25/09/2024
With stabilized prices, stablecoins are adopted gradually by organizations, business firms, and individuals who can take advantage of lower fees and rapid settlement. This can be noticed by the expansion and popularity of the crypto market. In September 2024, the stablecoin market hit a new high of 1.46 trillion, as reported by Cointelegraph. In political issues, stablecoins were used in across-countries issues by international organizations such as the UN and governments. Also, Tether’s USDT, one of the stablecoins, is leading in the market following Bitcoins and Ethereum. These can be a sign of the growth of stablecoins, but what exactly is stablecoin and how does it work? In this blog, Kryptodian will get you through these topics.
What is Stablecoin?
Blockchain technology provides many benefits to the financial future; one of the most important benefits is enhancing cross-border finance. It minimizes transacting time and cost compared to traditional methods—consequently, many organizations who wish to utilize cryptos for financial operations. However, the volatility of crypto prices drastically fluctuates over time due to decentralization, so it is hard to manage the fund. In addition, when swapping cryptos or transferring back to fiat money, they consume many fees, which are barriers, especially, for beginners.
From these pain points, stablecoin was invented to maintain a stable value by pe***ng the price to another asset, such as fiat currencies like the US dollar, EU euro, or a commodity. This pe***ng addresses several pain points within the crypto market. In general, the value of one stable coin equals the value of 1 USD or other currencies (1:1 ratio), but temporally the price can deviate called “depeg”. The stablecoin issuers can have different models to peg its value which we are going to discuss in the types of stablecoins section.
If you would like to trade the crypto but do not want to reverse back to fiat money and pay a fee, you can swap those tokens for stablecoins and later re-purchase them by paying with stablecoins. To put it simply, stablecoins work like the arcade’s token when we need to exchange fiat money with arcade tokens before playing the games.
Type of Stablecoins
After we understand the overall concept of stablecoins and the key advantage of stabilized price as the name suggests. Classifying is related to the pe***ng models to maintain stable prices. Some institutes can categorize differently due to dissimilar criteria. In this blog, we categorize based on collateral assets into three groups: Fiat-Backed, Crypto-Backed, and Algorithmic.
1. Fiat-Backed Stablecoin
The first type is fiat-backed when coin issuers collateralize fiat money such as the US dollar or other currencies in 1:1 ratio. In other words, one stablecoin is equivalent to one USD as its reserved asset, and each coin can refer to fiat money with a high stability pegged price of 1 USD. The price can volatile temporarily but not far beyond one dollar is pegged. The gas fee will apply when owners swap crypto back to fiat money. Despite price stability, some exchange platforms offer yield farming. The most adopted stablecoin is USDT by Tether with the 3rd largest market cap in the market, followed by USDC by Circle, and PYUSD by Paypal. In other currencies, those coin issuers also produce stablecoins for other currencies such as the EU’s Euro, China’s Yuan, Korea’s Won, etc. making them more accessible globally.
2. Crypto-Backed Stablecoin
Focusing on decentralization, crypto-backed type reserves cryptocurrency instead of fiat money to peg the value of stablecoins at 1 USD. For some providers, the lending model was used for coin minting, and the reserving ratio is over collateral which means users must deposit higher asset value in reserved stores than the minted stablecoins. The collateral ratio varies from 125%-150% depending on each platform; the exceeded value protects against the volatilization of the reserve's price because if the stored asset’s value is lower than lent stablecoins, the asset is liquidated to the market automatically by a smart contract. This mechanic provides crypto holders a choice in a fluctuating market, so they can deposit their price-fluctuating cryptos while using minted stablecoins, and then return the lent stablecoins to withdraw reserved assets during the normal market. Examples of crypto-backed stablecoins are MakerDAO’s DAI, EOS protocol’s EOSDT, etc.
3. Algorithmic Stablecoin
The last type is the most abstract model which does not require any asset in reserve to peg the coin's value, instead using the computing-algorithmic model to control supply and demand relating to price; some of these coins use duo-coin models to stabilize prices of each other. The model from each provider has its own unique, and complex, so users should take some time and carefully learn how their algorithm maintains the pegged price of their stablecoins. Examples of these coins are Terra’s Luna and UST, FRAX, NASDAQ’s AMPL, etc.
Why do we need stablecoins?
Many people are aware of the benefits of blockchain for digital finance but before the existence of stablecoin, the crypto market was so volatile like a barrier for new investors. When stablecoin was invented as a stable-price cryptocurrency, it also enhanced the potential of cross-border transactions to become more rapid and cost-saving. For instance, if we transfer fiat money to other countries, the process can take up to 3-5 days for settlement and the service fee can be added from intermediaries. With blockchain transparency, stablecoin transferring can be done in a few minutes and lower fees due to fewer stakeholders.
