In the world of cryptocurrency, volatility is often seen as a major risk factor. But with the emergence of stablecoins, the game has changed. Stablecoins are digital assets that are backed by a reserve asset and designed to maintain a stable value. These coins allow traders and investors to avoid the extreme volatility of cryptocurrencies and provide a more reliable and stable store of value.
In this article, we’ll explore the interesting world of stablecoins! We’ll cover what they are, how they maintain their price, the types available, why they have gained popularity, the pros and cons, and how to invest in them. So, let’s get started!
What Are Stablecoins?
Stablecoins are digital currencies that utilize blockchain technology while being immune to volatility. They are backed with a fiat currency or a commodity, and their value is linked to the price of the underlying asset. Examples of stablecoins include Tether which is linked to the US dollar, Tether Gold which is linked to gold, and Tether EURt which is associated with the Euro. These currencies are managed and secured by their respective platforms.
Cryptocurrencies that are pegged to an asset, such as a currency or precious metal, use blockchain technology but operate differently from other cryptocurrencies. Unlike other digital currencies, these pegged currencies do not fluctuate in value due to changes in supply and demand. Instead, the price of these currencies is fixed and consistent with the asset they are pegged to, making them a more reliable tool for digital payment transactions.
Stablecoins offer a convenient way to transfer money internationally and bridge the gap between fiat currencies and cryptocurrencies. People are increasingly trusting these coins, as they are backed by real assets. They can be used for a variety of purposes, such as holding, trading, borrowing, lending and making payments overseas.
What Ensures The Stability of Stablecoins?
When printing currency, the government keeps a fixed amount of collateral, such as gold, government securities, and foreign country assets, aside to ensure that the money in circulation never exceeds the amount of money people require. This ensures that risks of inflation are minimized, as the government only prints a fixed amount of money that is backed by collateral.
The developer of stablecoins follows the same procedure – they reserve a predetermined amount of gold, US dollars, or other cryptocurrencies before they issue the stablecoins. This guarantees that the demand for the stablecoins never goes beyond the quantity available.
The fixed assets and US dollars used as collateral ensure that stablecoins remain relatively stable and less volatile compared to other cryptocurrencies. This makes them a more reliable form of digital currency, as they experience fewer fluctuations.
Different types of stablecoins are backed by different assets. Some stablecoins are backed by US dollars, while others are backed by gold. Keep reading to learn more about stablecoins; this article provides an in-depth look at different types of stablecoins.
Different Types of Stablecoins
There are 4 Different types of Stablecoins:
- Fiat-Backed Stablecoins
- Commodity-Backed Stablecoins
- Crypto-Backed Stablecoins
- Algorithmic Stablecoins
1. Fiat-backed Stablecoins
Fiat-backed stablecoins are cryptocurrencies that are backed by a real-world currency, such as the U.S. dollar. Each stablecoin is tied to the corresponding fiat currency in a one-to-one ratio, meaning that one stablecoin is equal to one unit of the fiat currency it is linked to.
A stablecoin issuer maintains the stability of its cryptocurrency by holding an equivalent amount of fiat currency in reserve with a financial institution. For instance, if the issuer has one million USD in reserve, they can issue one million stablecoins, with each being worth one USD.
Examples of stablecoins backed by fiat currency include Tether (USDT), USD Coin (USDC) and Binance USD (BUSD).
2. Commodity-backed Stablecoins
Stablecoins are cryptocurrencies that maintain a fixed value by being backed by a real-world commodity such as gold, real estate or metals. Gold is the most common commodity used as collateral for this type of stablecoin.
Stablecoins that are backed by gold are pegged to a 1:1 ratio – 1 stablecoin is equivalent to 1 gram of gold. Holders of these stablecoins can redeem the equivalent amount of the commodity (eg. gold, precious metals, property) at any time.
Gold-backed stablecoins are the most popular type of stablecoin, as gold’s value has a tendency to increase in value over time. This type of stablecoin also provides higher returns.
Examples of this type of Stablecoin are Paxos Gold (PAXG) or Tether Gold (XAUT), which provide holders the opportunity to invest in the gold market, while also benefiting from the utility of cryptocurrency without needing to own physical gold bars.
3. Crypto-Backed Stablecoins
Crypto-backed stablecoins are cryptocurrencies that maintain their stability by using one or more cryptocurrencies as collateral. They employ smart contracts on the blockchain to lock in cryptocurrency reserves, rather than relying on a central financial institution to hold reserves as with fiat-backed cryptocurrencies.
