If you have ever wondered ‘what are stablecoins and how do they work?’ you’re in the right place.
In this article, we will explain everything you need to know about stablecoins. You will learn how they work and what role they play in the crypto ecosystem. And if you consider adding the coins to your portfolio, we’ll include our top five picks to give you a headstart.
Let’s get right into it.
What exactly are stablecoins?
Stablecoins are cryptocurrencies whose value is pegged to a different currency, commodity, or financial tool. They are designed as an alternative to other currencies tied to high market volatility rates.
Unlike other cryptos, stablecoins provide stable prices through algorithmic formulas meant to control supplies.
Reserve assets are also preserved as collateral boosting the stability of stablecoins in the market. Stablecoins can be backed by fiat currency, crypto, precious metals and algorithms.
Collateralized vs. non-collateralized stablecoins
Before we delve into collateralized and non-collateralized stablecoins, let us talk about collateral. Collateral is basically an asset that a lender accepts as security for a given traded item, which could be a loan, currency, digital asset or physical items.
- Collateralized stablecoins
In the world of crypto, collateral simply means a physical or digital asset that is pegged to a cryptocurrency. A collateralized stablecoin is one that is entirely backed by collateral held in reserve.
Collateralization is the process of ensuring stablecoin creators hold onto reserves of other assets or currencies. Collateralized stablecoins ensure buying and selling of affiliated assets through algorithmic mechanisms.
Collateralized stablecoins require liquid assets which can be easily traded in order to respond to varying changes in demand and supply.
There are two options for collateralizing;
- Off-Chain / asset-backed collateral
Stablecoins that are asset-backed keep their collateral on blockchain assets. For instance, issuers may hold fiat currency in managed accounts while others may decide to keep commodities of value such as gold as collateral. Some may take a portion of the collateral, invest it and keep the other portion in the form of fiat currency.
2. On-chain / crypto-backed collateral
These are backed by cryptocurrency just as the name suggests. They use cryptocurrencies as collateral. To create these stablecoins, you as the coin holder will use other cryptocurrencies as a deposit.
For example, if you are a DAI coin holder, which is pegged to the US dollar, you will lock Ether worth $150 and in return create DAI worth $100.
- Non- collateralized stablecoins
On the other hand, non-collateralized stablecoins do not rely on collateral but use smart contracts.
Smart contract integration yields infinite liquidity making non-collateralized stablecoins such as algorithm-based stablecoins an option. Non-collateralized stablecoins derive their stability from a working system such as that of a central bank. Since the price of non-collateralized stablecoins varies constantly, they may not be a viable option as compared to collateralized stablecoins.
How are stablecoins different from other cryptocurrencies?
Unlike other cryptocurrencies, stablecoins don’t have a volatile market price. The value of stablecoins is merely similar to that of any fiat currency. The quoted value helps in the exchange of fiat currency for stablecoins as the price of the stablecoins is not easily affected by market volatility.
Other cryptocurrencies such as Bitcoin and Ethereum experience a lot of market volatility hence their prices are not stable. The lack of a regulatory authority contributes to the volatility of these cryptocurrencies.
So, what is the need for stablecoins?
Stablecoins are gaining momentum in the crypto world. With this buzz in the market, one may ask, why were they introduced in the first place?
Other cryptocurrencies such as Ethereum and Bitcoin have faced a myriad of challenges since their inception. Stablecoins seem to be the answer to the high market volatility and the fraudulent and malicious cases
Although cryptocurrencies are built on a decentralized blockchain system. The lack of regulation has led to an increase in crypto fraud and loss of digital assets.
Stablecoins are regulated under the Stablecoin Trust Act and are tied to reserve assets. Attached physical assets ensure that crypto users can recover their digital assets through collateralized stablecoins.
Understanding the different types of stablecoins
- Fiat-collateralized stablecoins
These are stablecoins that maintain a reserve of fiat currencies like the US dollar as collateral. The fiat collateral is reserved by the central issuer, mainly the central bank. The collateral must reflect the number of other stablecoins in the market.
Examples of fiat collateralized stablecoins include the Tether USDT and TrueUSD (TUSD). These two stablecoins are backed by the US dollar reserves and denominated at parity to the dollar.
- Crypto-backed Stablecoins
Crypto-collateralized stablecoins are backed by other cryptocurrencies. The value of cryptocurrency held in reserves usually exceeds the value of the crypto-backed stablecoins. Over-collateralization is done to stabilize the reserve cryptocurrency since it is prone to high volatility.
