What are stablecoins?

A stablecoin is a non-volatile cryptocurrency that is pegged to a real-world fiat currency like the US Dollar, GBP, Euros, Francs, commodities like Oil, Gold or Real Estate, or other cryptocurrencies. They can also derive their stability from algorithms and smart contracts. Because they are pegged to fiat, commodities or other crypto assets, stablecoins combine the convenience of cryptocurrency for faster settlements and fewer regulatory hurdles while benefitting from the stability of their backing asset.

Most cryptocurrencies were created to be used as a medium of exchange, but because of their relatively small market capitalizations, some cryptocurrencies including the most popular ones like bitcoin and Ether experience wide fluctuations in their prices.

With stablecoins, users enjoy the decentralization of digital money without the accompanying volatility.

How do stablecoins work?

Stablecoins maintain their peg in two major ways;

Trust (Collaterization)

For a  fiat-backed stablecoin like USDC to maintain its value, people need to trust that 1 USDC = $1, otherwise, they will dump it. This trust is maintained by backing the stablecoin with an actual asset. For example, 1 USDC is believed to be backed by an actual US dollar which acts as its collateral. This principle also applies to other collateralized stablecoins like commodity-backed stablecoins and crypto-backed stablecoins, where 1 unit of the stable coins is set to a fixed unit of physical asset or cryptocurrency.

An advantage of this is that collateralized stablecoins are much more stable. However, this comes with certain disadvantages like;

  • The collateral cannot be invested
  • The collateral can be embezzled
  • It cannot be audited - this is why it is widely speculated that not all Tether’s USDT currently in circulation is backed by an actual dollar.
  • Collaterals like Oil and precious metals are also prone to price fluctuations

Supply (Algorithmic manipulation)

In this method, a stablecoin maintains its peg through the manipulation of the coin supply by using a smart contract. Depending on the price, the smart contract increases or decreases the number of stablecoins in circulation. For example, if the value of a stablecoin is maintained by an algorithmic peg, in the case of an increase in demand, the price of the stablecoin will increase thereby altering the peg. To prevent this from happening, the smart contract issues new coins to even out the price pressure created by the demand.

On the other hand, if people begin to sell off their stablecoins, the price will drop, so the smart contract removes some coins from circulation to sustain the peg.

The advantage of this method is that the stablecoins can easily be audited by just looking at the smart contract, the disadvantage is that they are less stable.

Types of stablecoins

Fiat-backed stablecoins

They are the most popular types of cryptocurrencies. They are pegged to fiat currencies which act as the collateral. An example of a fiat-backed stablecoin is Coinbase’s stablecoin, the USDC, which is pegged to the US dollar, therefore it is believed that 1 USDC will always be equal to 1 US dollar.

Commodity-backed stablecoins

These are stablecoins whose underlying collaterals are commodities or physical assets like oil, precious metals like gold, and real estate. Tether Gold (XAUT) and Paxos Gold (PAXG) are two popular kinds of gold-backed stablecoins. Holders of these tokens can sell them for cash or redeem an actual gold bar at any time. 

Crypto-backed stablecoins

You can already guess that these are stablecoins pegged to other cryptocurrencies as collateral. This process occurs on-chain using smart contracts. To purchase a  crypto-backed stable coin, you lock your cryptocurrency into a smart contract, and you will be issued a token of equal value. You can always put back the stablecoins to redeem your cryptocurrency. To guard against price fluctuations, crypto-backed stablecoins are usually over-collaterized. For example, to buy $500 worth of DAI, you need to deposit $1000 worth of ETH, so that if the price of ETH drops, the excess collateral buffers DAI’s price or is paid back into the smart contract to maintain stability.

Algorithmic stablecoins

Algorithmic stables coins are not backed by fiat, commodities or other cryptocurrencies. They have no collateral, instead, they rely on specialized algorithms and smart contracts for their stability by managing the total number of tokens in supply. The algorithm reduces or increases the number of tokens in circulation when the price of the stablecoin drops or increases.

Uses of Stablecoins

Now that we understand what stablecoins are, and their different categories, let’s explore their possible use cases.

  1. Stablecoins are typically held by users who want to lower their risk of exposure to more volatile assets like Bitcoin and Ethereum. For example, if you predict that the price of bitcoin will fall in the coming months, you can exchange your bitcoin for stablecoins like USDT, USDC, DAI, or BUSD to retain their current dollar value, and whenever you want some Bitcoins again, you can exchange the stablecoins back to Bitcoin. This move is often used on decentralized exchanges that do not have fiat integrations. Their users can trade assets back and forth using stablecoins without the need for fiat.
  2. Crypto transactions are much faster and cheaper than fiat transactions, and so, funds can be moved quickly between exchanges.
  3. Commodity-backed stablecoins are used to facilitate trade in assets that may be locally unavailable. For example, in regions where sourcing and storing precious metals like gold and silver are difficult, a commodity-backed stablecoin can be issued to investors seeking to exchange their cash for the tokens. This affords the token holders the chance to invest in those physical assets without having to hold them.

How to buy stablecoins

You can buy and sell stablecoins on centralized exchanges like Binance, Coinbase, FTX, and Gemini, and on decentralized exchanges like Uniswap, and dYdX.
Another method is that you can buy a volatile asset like Bitcoin from a centralized exchange like Coinbase, transfer it to your private wallet, and then trade your Bitcoin for a stablecoin like DAI on a decentralized exchange.

Things to consider before investing in stablecoins

While stablecoins are relatively safe in comparison to other volatile cryptocurrencies, they are not without their own risks. And you should consider them carefully before investing.

  1. No insurance: Unlike fiat currencies which are insured by the banks, stablecoins are not insured. This means that if a company that issues your stablecoins collapses, you risk losing all your money. A recent example of this is the collapse of the Terra ecosystem after the popular stablecoin, UST de-pegged.
  1. Collateralization issue: The value of stablecoins is maintained by the trust that people have in them. If that trust is threatened by a belief that a stablecoin is not sufficiently backed by fiat, it stands a risk of de-pegging.

Stablecoins are a great addition to cryptocurrencies, and if you want to invest in them, we strongly recommend that you do your own thorough research before diving into them.

Disclaimer: This article is not financial advice. Our contents are for educational purposes and are meant to guide you through your decision-making process. Always consult with a financial advisor before investing.

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