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What are Stablecoins?

Last updated 28th Dec 2022
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Stablecoins have their value pegged to another currency, commodity, or financial instrument. The goal of stablecoins is to offer a relatively safe alternative to the extreme volatility of cryptocurrencies.

They are a creative answer to the volatility of cryptocurrencies, these digital assets behave similarly to money but retain the utility of cryptocurrencies. Price stability is at the heart of stablecoins. Fiat-backed, crypto-backed, commodity-backed, and algorithmic stablecoins are the four main categories. Each type has a unique underlying collateral structure which we will discuss below.

Stablecoins vs. Cryptocurrencies

This table highlights some of the main differences between stablecoins and traditional cryptocurrencies.

FeatureStablecoinsCryptocurrencies
VolatilityStablecoins typically have quite low volatilityCryptocurrencies are known for high volatility and major price swings
BackingMany stablecoins are backed by assets held in reserve or by other meansCryptocurrencies are not backed
AuthorityThere is usually a central entity in controlThe majority of cryptocurrencies strive toward decentralization
UseStablecoins may be used as a medium of exchange or as a store of valueIt depends on the cryptocurrency. Some may act as a medium of exchange, while others are a store of value

Why Are Stablecoins So Important?

Even though Bitcoin is still the most widely used cryptocurrency, its exchange rate is notoriously volatile. As an example, the price of Bitcoin increased from about $5,000 in March 2020 to over $63,000 in April 2021 before falling by about 50% in the following two months. In addition, the cryptocurrency often rises more than 10% in a matter of hours during fluctuations, which can also be erratic.

Although volatility can benefit traders, it turns regular purchases into risky speculations for the buyer and seller. The vast majority of merchants will not accept Bitcoin or other altcoins as a means of payment because they want to avoid the risk of the crypto’s value dropping and suffering a financial loss.

A fiat currency that is not legal tender must be reasonably stable in order to function as a medium of exchange. It should guarantee those who accept it will retain its purchasing power in the near future. Even daily fluctuations of 1% in regular fiat currencies are uncommon in forex trading.

Stablecoins, as their name suggests, promise to solve this problem by keeping the value of the cryptocurrency constant in various ways.

The Different Types of Stablecoins

Stablecoins all represent the value of a separate asset, but they all go about it in different ways. As a result, certain stablecoins may be riskier than others and more susceptible to price fluctuations.

Cash-collateralized stablecoins

Cash-backed stablecoins are digital currencies backed 1:1 by a typical financial institution's holdings of an official reserve fiat currency, such as the U.S dollar or the euro.

The first stablecoin of this type was created in 2014 by startup Tether Limited as USDT, a cryptocurrency backed by the U.S dollar and intended to be traded continuously on the international cryptocurrency market. Tether is still one of the most popular stablecoins in 2022.

Cash-backed stablecoins are often managed by a central administrator that tracks their circulation and allows users to create and exchange tokens that are in its custody.

In some cases, these reserves are audited to ensure that the number of tokens transferred matches the company's reserves. USDT and USDC are two examples of stablecoins with cash collateral (pegged to the USD).

Crypto-collateralized stablecoins

Some cryptocurrencies back stablecoins with cryptocurrency collateral.

In most cases, these assets don't have a centralized custodian; instead, they rely on open software that allows borrowers to lock cryptocurrency assets (thereby collateralizing them) and create new stablecoins in the form of loans.

These stablecoins are often over-collateralized, meaning that the minimum deposit amount is usually a higher percentage than the value of the stablecoin. This is done to account for the volatility of the underlying cryptocurrency.

Borrowers must return the stablecoins to the protocol and pay a fee if they want to return their blocked cryptocurrencies. The supply of stablecoins cannot be changed by any member of the network due to their architecture.

Commodity-backed stablecoins

Physical assets such as precious metals, oil, and real estate are used as collateral for commodity-backed stablecoins. Gold is the most common commodity that is collateralized, and two of the most liquid stablecoins collateralized with gold are Tether Gold (XAUT) and Paxos Gold (PAXG). However, it is important to keep in mind that the value of certain commodities may decrease due to price fluctuations, which are more likely to occur.

Commodity-backed stablecoins can be used to invest in assets that would otherwise be out of reach for domestic investors. Obtaining a gold bar and finding a safe place to store it can be difficult and expensive in many places. Therefore, it is only sometimes practical to own physical assets such as gold and silver. However, those who wish to exchange tokens have access to this benefit via commodity-backed stablecoins.

Algorithmic stablecoins

Digital assets known as algorithmic stablecoins depend on smart contracts to maintain their stability.

The software underlying algorithmic stablecoins automatically changes the supply of a cryptocurrency in response to changes in demand, as opposed to using cryptocurrency deposits or issuing and repaying debt.

If demand is high, the price of each stablecoin rises above the set threshold, and the software expands the available quantity. On the other hand, if the demand is lower, the supply also decreases.

Of course, this is great in theory but does not always pan out in reality, as we saw with TerraUSD.

Why Use Stablecoins?

Users may be interested in buying stablecoins as they offer all the benefits of traditional cryptocurrencies, such as efficiency and transparency while protecting them from price fluctuations.

In addition, like other cryptocurrencies, they are borderless, programmable, and inexpensive to transfer, providing a valuable alternative to traditional banking institutions.

What are the Most Popular Stablecoins?

Because stablecoins don't offer the same kind of "get rich quick" opportunity as other cryptocurrencies, they often don't get as much coverage. But as of November 2022, the following were among the most popular cryptocurrencies by market cap:

  • Tether (USDT)

  • USD Coin (USDC)

  • Binance USD (BUSD)

Conclusion

Stablecoins provide a faster and less expensive alternative to payment processing and international transfers.

The stablecoin market is new and developing rapidly. However, in order to scale stablecoins and realize their full potential, a number of regulatory issues still need to be addressed, particularly in the area of central banking.

However, stablecoins have the potential for much wider adoption and practical use than other crypto assets, which could facilitate the transfer of trades and transactions from traditional financial markets to the blockchain. The development of stablecoins has the potential to significantly transform national economies and, ultimately, the global economy.

Note: The investing information provided on this page is for educational purposes only. BanklessTimes does not offer advisory or brokerage services, nor does it recommend or advise investors to buy or sell particular stocks, securities, or other investments.

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Emma Dwyer

Emma Dwyer

Emma is a law graduate with seven years of experience working in financial services. She has been writing in the cryptocurrency and blockchain tech space for two years now. Recently she worked as a Managing Editor and Head of Content for different crypto publications.