What is a stablecoin and what does it do?

It has become clear to many that blockchain technology enters the mainstream market, and that blockchain assets and cryptocurrencies may disrupt many industries, but there are still factors that hinder mainstream adoption, such as the following:

1. Volatility: highly speculative markets and extreme price changes;

2. Regulation: Uncertainty including grey areas and unstated government positions that make it difficult for businesses to build legal and credible solutions;

3. Scalability: There is uncertainty about the ability of blockchain technology to achieve global efficiency in order to compete with centralized solutions;

4. User experience: Owning and using cryptocurrencies is strenuous for most people, and using blockchain services can be challenging.

Among them, solving the problem of volatility is the most difficult, so what can be done to solve these problems?

Why are stablecoins created?

Since cryptocurrencies are subject to massive movements, they are less than ideal as a medium of exchange and a unit of account.

In fact, if the value of the digital currency drops significantly the next day, any merchant will not be able to accept the digital currency because there is no consensus on how much it might or will be worth.

The wider population is likely to embrace crypto assets only if volatility is reduced.

There are many reasons for volatility, changing public perceptions, emerging markets, static monetary policy and unregulated markets. In order to solve the problem of volatility, stablecoins came into being.

A stablecoin is a cryptographic asset that maintains a stable value against a target price. It is designed for any decentralized application that requires a low volatility threshold to survive on the blockchain.

So in which application areas do you need to reduce volatility?

Remittances, pay wages and rent or any other recurring payments, lending and prediction markets, trade and wealth management, express volatility through fiat, enabling easier visibility and adoption enabling arbitrage opportunities.

In other words, stablecoins are needed by anyone who wants to benefit from the advantages of blockchain technology without losing the guarantees provided by fiat currencies.

What types of stablecoins are there?

Stablecoins can be divided into three main types, namely, stablecoins collateralized by fiat currency, stablecoins collateralized by cryptocurrency, and stablecoins without low-collateralization.

1.Stable coins backed by fiat currency. The most typical case is the USDT issued by Tether, whose Chinese name is Tether.

Each Tether issued and circulated is pegged to the US dollar one-to-one, and the corresponding total amount of US dollars is stored in Hong Kong Tether Co., Ltd. When the unit of measurement is US dollars, the value of the collateral does not have any risk of fluctuation.

The limitations of such stablecoins are centralization, opacity, no deposit of funds or collateral and collateral costs to redeem tokens.

For example, the market's doubts about USDT's transparency and lack of supervision have never stopped: Are the US dollar reserves sufficient? Whether to issue air currency to cause bubbles and so on.

In the face of doubts, Tether has always claimed that it has sufficient reserves, but has not disclosed its audit data of its reserve accounts so far.

2.Stable coins with cryptocurrency as collateral. In this model, the collateral backing the stablecoin is itself a decentralized cryptoasset. This approach allows users to create stablecoins by locking up collateral that exceeds the total amount of stablecoins.

The collateral for a stablecoin is usually an volatile cryptoasset, such as ETH, and if the value of this asset drops too quickly, then the stablecoin doesn’t have enough valuable collateral.

Therefore, most projects using this model require the stablecoin to have excess collateral in order to prevent wild price swings. It is limited in collateral volatility, has little resistance to black swan events, and requires excess collateral.

3.Stable coins without low collateral: seigniorage shares/decentralized banks/algorithmic stability mechanism. Act as a (partially) decentralized bank and employ elastic supply mechanisms.

Usually involves some secured positions, algorithmic rules and complex stabilization mechanisms. It stabilizes the supply of money by algorithmically expanding and contracting prices, much like central banks do with fiat.

In this model, some stablecoin tokens are directly linked to assets such as the U.S. dollar after the initial distribution is completed. Coin supply changes automatically as the total demand for stablecoins increases or decreases.

Its limitations are that stability is often maintained by centralized mechanisms, monetary policy remains complex, unclear, unproven, and incentives may be insufficient.

Summary

Stablecoins are known as the "holy grail" of cryptocurrencies, which can greatly reduce the barriers to entry into the crypto market. Many different projects have issued stablecoins in various ways or are in development, but as of now, there is no clear best practice.

Other solutions from the traditional world, such as insurance or financial products, may offer other paths. More specifically, for stablecoins, derivatives are the biggest competitor on the list of cryptocurrency hedging solutions.