum. Stablecoins are mostly designed to hedge against the volatility in the cryptomarket


Lucrative money-making methods include:


1)   Earn interest on stablecoins:

Money can be made just like any traditional currency by interest earned on account deposits. Some stablecoins earn through a different approach by depositing them in some interest-earning platforms like Nexo and BlockFi by lending them to DeFi projects like Compound. 


There are platforms, where you can invest in precious-metal-backed stablecoins, the value of the coin will fluctuate based on the price of gold. You are essentially holding gold by buying it at a lower price and selling it for higher profits.


2)   Crypto lending : 

Loaning out these popular currencies for the interest is another way crypto holders make stablecoin work for them. This involves handing over your stablecoins to a trusted loans provider.


3)   Trading your stablecoins:

The common way most investors tend to make a profit on their holdings is to trade them during the price increase on a cryptocurrency exchange.


However, the stablecoins that are tied to physical assets like gold or any precious metals are more profit-based than coins like Tether, which is tied to the US dollar--a stable currency. 


How are stablecoins taxed?

Since stablecoins are treated as property, sales or exchanges of coins must be reported for taxes purposes, even if you incur a loss.


The sale or exchange of assets like purchasing good and services via stablecoins is taxed. Taxation are no different than that of fiat currency, where receiving currency/coins in exchange product and services is taxed under income tax. The tax on the stablecoins is calculated in terms 1 to 1 ratio. Eg: 100 USDC is the equivalent of $100 cash. However, for cryptocurrencies like bitcoin, the date of receipt will determine its value for income reporting purposes. 


The sale of the stablecoins to exchange it for cryptocurrencies is subject to capital gains tax and must be reported as an income, even if there is no capital gain. Other taxable events include converting other cryptocurrencies to stablecoins or purchasing other cryptocurrencies using stablecoins. Even though buying coin for cash and holding it is a non-taxable event.


What is the purpose of Stablecoins?

Stablecoins is used for various purposes depending upon areas of applications. As the name suggests the general purpose of stablecoin is to remain stable by relying on the stability of the fiat coin.


Highly volatile cryptocurrencies are problematic for businesses. Stablecoins has low risk, which may enable businesses and countries to make it a legal tender. This makes it easier to transfer funds across borders with quick transfer and less transaction fee on a global scale. 


"One of the most powerful uses of stablecoins is payments," says Nemil Dalal, head of the crypto at Coinbase.


Stablecoins are tokenized version fiat currencies like USD. They are very useful in payments and to avoid the tedious process of transferring fiat currencies across the border. Transfer of funds or pay for items in US dollars will be easier, which will bypass converting national currency to USD just to purchase an item in USD.


Dalal adds "When cryptocurrencies are down, people generally seem to buy stablecoins and use them to get out of the volatility," 


When there are major price movements in the crypto space, the investors and users could move their money to stablecoins until the market stabilizes. The coins purchased through fiat currency will not change its valve until they are moved to highly volatile cryptocurrencies like bitcoin. It is also highly liquid and tradable, increasing ease of use across cryptocurrency exchanges or exchange into fiat currencies.


Why use Stablecoins?

Stablecoins are not affected by price volatility like other cryptocurrencies. They combine the stability of the U.S. dollar with the efficiency and transparency of blockchain technology. 


Further, like other cryptocurrencies, they have other features like security, immutability, digital wallets, programmable, fast transactions, low fees, and privacy. This could benefit people with no bank accounts, migrant workers to send remittances to their country, companies and individuals that are looking for cheaper and more efficient ways to make international payments without worrying about a sudden decrease in value like bitcoin.


Stablecoins can be used as an arbitrage which is near impossible with the traditional banking system. Also in the event of volatility or market crash, crypto investors can trade their bitcoin or other cryptocurrencies to a stablecoin within a matter of minutes avoiding massive losses. When Bitcoin, Ethereum prices are going back up again, crypto holders could convert their stablecoin back to higher risk cryptocurrencies. 


Real-world applications of stablecoins


Although still in its early stages, stablecoins are gaining rapid popularity with many potential real-world applications poised to transform the financial market. 


1)   Alternate currency :

Stablecoins could be used just like any other currency (with the benefits of digital currency) or can replace the traditional currency if there is global acceptance. This could be a solution for cheaper and faster cross-border payments improving the lives of millions of migrant workers and their families in developing countries. The current transfer system to send remittances is a slow and costly process, taking three to five days to process a transaction. 


2)   Streamlining recurring and P2P payments:

Stablecoins also allow the use of smart financial contracts that exist on a blockchain network. Smart contracts are self-executing, function autonomously, executing financial rules without requiring any regulating authority to manage it. These transactions are autonomous and automatic making them ideal for recurring and P2P payments like salary and loan payments, tax and rent payments, and subscriptions.  



3)   Protection from local currency crashes:

Stablecoins could offer protection at the time of volatility in the global crypto market, safeguarding against hyperinflation of native currency, which if not controlled could lead people to poverty and inaccessibility to basic human needs.


The local capital control laws imposed by such countries suffering from hyperinflation pose challenges in moving the capital out of the country. Local fiat currency can be converted to stablecoins and retain the purchasing power of the local currency, thus protecting them from further drops in value.


The Future Potential

Stablecoins have been gaining popularity as they offer the best of both worlds – transparency of decentralized cryptocurrency and stability of fiat currency. Increased adoption as a legal tender can catapult its popularity, and witness more secure and borderless world. . 

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Pavan A

CBW - External Analyst


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