A stablecoin is a type of cryptocurrency designed to minimize the price volatility of the coin. The most common way to do this is to peg the stablecoin to a stable asset, such as gold or the US dollar. Stablecoins are a popular choice for crypto traders and investors who want to avoid the volatility of the crypto markets. They are also used as a medium of exchange and a store of value on decentralized exchanges (DEXes), where they can be traded for other cryptocurrencies.
If you’re new to the world of stablecoins, this article will give you everything you need to know about them, including how they work, their role in the crypto ecosystem, and their benefits and risks.
What Are Stablecoins?
Stablecoins are crypto tokens (or cryptocurrencies) that are designed with stability in nature. Unlike currencies like Bitcoin, which are pegged to the value of an external currency, stablecoins are not affected by factors such as supply and demand, investor confidence, and historical events.
It can include fiat currencies such as the US dollar and commodities such as gold, oil, and minerals. Even another cryptocurrency can be used if its price stays relatively high.
The stablecoin will be stable enough to keep the underlying asset value stable. The market volatility of stablecoins is less than that of standard cryptocurrencies since their value is constant. Even though Bitcoin, Ethereum, and other significant cryptocurrencies may experience volatility in their pegged assets, these price fluctuations will be less dramatic than in those of its pegged assets.
Why Are Stablecoins So Important?
Although Bitcoin remains the most popular cryptocurrency, its price, or exchange rate, tends to be highly volatile. In March 2020, Bitcoin’s price was just under $5,000 before it rose to nearly $63,000 in April 2021 before plummeting almost 50% by June 2021. A cryptocurrency’s price can move over 10% within a few hours; cryptocurrency prices fluctuate regularly.
All this volatility can be great for traders, but for buyers and sellers, it makes purchases risky speculations. Investors holding cryptocurrencies for long-term appreciation want to avoid becoming famous for paying 10,000 Bitcoins for two pizzas. Meanwhile, most merchants want to avoid loss if the price of a cryptocurrency plunges after they get paid for it.
It is essential that a currency that is not legal tender remains relatively stable, ensuring that it will maintain its purchasing power in the short term for those who accept it. Daily moves of even 1% in forex trading are relatively rare among traditional fiat currencies. As the name implies, stablecoins aim to address this problem by promising to hold the cryptocurrency’s value steady in various ways.
Types Of Stablecoins
The market cap for stablecoins today is $100 billion. In Latin America, more and more people are trading crypto, gaining interest in DeFi applications, and protecting their wealth from currency volatility by using these applications.
The demand for the digital currency will undoubtedly increase the popularity of stablecoins.
Digital Dollar Stablecoins
Right now, stablecoins pegged to dollars are the most popular. Because they’re backed by reserves 1:1, they’re digital representations of physical dollars.
Among crypto exchanges, Tether (USDT) is the most widely accepted digital dollar stablecoin. In addition to Tether and USDC, traders can use other popular digital currencies, such as Litecoin, to move money between digital wallets, keep a reserve of funds on hand for market opportunities, or cash out in USD coins if needed.
Crypto-Collateralized Stablecoins
Cryptocurrency adoption and usage are rising, meaning more people own crypto assets than ever before. Stablecoins are a great way to unlock collateral’s liquidity and enable investors to invest over the long term since most people are invested long-term.
Stablecoins can be collateralized and issued using crypto collateral with relative ease. Stablecoin vaults such as Maker DAO allow users to deposit crypto and mint stablecoins against that collateral (in Maker’s case, DAI). Your collateral and loan repayment remove DAI from circulation once you repay your loan.
Moreover, because blockchains like Ethereum are programmable, they open up a whole world of stable synthetic assets. An example would be a plastic banana that resembles a real banana but isn’t. Synthetix mints sUSD from a vault collateralized with SNX tokens, so it goes with stablecoin synthetic assets like the sUSD.
Algorithmic Stablecoins
Crypto collateralized stablecoins like the digital dollar stablecoin are 1:1 backed by other assets or over-collateralized by them. Even though this makes them more resilient to pricing volatility and black swan events, sourcing, safeguarding, and storing collateral is a significant burden.
Cryptocurrencies like Tether, Maker, and Synthetix, issued by reserve banks, are algorithmic stablecoins. Instead of holding collateral, stablecoin protocols that depend on algorithmic trading buy and sell their coins.
The market-making activities of their firm drive a stablecoin closer or farther away from the peg it was intended to follow. Terra’s UST, an algorithmic stablecoin, aims to encourage arbitrage opportunities between UST and Terra’s LUNA token.
A stabilizing mechanism in UST swaps $1 of LUNA for $1 of UST when UST goes over $1. Therefore, you will be able to sell each UST for more than $1 on the market and dilute the supply of UST. It will dilute the supply of UST, which will cause the price to return to its USD peg.
How Does It Work?
Stablecoins are coins whose market value is pegged to some external reference, generally the value of fiat currency. More volatile cryptocurrencies are less valuable as a medium of exchange than more stable ones.