A cryptocurrency worth $100,000 might be held as a reserve to issue $50,000 worth of crypto-backed stablecoin. The 50% decline in the price of the reserved cryptocurrency acts as insurance. Examples include the MarkerDAO’s DAI stablecoin, pegged to the US dollar. The DAI is backed by Ethereum and other cryptocurrencies at 150% less than the stablecoin in the market.
- Commodity-backed Stablecoins
Commodity-backed stablecoins are stablecoins that are backed by physical assets such as real estate, oil reserves and precious metals. Gold is considered to be the most popular commodity to be used as collateral.
Gold-backed stablecoins include Paxos Gold (PAXG) and Tether Gold (XAUT). Commodity-based stablecoins facilitate investments that may be out of reach at a local level. Although these commodities boost asset insurance, their prices may fluctuate hence a decline in stablecoin value.
- Algorithmic Stablecoins
The stability of algorithmic stablecoins results from the use of special algorithms and smart contracts. Smart contracts manage the circulation of tokens within the market. When the price falls below the price of a fiat currency tracked by the stablecoin, the algorithms reduce the number of tokens in circulation.
If the price exceeds that of the fiat currency tracked, new tokens are released to adjust the value of the stablecoin. Examples include Ampleforth, Tribe, Frax and Neutrino USD.
How can I use stablecoins?
Trade
Trading in the crypto exchange platforms is primarily facilitated by stablecoins. Instead of buying Ethereum or Bitcoin directly using fiat money, users can exchange fiat or stablecoins. Then the traders can then use the stablecoins to purchase another cryptocurrency in the exchanges.
Earn interest
Stablecoins are also an easy way to earn interest. The interest rates are higher compared to those offered by a commercial bank. For example, Crypto.com offers an interest rate of up to 10% on stablecoins in the US.
Cheap transactions
You don’t need a bank to transfer money or trade assets. The stablecoins tied to the dollar are easy to transfer. The trading of stablecoins is also coupled with low transaction fees and high processing speeds.
International transfers
The cheap transaction fees make stablecoins a better alternative when it comes to facilitating cross-border transactions.
Reduced volatility
By being pegged to a stable currency, buyers and sellers are guaranteed that the value of the tokens won’t fluctuate unpredictably in the future.
Everything you should know about picking the right stablecoin
The most fundamental question to ask yourself before picking a stablecoin is why you are actually doing it.
Doing your own research before settling on a stablecoin to use is essential. There are several investment options available, some of which offer greater stability and less risk as compared to digital currencies.
Although stablecoins are in essence considered to be ‘stable’, their value can depreciate in the case of non-collateralized stablecoins.
Price volatility may also affect the value of crypto-backed stablecoins whilst commodity-backed stablecoins lose value when prices of commodities fluctuate.
Stablecoins are still risky as fiat currency-based stablecoins lose value when the currency tied to it diminishes. There is also a possibility of huge losses for crypto-backed stablecoins.
What to consider when choosing stablecoins for your portfolio?
- Collateral – the stablecoin should be strongly backed by a physical asset that does not experience high market price volatility.
- Utility – traders need to determine whether the stablecoin favors the intended need to trade. Some stablecoins can be traded through a fiat-cash system or fiat-crypto trading system and are used to purchase digital assets.
- Stability – a stablecoin that is backed and stabilized by deposits of commodities or reserve cryptocurrencies should ensure that the reserved commodities or cryptocurrencies are of high value and can stabilize when markets are volatile.
5 best stablecoins to consider in 2022
- Tether
Tether has a market cap of $66,767,585,683, with a trading volume of $41,238,334,367. The tokens’ total supply is 68,610,622,657 and its circulating supply stands at 66.83B USDT.
Tether, a popular stablecoin founded in 2014, has been a stable cryptocurrency in the market. It is a fiat-collateralized stablecoin pegged to a fiat-cash system and can be exchanged with the US dollar.
The stablecoin aims to maintain a fixed exchange ratio of 1:1 with the U.S dollar. It is ideal for low-risk trading.
Tether was launched to address major cryptocurrency issues such as high volatility and the ability to be converted between cryptocurrencies and fiat currency.
Tether uses the Omni layer, a protocol layer for Bitcoin, as a representative of the USDT tokens.
Since it was founded, tether has had controversial issues after it failed to provide audited financial statements that show it has adequate USDT backing reserves. In 2018 Tether revealed its banking partners to settle some concerns raised by Bitfinex.
