Stablecoins, Explained: The Convenience of Crypto with the Stability of a Standard Currency

Stablecoins, Explained: The Convenience of Crypto with the Stability of a Standard Currency

Stablecoins Explained: The Convenience of Crypto With the Stability of a Standard Currency

Erin M. Sarris

Erin M. Sarris

Erin M. Sarris is the managing editor of ngenuity journal. With more than 10 years of experience in payments, she oversees all aspects of the publication to ensure it covers a variety of topics related to financial services.

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You can't scroll past your news feed without seeing an article about cryptocurrency, but it's not always for the best reasons. Yes, they have promise for an improved payment system with lower fees, better security and fewer errors. But they also can be extremely volatile, with the price of bitcoin, for example, jumping or dropping 5 to 10% in just an hour.

For investors, this can be great news. But as a consumer who wants to use crypto as a currency, it's not ideal for the purchase of goods and services. Our traditional, government-based currencies like the U.S. Dollar or Japanese Yen generally hold their value from one day to the next. After all, the economies of the world depend on this type of stability.

This is where stablecoins can come in, bridging the best of cryptocurrencies' perks with the stability and order of legacy currencies. They were designed from the ground up to hold a stable value and have tremendous promise for consumers and businesses looking to use crypto without the risk and volatility.

The need for stablecoins

The prices of most cryptocurrencies are so volatile that they can change between the time you put a product in a shopping cart and the time you check out. Because of this volatility, standard cryptocurrencies like Bitcoin, Ethereum and Ripple don't work well with day-to-day commerce. And that means very few companies are willing to take cryptocurrency as payment.

Microsoft accepted Bitcoin back in 2014, but eventually shuttered the program because the price was just too volatile. Most companies won’t even consider using a cryptocurrency payment system.

Yet, there are clearly benefits to cryptocurrencies. Transactions are fast. A payment can be processed in seconds. Blockchain technology is proven to be secure. The fees are low. And the transactions are immutable, forever embedded in a public blockchain for posterity.

Stablecoins defined

There are four main types of stablecoins.

  1. Fiat-backed stablecoins

    The most common type of stablecoin is backed by a fiat currency like the U.S. Dollar or the Euro. These stablecoins are collateralized at a 1:1 ratio. This means that one stablecoin is worth one unit of the fiat currency.

    For every fiat-backed stablecoin that is minted, there will be one unit of the fiat currency in a bank account as collateral. When a consumer wants to exchange the stablecoin for the underlying fiat currency, it is transferred to the consumer's bank account and the stablecoin is destroyed. This keeps the 1:1 ratio balanced.

  2. Commodity-backed stablecoins

    Stablecoins can also be backed by other valuable assets. One of the most common is gold. Other stablecoins are backed by real estate, oil, diamonds or precious metals.

    Owners of an asset-backed cryptocurrency own a piece of that asset, which means the value of the cryptocurrency will follow the value of the underlying asset. Since the assets used as collateral tend to increase in value over time, so will the stablecoin. This gives consumers an added reason to hold and use this type of currency.

  3. Cryptocurrency-backed stablecoins

    This type of stablecoin is backed by other cryptocurrencies. At first glance, this may be confusing, but these stablecoins are majorly over-collateralized by the underlying cryptocurrency to account for the volatility in the market.

    In practice, it looks like this: Let’s say you wanted $100 in a certain type of cryptocurrency-backed stablecoin. You would have to lock up $200 of the underlying cryptocurrency to receive it. If the market drops, the added collateral can absorb the change, and if it drops far enough, the stablecoins will be liquidated.

  4. Unbacked stablecoins

    Another type of stablecoin is not backed by anything other than smart contracts, a type of software embedded in the blockchain. The algorithms written into these smart contracts increase the supply of the stablecoin when demand increases and will buy back stablecoins when demand drops. This keeps the price of the stablecoin level.

Use cases of stablecoins

It's no secret we live in a busy world with information available in an instant, but the economy still runs on legacy monetary systems. And even when fiat currency is transferred electronically, the transfers are controlled in centralized systems prone to hacking and fraud, and the numbers in the bank ledgers only represent the physical currency.

Four Types of Stablecoins, Explained: 1) Fiat-backed 2) Commodity-backed 3) Crypto-backed 4) Unbacked

Stablecoins are legally backed by a valuable asset, or fiat currency, and can be used for standard commerce. In a stablecoin transaction, the value in the ledger or blockchain is the actual currency, and this ledger is public, cryptographically secure and occurs in seconds. 

Because the process is controlled by software, fees are low and stablecoin can be transferred directly to another person thousands of miles away instead of through a third party like a bank. This makes it a perfect solution for overseas transfers and payments.

And because stablecoins are electronic money, they can be controlled by smart contracts. This means that all kinds of automatic payment systems can be written in code and stored publicly on a blockchain for reference.

Cryptocurrency has come a long way since Bitcoin, and it still has a long way to go to gain acceptance. But stablecoins are a step in the right direction. They provide the speed, security and convenience of a cryptocurrency with the stability of a fiat currency.

The statements and opinions of the writer do not necessarily reflect those of TSYS.

Other Articles by Erin

Erin M. Sarris

Erin M. Sarris is the managing editor of n>genuity journal. With more than 10 years of experience in payments, she oversees all aspects of the publication to ensure it covers a variety of topics related to financial services, including mobile, B2B and emerging technology.

Erin has written for publications of The Chicago Tribune, RedEye and Metromix.com, as well as The Washington Post's Retirement Living, TV Guide, Washington Spaces, Columbus Valley Parent and The Peoria Journal Star. She graduated from Bradley University with a bachelor of science in political science and communication, and from Columbus State University with a master’s in business administration.

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