The arrival of blockchain technology is and will change the way society thinks, interacts, relates and exchanges value. Exchanges to a greater or lesser extent are supported by digital assets (tokens and cryptocurrencies), essential for this complex decentralized system to function correctly.

Since their inception, cryptocurrencies and tokens, despite their countless advantages, have been characterized by being highly volatile, negatively affecting the development of decentralized financial products.

Developing an investment strategy based solely on volatile assets or transferring value between people or companies with cryptocurrencies as a payment method was a great inconvenience, which often led to abandonment or rejection.

Given this unstable and inefficient situation, the appearance of a crypto asset with a stable price was imminent, that is, a digital asset whose objective was to provide prices that did not vary abruptly and that would allow greater stability to be maintained in the market.

As you can imagine, the name of these is stablecoins.

What are stablecoins?

A stablecoin is still a token , which is used as a digital currency in the blockchain, and whose price is linked 1:1 to fiat currencies such as the dollar, euro or others.

Stablecoin token offer numerous advantages, since they continue to be crypto assets registered in the blockchain, and therefore continue to retain their properties such as immutability, traceability, privacy, agile marketing and storage, etc. In addition to providing a framework of stability to all actors without the need to move to the off-chain world to protect themselves from high volatilities.

The popularity of stablecoins has been increasing exponentially in recent years with the mass adoption and emergence of new currencies that keep their value pegged to the dollar. But as we can imagine, some have become more popular than others, mainly due to the mechanisms used to keep their price stable and whether these mechanisms are centralized or decentralized.

How do they work?

Stablecoins refer to cryptocurrencies whose purpose is to sustain a stable value compared to a fiat currency, like the U.S dollar. They use multiple ways to attain this end such as:

Reserves: Reserve-backed stablecoins hold an equivalent amount of fiat currency in reserve for each stablecoin unit issued. For example, if a stablecoin is backed by US dollars, then the issuing company must have a sufficient amount of US dollars in reserve to cover all units of the stablecoin in circulation.
Algorithms: Algorithmic stablecoins use algorithms to automatically adjust the supply of coins in circulation in order to maintain their stable value. For example, if the price of the stablecoin rises above its target value, then new coins are issued to reduce the price, and if the price falls below its target value, coins are burned to increase the price.
Collateralization: Collateralized stablecoins use a cryptocurrency as collateral to back their value. For example, a Bitcoin-collateralized stablecoin could hold an amount of Bitcoin as collateral for each unit of the stablecoin in circulation.

They are a useful tool for those who want to use cryptocurrencies without the volatility associated with traditional digital currencies.

‍

How do stablecoins maintain their price?

The way stablecoins maintain their price is directly related to how they are generated or created. Let's see this in detail.

Stablecoins generated through fiat money

There are different ways to create stablecoins, although the most used is by using fiat currencies as collateral.

A company centrally generates new stable coins while depositing the same number of dollars or euros in a financial institution (it issues a stablecoin for each fiat currency it deposits).

This means that each stablecoin is backed by a government currency, and the market understands it this way, therefore, its price is directly linked to that of this currency and is corrected for possible deviations through arbitration.

If we want to place our trust in this type of stablecoins we should ensure that the fiat deposits that support them are audited, otherwise it could happen that the emissions are partially backed, with the possible risks that this would entail.

Some more popular fiat-backed stablecoins are; USDT, USDC, BUSD AND GUSD.

These stablecoins can be purchased on a secondary market through DEX or a centralized exchange. You could also purchase them directly from the platform that is responsible for issuing them, although in this case you will have to go through an identification process (KYC/AML).

Advantages

Stable: being backed by fiat money, usually the euro or dollar, they are quite stable. Furthermore, if the collateralization process is correct we have greater guarantees in terms of legal coverage.
Simplicity: the creation process is simple and quite intuitive, and leaves aside possible risks in relation to smart contracts as occurs with other types of stablecoins as we will see below.

