Tue. Sep 27th, 2022
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Mariangela Cistaro Expert consultant in tax law, labor law, real estate law and digital law; trainer and company speaker

HomeBlockchain DLTStablecoin: what they are and how they work 31 March 2022 Blockchain DLT The stablecoins are cryptocurrencies whose value is linked to that of a stable reserve asset, such as a national fiat currency or an external asset. Indeed, the term stablecoins it originates from the union of the two words: stable (stable) and coin (coin). From this it follows that their volatility, compared to classic cryptocurrencies, is reduced, to better specify it is more predictable and measurable. Consequently, they constitute a form of digital currency much more suitable for daily trading, quickly revealing themselves as one of the most widely used and appreciated tools for safeguarding value. Just think that Tether (USDT), the most relevant of the stablecoins, which has a 1: 1 relationship with the US dollar, was defined as “the digital dollar of America” by Bloomberg in the Crypto Outlook of June 2021.

What are stablecoins for

Stablecoins are used to make transactions. The substantial difference compared to cryptocurrencies is essentially due to their methods of use. In fact, cryptocurrencies are mainly used as an investment, while stablecoins are used as payment currency. They make transactions much more stable and impartial, by virtue of the fact that they are tied to a stable medium of exchange. Thanks to their stability, in fact, companies and individuals can use them for daily payments. Due to their stability of value, stablecoins are also referred to as the “anti-Bitcoins”. Stablecoins can serve to protect the purchasing power of citizens in countries with an economy characterized by high inflation. The stablecoins are still used for the operations of hedging, as the sale or purchase of one or more derivative contracts whose value derives from the same asset, offers interesting solutions in this area. In fact, the allocation of a given part of a portfolio in stablecoin is an adequate method to reduce the overall risk of loss.

The different types of stablecoins

The stablecoins are not a homogeneous category and can be grouped into 4 large classes, based on the underlying reference asset: with underlying currency; with underlying commodities (raw materials); with underlying cryptocurrency; not collateralized. The stablecoin with underlying currency they are the most widespread and well-known and have a fiat currency as a reference value, which can be a national or international currency. The stablecoin with underlying commodities (commodities), are the one in which the reference asset is a stable value asset that is not subject to large price fluctuations over time. Gold is usually used, the ultimate safe haven asset. In this case the correlation arises from the token that digitally represents a value referring to a given quantity of gold. An example of a gold-based stablecoin is Paxos Gold (PAXG).
The stablecoin with underlying cryptocurrency, whose asset is the value of another cryptocurrency, are used with integration with smart contracts. The unsecured stablecoins, in the end, they are those in which a sort of “algorithmic central bank” operates, capable of managing supply and demand and are governed by smart contract codes, as there are no underlying tangible resources.

How stablecoins work

The creation of a currency linked to the price or value of an asset requires a pegging system, in which the value of the same is linked to the value of another currency that is considered reliable and highly stable.
In stablecoins with a currency underlying the issue procedure is quite simple: the capital is accumulated in the reference currency, which is, in turn, deposited with a third party; the third party will assume the role of custodian; the tokens that will be sold on the market are issued. Keep in mind that, usually, the ratio is 1: 1, that is, a token is worth 1 quantity of the currency that was used as an underlying. For example, TrueUSD which, using the smart contract system, currently maintains this relationship.
Holders can change from fiat to stablecoin and vice versa at the relevant anchor rate. In the event that the price of the token moves away from the underlying fiat value, usually the arbitrator will bring the price back to the fixed rate.
In stablecoins with underlying commodities (commodities) the issuing procedure is similar to that described above. The custodian of the quantity of raw material must guarantee the correspondence between the token and the value of the measurement of the matter. The materials used are gold and oil. Each deposit corresponds to a digital certificate that activates the smart contract and consequently the token. Whoever owns the token can convert it to the underlying matter.
In stablecoins with underlying cryptocurrency the issue is similar to that described so far, with the only difference that they are guaranteed by a crypto-backed currency. Considering that the cryptocurrency market is very volatile, crypto-backed stablecoins need to over-collateralise reserves to try to keep price swings stable. To manage the rules of the different distributed consensus algorithms that govern the blockchains on which the underlying cryptocurrencies are based and, more generally, to govern the inflation and deflation of the same cryptoassets, smart contracts are used in order to allow users to control them independently. In a simplistic way, we could say that it is a “promissory note” in traditional currency: you buy a stablecoin in currency that can then be cashed in and redeemed in the original currency. In the non-collateralized stablecoinsinstead, we have said that there is no underlying asset but one algorithmic central bank”Which manages supply and demand on the basis of rules encoded in a smart contract. Keep in mind that this is a fairly new and evolving category.

Why are they important?

Stablecoins are important because they can be used as a medium of exchange and store of value, thanks to their characteristics. We refer, in particular, to low volatility. In fact, the anchoring to another asset does not respond to the logic of supply and demand typical of cryptocurrencies and the anchoring is implemented off-chain, that is, outside the cryptocurrency circuit. Furthermore, they have all the typical characteristics of cryptocurrencies, that is, they are always accessible via the internet, global and can be used in smart contracts. The stablecoin technology connected to the blockchain allows to carry out immediate transactions, enjoying great transferability and ease of exchange, in some cases even much faster than in the traditional banking system. Not only that, they are extremely multifaceted, being able to be transmitted to anyone who has a wallet capable of securely storing the private encryption keys necessary to carry out transactions, with a reduced risk of false transactions.

The most capitalized stablecoins

The most capitalized stablecoins are, at the moment:
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Source: https://coinmarketcap.com/ (last accessed 31/3/2022)

Where to buy stablecoin

You can buy stablecoins on exchange or through cryptocurrency broker. Once the digital currency has been purchased, it can be placed in your digital wallet (personal wallet).

The risks

The risks of stablecoins are, in particular: no guarantee of maintaining the anchor; the need for greater reliance on a central entity that holds the reserves; lack of transparency. Keep in mind that most stablecoin issuers provide dossiers by their own independent auditors, unlike large corporations which are audited by external auditors to verify compliance with the law.