In a market prone to extreme volatility, interest in stablecoins makes sense. But what is a stablecoin, and is it really reliable? This guide covers the different types of stablecoins on the market and the broader role of asset-backed cryptos in blockchain-based ecosystems.
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What is a stablecoin?
As its name implies, a stablecoin is a cryptocurrency designed to maintain a set value. These financial instruments are popular options for investors looking to benefit from interacting with digital assets while removing some of the market volatility associated with crypto.
This is because the value of a stablecoin is (mostly) tied to another asset, such as gold, a fiat currency, or another crypto. Or the supply can be regulated by an algorithm. The intention is that the value of a stablecoin is always equal to the asset to which it is linked.
How do stablecoins work?
Due to crypto volatility, the entire market was considered speculative at best. Stable cryptocurrencies are an attempt to establish a form of guarantee to the market. Because they are tied to a real asset, they represent real money. Essentially, stablecoins were created to reduce price volatility and create a trusted environment for cryptocurrency adoption.
Stablecoins are backed by “reserves”, where the assets backing the stablecoin are safely stored and serve as collateral.
One of the main uses for stablecoins is as a reliable medium of exchange. These coins can be traded just like any other coin and can be used as an intermediary between sending and receiving payments. This is great for both institutions and retail users of crypto as they can be sure that the price will not change between transactions. Bridging TradFi and digital assets, stablecoins have become an integral part of the crypto ecosystem.
For example, traders do not want to risk a loss if the price of crypto drops after a payment. Furthermore, institutions view stablecoins as a universal solution for settling international payments. Stablecoins generally make cross-border transactions cheaper, faster and more efficient.
Types of stablecoin
Not all stablecoins work the same way. Some are backed by fiat currency, while others are algorithmic in nature.
Fiat backup
As the name suggests, these coins are backed by fiat currencies and are backed by fiat-equivalent reserves equal to the coin’s market capitalization, thus securing its value. In other words, it is a 1:1 ratio in which one stablecoin can be exchanged for one currency. Furthermore, independent entities regularly audit and maintain these reserves to ensure legitimacy. Although this type of stablecoin is the simplest, it is also the most centralized.
Commodity support
Commodity-backed stablecoins derive their value from another tangible asset, such as a precious metal such as gold or silver. To illustrate this, Paxos Gold (PAXG) is linked to real gold reserves held by Paxos.
The token was created to represent the price of one ounce of a gold bar. As such, customers get the benefit of retaining fractional ownership of the physical bars. Apart from precious metals, other commodity-backed stablecoins include those backed by other commodities such as crude oil.
Crypto-backed
Other cryptocurrencies support this type of stablecoin. They are issued to launch the underlying crypto asset on other blockchains. Crypto-backed stable cryptocurrencies are often over-collateralized. This means that the crypto held in reserve for backup purposes greatly exceeds the value of the issued stablecoins. This is due to the extreme volatility of the market, which causes the reserve to also be prone to volatility. For example, MakerDAO’s DAI (DAI) is pegged to the USD but backed by ETH and other cryptocurrencies worth 150% of the DAI in circulation.
Algorithmic
The algorithmic stablecoin may or may not be backed by reserves. These coins are kept stable by a computer program that executes a predetermined formula; hence his name. The algorithm controls the coin’s supply and demand, which is determined by smart contracts, which affect its value. Since there is no centralized reserve for these stablecoins, they can easily be dubbed decentralized. One famous algorithmic stable coin is the TerraUSD (UST) which lost its peg in 2022.
What are the most popular stablecoins?
Tether
The largest stablecoin launched in 2014, by market cap, is Tether USDT.
This stable cryptocurrency can be found in most major crypto exchanges. The primary use case is to quickly move funds between exchanges. Traders can benefit from arbitrage when the crypto prices on two exchanges differ.
The currency claims to have a 1:1 relationship to the US dollar. For every USDT, there is one dollar in reserves, according to the crypto giant. While USDT remains the most popular stablecoin, it remains a controversial entity for some.
The company was fined $42.5 million in October 2021 by the US Commodity Futures Trading Commission (CFTC), which was charged with lying about its reserves between 2016 and 2019. Whether Tether continues to be honest about its reserves is ‘ a subject of controversy. Tether continues to debunk “misconceptions” about Tether and USDT amid ongoing scrutiny from the regulator.
USD coin
Cryptocurrency firms Circle and Coinbase launched the USD coin in 2018. Like USDT, this coin is pegged at a 1:1 ratio to the US dollar. It is an open source protocol that other companies and individuals can use to create their own products.
USD Coin became very popular as it provided an alternative to USDT as it provided proof of its backing by assets derived from the US dollar.
DAY
Created by The Maker Foundation, DAI is the most popular crypto-backed stablecoin. Originally created to provide a non-volatile lending asset for businesses, its management was later given to MakerDAO.
Especially, DAI is too much guaranteed. So, for every Dai that exists, there is collateral in excess of the value locked away in a Maker Vault as a precaution against the impact of market volatility.
DAI is the most widely used stablecoin when it comes to integrating DApps, supporting more than 400 DApps and wallets.
Binance USD
The stablecoin BUSD is a collaboration project between Paxos and Binance. It is backed by US dollars held in Paxos-owned bank accounts.
It is one of the few stablecoins that Wall Street regulators have approved. However, recently there was a halt to BUSD trading on Coinbase following liquidity concerns. BUSD has since been delisted from the exchange. Additionally, increasing SEC scrutiny has caused problems with the project, and now Paxos is facing a lawsuit over an alleged violation of investor protection laws.
Stablecoins vs bitcoin
The main difference between bitcoin and stablecoins is that the value of bitcoin is not tied to another asset. Instead, the price of bitcoin can fluctuate and is generally seen as quite volatile.
Bitcoin is primarily a store of value and can be used to make purchases. However, stablecoins exist to bring stability to the market and allow easy, cheaper movement of cryptocurrencies between exchanges. In addition, a stablecoin transaction is faster than that of bitcoin. Unlike stablecoins, bitcoin can be used for trading, as its volatile market swings offer traders the opportunity to profit.
Are stablecoins safe?
When comparing cryptocurrencies in the market, stablecoins are often considered the safest, as they lack the volatile nature of other currencies. It works in theory, but the concept collapses if companies use shady practices and can’t show proof of reserves. A stablecoin’s level of security depends largely on how it is backed and its issuer. In addition, reserves backing the coin may be subject to credit, market and liquidity risks. Just because they once existed is no guarantee that they will always remain safe.
While stablecoins were touted as an answer to crypto’s volatility and could be seen as more regulator-friendly than other coins, the reputation of this asset class took a nosedive after the implosion of Luna (Terra): UST, the algorithmic stable coin of the Terra ecosystem, disconnected in May 2022.
Issuers must be regulated; if they are not, it could lead to legal problems for the stablecoin project. In fact, the lack of regulation surrounding stablecoins has made it more feasible for issuers to make false claims about their backing.
To be on the safe side, it is best to stick to stable cryptocurrencies that are more well-known and have a high market cap.
What is the role of a stablecoin in the future of crypto?
Stablecoins have had a huge impact on our financial lives. This type of crypto can offer cheaper, faster transactions and greater security – in some cases. And as governments struggle to accelerate crypto-asset regulation, stablecoins might just be a palatable solution to upgrading payment systems and facilitating cross-border remittances.
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