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Category: Economics

What is a Stablecoin and How Do They Work?

You’ve heard of bitcoin, crypto and blockchain, but what about stablecoin? If you’re unfamiliar with this new, up-and-coming digital currency, it...

21 April 2022

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You’ve heard of bitcoin, crypto and blockchain, but what about stablecoin? If you’re unfamiliar with this new, up-and-coming digital currency, it’s high time you studied up to realize its benefits and potential.

To help you get to grips with stablecoin, we’ve put together this need-to-know guide covering what it is, how it works and – most crucially – whether it’s safe, secure, and worth investing in.

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What is a Stablecoin and How Do They Work?

Stablecoin is a digital currency that is backed by assets such as gold and fiat currency. It was developed as a safer alternative to other cryptocurrencies, which have historically been highly volatile and liable to peaks and plummets in value.

While the rise of cryptocurrencies was meteoric, they remain a divisive asset among investors. This is largely due to their instability and unpredictability, which make it difficult for investors to choose the right coin and forecast their expected return.

Stablecoin goes some way to solving this problem, affording investors greater certainty of value. Unlike other digital currencies, these coins are attached to ‘stable’ assets such as gold or fiat money, which means they circumvent the dramatic peaks and troughs in value that other crypto can suffer.

As well as this, stablecoins are also decentralized; they’re not attached to a single organization, system, or agency like other crypto. This affords greater liquidity, simpler access, and enhanced autonomy, so they’re much easier to trade and transfer.

To summarize then, stablecoin essentially bridges the gap between fiat money and cryptocurrency, providing a safer and more attractive prospect for investors. And while it does have its risks and drawbacks (including low yields compared to other crypto), it’s fast becoming one of the most popular ways to invest in the cryptocurrency ecosystem.

What Affects Stablecoin Prices?

Stablecoins act much differently to other cryptocurrencies. Because they’re pegged to fiat money, commodities or physical assets like gold, their price is affected by economic performance, demand for US currency and the current monetary policy of the Federal Reserve.

When looking at the value of stablecoin, it’s worth touching on an important point: the likelihood of making a return.

In the eyes of many investors, one of the key drawbacks of stablecoin is the low rate of return compared to other crypto. This is due to stablecoins being tied to the performance and value of other assets.

For this reason, you shouldn’t see stablecoins as a boom-or-bust investment like other cryptocurrencies. Their stability means they offer a low-risk but ultimately low-reward investment opportunity, with interest the only real way of making money in the long term.

Instead, consider stablecoin a safe jumping-off point into the world of digital currency. With the security of fiat money backing and streamlined accessibility, it affords an attractive means of dipping your toe in crypto without taking a huge risk.

How Safe Are Stablecoins?

In short, very. Not only are stablecoins backed by a combination of fiat money, gold, and commodities, but their value is also monitored and maintained by algorithmic mechanisms, which further enhance their safety and stability.

To put it another way, stablecoins are subject to the same risks as the assets that back them. So, just as the US dollar can rise and fall in line with economic health, so too will the value of stablecoins.

One thing to note, however, is that many people believe you should always look to invest in decentralized stablecoins, and not those linked to a single agency or organization. That’s because they’re much more vulnerable to theft, disruption and interference when stored in a central location, as opposed to being open, global, and accessible.

It’s worth remembering, too, that stablecoins are a relatively new type of digital currency. And given the pace of change within the crypto ecosystem, there may yet be some undiscovered risks associated with this type of coin, so be sure to undertake the appropriate due diligence before you invest.

How is Stablecoin Regulated?

Despite being billed as a safe digital currency, stablecoin isn’t currently regulated in the US and many other parts of the world. This is despite plans to regulate it having reached the halls of Congress, where it is still being debated by members months later.

The issue of regulating stablecoin is a complex one. While many high-profile corporations, including Meta, have come forward in support of regulating the currency, the President’s Working Group on Financial Markets, who are tasked with assessing stablecoin’s viability, have raised questions about what bringing the currency into the mainstream could mean for market integrity and economic health.

It argues that while the majority of stablecoins are claimed to be pegged to fiat money, some are actually backed by other assets, including US Treasury Debt (USD Coin) and Tether, another type of cryptocurrency. This ultimately makes general regulation much more difficult, since there may be huge variances in what different stablecoins are worth at any given time.

So, while stablecoin regulation could well happen, the currency has a few hurdles to overcome before it’s officially rubber-stamped.

Different Types of Stablecoin Explained

As if the world of stablecoin wasn’t confusing enough, there are four types of coins you need to be aware of. We’ve broken these down below.

  1. Fiat-collateralized stablecoins – these are the most prevalent form of stablecoins and comprise of a digital currency backed by a fiat currency like the US Dollar. Since they’re based on real money, they can easily be exchanged and transferred, so they’re among the simplest stablecoins to manage and purchase.
  2. Commodity-backed stablecoins – commodity-backed stablecoins are those backed by assets including gold and other precious metals, as well as things like oil and gas. Though not as liquid as the fiat-collateralized variant, they’re more likely to fetch a higher return since the value of commodities isn’t tied to currency rates.

  1. Algorithmic stablecoins – this is where the world of stablecoin can get confusing. The algorithmic variation is controlled by unique mechanisms that monitor supply and demand, raising or reducing the number of available stablecoins to match. Unlike other stablecoin types, there’s no commodity or cash backing here, so investors are more at risk of sizeable losses.
  2. Crypto-backed stablecoins – backing stablecoins with cryptocurrency may sound counterintuitive, but it’s all about optimizing decentralization. Typically, stablecoins of this type are backed by a combination of cryptocurrencies, spreading the risk while allowing the opportunity to make a greater return on your investment.

We understand that the stablecoin ecosystem can be confusing. But with millions currently being invested into this type of digital currency each year, it’s something many investors are looking to consider in the future.

 

At Glint, we make every effort to demonstrate a balanced conversation between gold, crypto and fiat currencies when it comes to purchasing power and, while we strongly believe that gold is the fairest and most reliable currency on the planet, we need to point out that it isn’t 100% risk free. While we have seen a steady increase over time, the value of gold can fall, which means that its purchasing power can also decline.
 
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