The supply of stablecoins can be controlled by an algorithm or by pegs to currencies like the U.S. dollar or commodities like gold. Additionally, they maintain reserves either as collateral or through algorithms that are supposed to control asset supply.
What Are The Benefits Of Stablecoins?
The benefits of stablecoins have been explained above, so let’s examine the different advantages and determine whether stablecoins are a worthwhile investment for 2020 and beyond.
- Stablecoins are an effective way to manage risk, which is why they are so popular. Using stablecoins as a hedging tool is an excellent way to protect your portfolio against threats that your more risky investments may bear.
- It is easy to convert stablecoins into fiat currency, which makes them a convenient intermediary between fiat and cryptocurrencies
- Even though stablecoins are incredibly volatile, investors require little monitoring of their values
- The benefit of using them is that you don’t have to worry about exchange rates or cross-border fees when transferring large amounts of money offshore
- The blockchain doesn’t store collateral for stablecoins, which makes them less vulnerable to hacking than conventional cryptocurrencies.
- A stablecoin’s reserves do not need to be fixed, making it highly scalable.
What Are The Disadvantages Of Stablecoins?
There are many advantages to stablecoins, but they are still flawed. It’s quite the opposite! The following are the main disadvantages of stablecoins that investors need to consider before investing.
- Using stablecoins as hedging tools can be beneficial, but they could be better investment vehicles. Since they have no underlying value, their value will never increase – it will always equal 1 unit of the underlying asset over time
- The performance of stablecoins needs to be monitored by a custodian or auditor to ensure they remain pegged. Because of this, investors have to place their trust in someone, meaning there is a chance for human error.
- Some people have compared algorithmic stablecoins to pyramid schemes. Since the basis ($1) is low, new investors must buy into ‘the scheme’ to benefit from its growth.
- A fiat-backed stablecoin may lack transparency. For instance, Tether is criticized for having insufficient USD reserves to support its claim that it holds $1 in cash for every Tether token it issues.
The Best Stablecoins
Each day, new stablecoins emerge in the crypto market. Which stablecoins are trustworthy, safe, and famous? Below is a list of the best stablecoins currently available.
DAI
The DAI coin is a decentralized stablecoin released under the Maker DAO protocol based on Ethereum. You can mint DAI by storing ETH in Maker’s vault. Dollars are pegged to the price of DAI. It has faithfully kept its price pegged for over five years, making it the most liquid stablecoin in the crypto industry.
USDT
There is more controversy surrounding Tether (USDT) in the crypto space than it has about its success as a stablecoin. USDT dominates every trading pair you see. As USDT trading volumes beat BTC volumes on some exchanges, Bitcoin’s dominance is diminished, leading to a potential decoupling from the market.
Multiple audits have confirmed that the USDT is backed 1:1 by dollars in reserve after years of rumors. It is not surprising that Coinbase decided to list USDT on its exchange over the summer, confirming USDT’s legitimacy.
USDC
USDC is an ERC20 stablecoin built by Circle, a Goldman Sachs-backed payment company. Its core purpose is to be a digital currency designed for use by institutions and comes with a robust, regulated infrastructure and 1:1 reserve of dollars.
Crypto exchanges and merchants have quickly adopted USDC due to its compliance and backing by a large institution. Since the beginning of the year, blockchains such as Ethereum, Algorand, and Solana have processed around 750 billion USDC in USDC.
BUSD
Binance USD (BUSD), also called Binance USD, is an official stablecoin, unlike USDC, which is Coinbase’s unofficial stablecoin. With Binance being the world’s largest cryptocurrency exchange, creating BUSD was a natural step.
Paxos partnered with Binance to create BUSD. Together, they have accrued a large reserve of audited US dollars held in banks that the FDIC insures insured banks. Since Binance’s user community is so large, BUSD reaches a large market by default regardless of its popularity outside of Binance.
Diem
Diem is a global digital currency that Facebook is developing. It utilizes a blockchain-based payment system to compete with upcoming central bank digital currencies (CBDCs). Although Diem has not yet been released, we can expect it to be one of the most widely used digital currencies shortly. Why? The number of Facebook users is nearly three billion.
The Future
The Financial Action Task Force (FATF) cited standards in July for stablecoins to prevent money laundering and terrorism funding. KYC compliance processes should be implemented to monitor the transactions of exchanges, OTC desks, and stablecoin providers.
Despite its monopoly on the market, USDC, a competitor, has gained traction due to legal questions surrounding Tether’s legality. Several DApps are now using USDC, and the technology has gained traction since March. Facebook’s Libra project will also likely disrupt the market if it ever gets off the ground.
With the maturation of the cryptocurrency industry, stablecoin usage is expected to increase significantly. Stablecoin’s place in our everyday lives will undoubtedly be strengthened and normalized by continued adoption by traditional finance entities.
A stablecoin was discussed at the November 2019 World Economic Forum, which stressed its potential to improve financial inclusion and equity.