Price stability makes stablecoins look easy to use, even for new investors when compared with other fluctuating tokens, so many decentralized financial platforms (DeFi), blockchain networks, and Web3 accept stablecoins for alternate paying methods. Occasionally, if you would like to use infrastructure on different networks, some tokens are not available on some platforms, so you need to buy or swap tokens for native coins leading to inconveniences. Alternatively, stablecoins can be used on different chains due to acceptance, so if you are holding stablecoins, you can use them on various platforms across chains.
For these reasons, stablecoins seem like the bridge between traditional decentralized finance, DeFi platforms, and blockchain networks, and these coins can be the fundamental landscape for digital currency in the future since there are numerous use cases for stablecoins.
Rapid settlement is the key advantage of stablecoins applying blockchain technology to tackle the traditional transferring process. To illustrate, if you transfer money from one country to another country via SWIFT which requires many contributors like banks that also have fixed operating time, the remittance can take up to three to five days with service fees, but stablecoins can simplify the process by avoiding intermediaries. Consequently, the process will send local currency, convert it to stablecoins, and convert it back to received local currency, and this process can shorten time and reduce costs per transaction.
In consumer payments, businesses can offer stablecoins as an alternative payment method to customers especially when expanding to the new market because apart from USD, stablecoins are also available in other currencies like EU’s Euro, China’s Yuan, South Korea’s Won, etc. In 2022, there were pioneer crypto adopters in industries such as Gucci, Tesla, Tag Heuer, Robinhood, etc. offering crypto payment solutions for their customers. Especially, stablecoins can fix the problem when converting between fiat and cryptos, so it makes day-to-day merchandising faster and easier. Also, the blockchain settlement can have no chargebacks which can protect businesses from losing revenue by payment process since it will be immutable on the blockchain.
International organizations can also use cryptocurrency as an alternative payment methods and utilize stablecoins for internal financial operations. With the rapid accessibility of blockchain, stablecoins can be accessed from anywhere which has an internet connection and is not limited by geographical boundaries. By accessing the distributed ledger and engaging with smart contracts, the operation can access tools and infrastructure in the ecosystem to enhance performance. Moreover, fewer intermediaries lead to lower foreign exchange fees. To illustrate, the payroll process can take nearly a month to plan and be approved in multinational companies. With such enormous money transferred in traditional ways, operating time, processing duration, and exchange fees are inconvenient barriers. After approval, on the other hand, account payables can exchange fiat money for stablecoins, which will proceed on the blockchain network, and then convert to the local currency of receivers in a few minutes anywhere and anytime.
Considering Points
Even if stablecoins can benefit every industry and individual, some countries may still have concerns from regulators who suggest stablecoins should be more transparent and well-conducted, especially for coin stability and monetary policy. In practice, stablecoins for retail and commercial payment are still prohibited in many countries. However, with the growth of stablecoins and cryptocurrency adoption at the macro level we need to be prepared once it is approved by local authorities.
Another vital consideration is collateral compliance. As we already know that stablecoins must apply a collateral model and policy to back their coins, we need to understand how issuers preserve those assets. For fiat-backed, with a high volume of minted stablecoins, issuers must reserve their asset in custodian to guarantee when the users would like to return stablecoins to fiat money, and almost of providers categorize their reserve in many forms and locations determining the potential when exchanging to fiat money such as treasury bills, cash deposit, corporate bonds, precious metals, or even Bitcoins. For crypto-back, one of the risks is when the asset in reserve is liquidated due to devaluation of the reserved asset less than lent stablecoins, so users should understand both the stabilizing model and deposited assets.
Crypto Custodian Enhancing Stablecoins Usage
Stablecoins can be a bridge between traditional financial and advanced digital finance like DeFi, blockchain, and cryptocurrency. Preparing knowledge about stablecoins and wallet security is necessary. Self-learning consumes a lot of time and effort for understanding stablecoins and applying a properly secured wallet; alternatively, you can select an expert digital custodian to get a one-stop service for your wallet solution. Especially, for highly valued funds of institutes, corporates, and exchanges that frequently utilize stablecoins for trading and cross-border payments, the wallet security and management cannot be compromised. For this reason, Kryptodian supports enterprise-grade custodial wallet solutions and supports extensive stablecoins on all major networks. Please reach out to the team to find out more.