In March 2019 Tether disclosed an updated statement claiming that the USDT tokens were no longer 100% backed by the US dollar. Instead, it was backed by its reserves. The reserves included fiat currency and cash equivalents among other assets.
Tether ranks position 3 on CoinMarketCap.
2. USD Coin
USD Coin has a market cap of $55,806,783,013 with a trading volume of $4,350,356,979. The tokens’ total supply is 55,802,605,113 and its circulating supply stands at 55.80B USDC
The USD Coin is a popular fiat-collateralized stablecoin pegged to the dollar-based assets and is mainly used in decentralized finance (DeFi).
USD Coin ranks position 4 on CoinMarketCap.
3. Binance USD
Binance USD has a market cap of $17,436,132,283 with a trading volume of $5,412,699,834. The tokens’ total supply is 17,408,263,220 and its circulating supply stands at 17.41B BUSD.
Binance USD is the most used stablecoin in the market and is traded with the US dollar.
The stablecoin was launched in September 2019 as a fiat-collateralized stablecoin. It was created to improve a more extensive financial ecosystem by developing a frictionless international network. This would enable digital assets to be mobilized with significantly increased speed, flexibility and accessibility.
Binance USD ranks position 6 on CoinMarketCap.
4. DAI
DAI has a market cap of $6,776,468,239 with a trading volume of $260,463,021. The tokens’ total supply is 6,773,149,248 and its circulating supply stands at 6.77B DAI.
DAI is a stablecoin backed and stabilized by Ethereum and is deposited at the MakerDAO (Marker decentralized autonomous organization) vault. Ethereum is used as collateral and stablecoin is pegged to the dollar at a 1:1 ratio.
Through DAI, Marker’s goal is to provide individuals with a payment tool at the selling point, protection against volatility, and use on prediction markets. Marker also intends DAI to be used in lending and as a tool for cross-border transfers in businesses.
DAI is decentralized, meaning it has no central body governing its supply. The stablecoin is quite volatile as compared to tether but is still very effective.
DAI ranks position 12 on CoinMarketCap.
5. TrueUSD
TrueUSD has a market cap of $1,200,098,390 with a trading volume of $77,917,933. The tokens’ total supply is 1,199,480,554 and its circulating supply stands at 1.20B TUSD.
TrueUSD is a completely collateralized stablecoin that maintains a 1:1 trading ratio with the dollar. It is highly protected and has a verified ERC-20 token.
TrueUSD ranks 40 on CoinMarketCap.
Advantages and disadvantages of stablecoins
Pros
- They are maintained by blockchain technology and are able to conduct transactions at high speeds and at less costs.
- When stablecoins are pegged to a fiat currency or commodity, they become less volatile.
- Stablecoins are used by traders to hedge against other cryptocurrencies in cases of price decline.
Cons
- While the crypto world celebrates the decentralization of systems, stablecoins bring in an aspect of centralization.
- There are high stakes in transparency levels regarding the assets reserves as regulatory authorities question the depth of these reserves.
Are stablecoins really stable?
Stablecoins are a controversial topic of discussion as cases such as the TerraUSD experiment exposed weaknesses in the network.
Despite being considered a ‘stable’ and regulated cryptocurrency, the UST and LUNA crash prove otherwise. The de-pegging of the UST to the dollar led to extreme volatility and the collapse of the stablecoin, which in turn caused a ripple effect on the entire crypto market.
Stablecoins and government regulation
Given the rapid growth of stablecoins, estimated at $130 billion, cryptocurrency has the potential to affect the broader financial system. In October 2021, the International Organization of Securities Commissions (IOSCO) proposed that stablecoins be regulated.
The organization insisted that the stablecoins be regulated alongside payment systems, financial market structures and clearing houses. Politicians and lawmakers in the US, Canada and the European Union have called for regulation of stablecoins and other cryptocurrencies.
So, what next for stablecoins?
Stablecoins offer a great solution to the market volatility, security and stability of cryptocurrencies in the market. With improved financial infrastructure and regulated systems, stablecoins may solve all crypto problems in the future.
Investing in stablecoins and other cryptocurrencies is a highly risky and speculative approach. We, therefore, recommend that you first do your own research before embarking on investing in stablecoins.
We offer you the credible details that you need to know within the cryptocurrency space and we intend to make the crypto investing journey easier. Watch out for our next article as we unpack more about stablecoins and other cryptocurrencies.