Disadvantages

Centralized: the issuance is carried out by a private entity in a centralized manner, in which we must place our trust as with government money.
Regulatory limitations: Organizations that issue stablecoins are subject to country regulations, which could change at any time and directly affect their owners. They may be frozen or confiscated, as has happened on some occasions.
Collateralization problems: the collateralization process is not recorded in the blockchain, therefore, we do not have true proof that the issues are fully backed.

Stables backed by other tokens

These stable cryptocurrencies are created through loans collateralized by tokens, that is, if for example I have ETH, I can request a loan against ETH in the form of a stable currency.

Its operation is more complex than that of stablecoins backed by fiat money, since in this case smart contracts are used that manage the issuance and collateral so that the new stablecoins do not remain partially collateralized.

The way to avoid this situation is:

Using multiple tokens as backup instead of one, so if the price of one of them drops sharply, it will still be backed by the others.
Another very important factor is that the emissions are overcollateralized so that, in a situation of high volatility in the market, the protocol has time to react by selling the collateral before its value falls below the value of the stablecoins issued with that backing. .

The first cryptocurrency-backed stablecoin to appear was DAI, and it is currently one of the best known. DAI through its decentralized protocol (Maker DAO) allows creating cryptographic currencies in the form of a loan, depositing ETH or other cryptocurrencies as collateral.

The protocol ensures its stability by locking the collateral, which, if it loses its value below a predefined limit (collateralization ratio), will automatically liquidate the position. We will dedicate a complete article to talk about this revolutionary protocol.

As you may be imagining, these types of stablecoins align with the philosophy and principles of blockchain technology by maintaining issuance, storage and governance in a decentralized manner, without depending on any centrally managed bank or collateral.

Main use cases for stablecoins

Reserve of value and protection against volatilities

By having a 1:1 parity with the dollar or euro, in a way it implies that we have tokenized fiat money and this can be very useful to avoid the risks associated with market volatility.

For example, a user can use stable cryptocurrencies in bearish market times to protect their capital, divest it without having to convert it to fiat money, which is much more practical and efficient.

They also help to enhance the liquidity of crypto assets since almost all tokens and cryptocurrencies are usually traded for a stablecoin, since it is safer and easier for the investor.

Finally, if we live in countries extremely affected by inflation, such as Argentina, the use of stable cryptocurrencies could be useful as a tool to protect the value of our assets, with greater privacy than if we did so directly in dollars.

Payment method and digital money

Although it may seem like a trivial use case, since as we say they represent fiat money, it is not very widespread at the moment, although it is true that we are already seeing some projects that allow payments in businesses through stablecoins. In the near future we could see greater adoption driven by the advantages that having a fiat currency represented by a token would add.

Among these advantages we can find much faster international payments, as well as micropayments, greater accessibility and use by countries whose population is unbanked.

DeFi Protocols

Perhaps this is the most widespread use and one of the main reasons that helped create this type of token. Stablecoins lay the foundation for decentralized finance, and allow the development of financial products that would be difficult to viable without their help.

Thanks to the establishments, decentralized finance protocols are more stable and secure and allow us to offer more interesting investment alternatives than traditional banking.

We can use stablecoins to make our savings profitable by providing liquidity to a DeFi protocol, or by lending our money in the form of stable currency to other users in a completely decentralized way in exchange for interest, or directly by doing yield farming together with another token or cryptocurrency.

Conclusion

We can say that stablecoins are here to stay and that they are solving big problems that limit the growth of the crypto world.

They improve the user experience and therefore its adoption, help protect against high volatilities, allow the design of a more affordable and simple investment strategy, and of course, generate passive income by using DeFi protocols, such as Compound, a brow/lend protocol.

But despite all these advantages, we cannot forget the underlying risks, such as the high volatility of the crypto market, increasingly tough regulations, possible security deficiencies in smart contracts or the high liability in their storage (the loss of the private key associated with the wallet, would mean the loss of all funds).

StableCoins development: What Are They and How Do They Work?