A reserve of $2 million worth of cryptocurrency could be used to issue $1 million in crypto-backed stablecoins, with the reserve acting as a safeguard in the event that the price of the cryptocurrency drops by 50%. Cryptocurrency-backed stablecoins experience more extreme fluctuations in their value than other types of stablecoins.
4. Algorithmic Stablecoins
Algorithmic stablecoins are not backed by any commodity or fiat currency. Instead, their value is determined by a mathematical algorithm which adjusts the demand and supply of stablecoins. If the price of the stablecoin increases, the algorithm will issue more coins. Conversely, if the price of the stablecoin decreases, the algorithm will sell off coins to reduce the supply.
Why Have Stablecoins Become so Popular?
Tether, pegged to the US dollar, was the first stablecoin to enter the market in 2014. Its market capitalization has grown significantly, and it is currently the third-largest cryptocurrency. USD Coin, also backed by the US dollar, is ranked in the top 5 cryptocurrencies by market capitalization and trade volume. Both of these coins have gained traction in the industry, as their market caps and adoption have grown.
Today, there are approximately 200 globally distributed stablecoins. Some major exchanges have also released their own stablecoins such as USD Coin (USDC), Binance Dollar (BUSD), and Gemini Dollar (GUSD).
Stablecoins have become more popular and widely used for global business and cross border payments because of their ability to resist fluctuations in value.
Pros & Cons Of Stablecoins
Pros of Stablecoins:
Using stablecoins has numerous advantages. They are faster, cheaper, more transparent, borderless and programmable than fiat currencies. Additionally, they provide the following benefits:
- Investors can quickly and easily enter the crypto market by converting their fiat currency into stablecoins. These coins act like regular currencies on exchanges, providing stability and convenience.
- Stablecoins can be stored in non-custodial wallets such as Metamask without the need for an intermediary, allowing them to be used as capital.
- Stablecoins enable fast, peer-to-peer international payments with a level of anonymity, and the associated fees are much lower than those charged for traditional fiat currency transactions.
- By staking stablecoins, investors can earn a higher return than with traditional financial instruments in DeFi applications. Moreover, when adding liquidity to DeFi protocols, the risk of impermanent loss is minimized due to the stablecoin’s price stability.
- Blockchain technology provides investors with greater transparency and access to information about liquidity flows, enabling them to make more informed decisions.
Cons Of Stablecoins:
In the past, stablecoins had a reputation for controversy in the crypto world, but regulatory approval has increased in recent years, reducing many of the associated risks.
- The trustworthiness of stablecoins depends on third-party assurance that the coins are backed by the stated assets. External audits must be conducted to guarantee that the assets are accurately recorded.
- Stablecoins used in DeFi applications provide lower yields than regular cryptocurrencies, yet the returns are still significantly higher than what traditional banks offer.
- Stablecoins used in DeFi applications can be exposed to the same risks as other unregulated crypto projects. The TerraLuna fiasco was a prime example of what can happen when things go wrong with an algorithmic stablecoin.
- Due to the early stages of development of stablecoins and other crypto technologies, there is an element of trial and error when getting involved with newer projects or protocols, which carries a certain degree of risk.
- As the stablecoin market continues to expand and add billions of dollars to the crypto market, it will likely attract more attention from regulatory bodies.
How To Make Money With Stablecoins?
Investing in stablecoins is gaining traction as a safe way to invest in cryptocurrencies. Investors can make money from stablecoins by lending them or staking them. To lend stablecoins, an investor must provide them as a loan to other investors. To stake stablecoins, they must put them up as collateral in a proof of stake process to win rewards.
- To earn interest on stablecoins, a user must open a demat account and select an app that supports cryptocurrency trading. Popular apps for this include Coin DCX, Binance, and Digifinex, which offer the option of buying stablecoins.
- Once the application is chosen, the user must deposit an amount of money into the account. Any form of payment is accepted on the cryptocurrency platform. The deposited amount will then be transferred to the user’s cryptocurrency wallet.
- Once the money is in the cryptocurrency wallet, the user can use it to purchase any stablecoin they want.
[Disclaimer: The content of this article is not intended as financial advice, and should not be construed as such. Neither readaboutcrypto.com nor the author is responsible for any investment decision made by any reader.]