What are Stablecoins?

Stablecoins offer a safe haven from the volatility and price swings which are a common feature of most cryptocurrencies.

By understanding how stablecoins work, the types available, and their various use cases, anyone can confidently navigate the crypto landscape and make informed decisions about incorporating stablecoins into their investing strategy.

What Are Stablecoins?

Stablecoins are cryptocurrencies whose value is pegged to an existing asset—most often the U.S. dollar, though there are others tied to the Euro and even gold.

Traders buy tokens like Tether (USDT) or USD Coin (USDC) with real dollars. Those tokens can then be used to trade bitcoins and other cryptocurrencies.

And whenever someone wants to cash in, they can get the equivalent amount of dollars for
however many stablecoins they want to redeem.

1/ Our latest #Stablecoin & CBDCs Report is live, providing insight into recent stablecoin developments, market capitalisation, & more!

In May, the stablecoin market cap rose 0.63% to $161bn (as of May 23), marking the 8th consecutive monthly increase & highest since April 2022. pic.twitter.com/FrtXkv1z2E

— CCData (@CCData_io) May 29, 2024

What Are Stablecoins For?

For any financial market to be efficient, it needs to be liquid – there must be a lot of trading going on for it to function smoothly.

A problem with crypto is that transferring from fiat currencies like dollars into crypto is time-consuming and somewhat costly. Stablecoins solve that problem by allowing you to transfer an amount of fiat currency into an equivalent number of tokens. Then, those tokens can quickly and cheaply be traded on exchanges

How do Stablecoin Pegging Mechanisms Work?

Stablecoins are ‘stable’ because they are pegged to fiat currencies. This means the coins are linked to a real-world currency in a ratio of 1:1.

Take Tether as an example. One United States dollar is equal to one Tether. Tether’s stability is maintained through a mechanism known as backing. Whenever you buy one Tether, an equal value of one US Dollar is added to it, and when you sell one, an equal value of USD is exchanged.

Types of Stablecoin Mechanisms

Fiat-backed stablecoins

Fiat-backed stablecoins are by far the most popular. Reserves of traditional fiat currencies such as the US dollar or the euro back them.

To maintain their one-to-one peg to a currency, the stablecoin issuer ideally holds the currency in cash or cash equivalents such as treasuries, which should match or exceed the circulating supply of the stablecoin.

Crypto-backed stablecoins

Crypto-backed stablecoins originate from DeFi applications and are backed by cryptocurrencies held as collateral. However, due to the volatile nature of cryptocurrencies, crypto-backed stablecoins typically require over-collateralization to a specific ratio to ensure stability.

For example, a collateralization ratio requirement of 150 percent means that a user needs to deposit 150 dollars worth of crypto to mend one hundred dollars of a stablecoin. MakerDAO’s DAI token is a well-known crypto-collateralized stablecoin.

Algorithmic stablecoins

Algorithmic stablecoins are also meant to be decentralized, but unlike collateralized stablecoins, they may or may not actually be backed by anything. Instead, they rely on algorithmic and incentive mechanisms to maintain their price stability.

However, historically, this mechanism has not been sustainable since it’s dependent on consistent demand for the stablecoin. Once that disappears, the mechanism goes into a so-called death spiral, where it collapses the stablecoin.

Titan and Terra (UST) are some of the well-known examples of failed algorithmic stablecoins.

Are Stablecoins Safe?

If we mean ‘safe’ in terms of lower volatility when compared to other cryptocurrencies, then yes.

But stablecoins, like any financial investment, have risks. Concerns have always been that some of these stablecoins are not fully backed by cash. Instead, they’re sometimes backed by other assets labeled as equivalents.

Regulators have also scrutinized stablecoins. Government actions or legislation against stablecoins could damage their value. In April 2024, US Senators proposed a new bill banning algorithmic stablecoins and there remain plenty in Washington D.C. with concerns about how stablecoins could affect the dollar.

What Are The Best Stablecoins?

What is the ‘best’ stablecoin is somewhat subjective, but we can identify the biggest ones by their market cap.

Top 10 stablecoins by market cap. Source: CoinGecko

1. Tether (USDT): The most dominant and commonly used stablecoin, Tether is pegged to the U.S. dollar. Despite controversies surrounding its reserves, Tether remains popular among crypto traders.

2. USD Coin (USDC): Another U.S. dollar-pegged stablecoin, USD Coin is issued by blockchain firm Circle. This means USDC is viewed by some as a safer stablecoin because Circle has its reserves attested to by an independent auditor monthly.

3. Dai (DAI): Dai is a stablecoin token on the Ethereum blockchain that uses smart contracts designed to keep its value tied to the US Dollar. DAI has become a key contributor to the overall growth of the total stablecoin volume, transacting $600 billion in April 2024 alone.

The Bottom Line

Stablecoins have become a $160 billion ecosystem for a reason. They can provide liquidity in a fiat alternative that is better than fiat – all the qualities of the us dollar without its limitations.

They’ve also become immensely popular for their use in DeFi protocols and for transforming traditional finance, as payment networks and banks are using them.

As you might expect, this popularity does come with its fair share of skeptics. We may see regulatory interventions towards stablecoins in the future, but they remain a vital cog in the crypto machine and provide an excellent bridge between traditional finance and DeFi.

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