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What is a stablecoin?
Stablecoins represent digital currencies pegged to the value of another asset.
They are primarily created using blockchain technology and smart contracts.
Throughout this article, we'll delve into what stablecoins entail and their significance in our evolving decentralized era. We'll explore their functionality, the mechanism behind them, and reasons for considering them in your cryptocurrency investments.
What are stablecoins?
Stablecoins, unlike Bitcoin and other cryptocurrencies, aim to maintain a stable exchange rate, often tying their value to the US dollar, acting as a hedge against the volatility witnessed in cryptocurrency markets.
They're also referred to as fiat-backed cryptocurrencies (FBAs).
FBAs offer traders an alternative method to hedge against fluctuations in cryptocurrency values by leveraging central financial institutions such as Goldman Sachs.
The basics of stablecoins
Stablecoins are a specific type of cryptocurrency engineered for stability in value. They are backed by fiat currencies like dollars or yen, serving purposes in commerce and investment.
The advent of stablecoins traces back to 2011 with Tether (USDT), currently the largest stablecoin with a market cap of $1.9 billion.
Tether enables investors to partake in cryptocurrencies without handling their private keys or encountering mining fees, common in currencies like Bitcoin Cash (BCH) or Ethereum Classic (ETC).
The most prominent stablecoins include USD Coin (USDC) and BinanceUSD (BUSD), raising over $200 million via initial coin offerings (ICO) this year, reflecting strong investor demand for safe digital asset storage and investment.
Key facts about stablecoins
- Stablecoins, digital assets designed for stability, are tethered to a reference point like a currency or commodity.
- They are considered more reliable than conventional cryptocurrencies, offering stability for transactions.
- These coins can be tied to the U.S. dollar or the value of commodities such as gold.
- Stability is maintained via collateral reserve assets or algorithms regulating supply.
How do stablecoins work?
Stablecoins are backed by either tangible or real assets. While most tie their value to fiat currencies, some utilize precious metals and other cryptocurrencies.
For instance, Tether (USDT) is backed on a 1:1 basis by US dollars, meaning one USDT token equals one US dollar.
However, terms vary among stablecoins. MakerDAO’s Dai coin is collateralized against collateralized debt obligations (CDOs), enabling redemption for USD without affecting its value.
CDO investors gain compensation through interest and dividends from their investment holdings.
Why invest in stablecoins?
Investing in stablecoins serves as an excellent portfolio diversification strategy due to their status as a safe haven for investors. They are widely accepted by merchants, akin to traditional currencies like the US dollar or euro, ensuring accessibility and stability in transactions.
However, a potential risk exists wherein a single unstable stablecoin might negatively impact others.
Why are stablecoins important?
Stablecoins play a crucial role in trading, payments, commerce, and various other domains. They offer avenues to invest in fluctuating assets like real estate, expanding access to financial products beyond traditional banking services (e.g., loans).
This particularly benefits populations in underdeveloped or conflict-affected regions, granting access to bank-like services and an avenue to preserve cash value amidst rampant inflation. For instance, in Sri Lanka's governmental collapse, savvy crypto users safeguarded their assets by converting cash into stablecoins, effectively preserving their USD holdings.
Types of stablecoins
Stablecoins come in various types, each backed by different assets:
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Commodity-backed stablecoins
These stablecoins are supported by assets such as gold or real estate.
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Fiat-backed stablecoins
Backed by fiat currencies like the Chinese yuan, these stablecoins use currency as collateral in a regularly audited reserve managed by an independent custodian.
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Crypto-backed stablecoins
Backed by other cryptocurrencies, these stablecoins maintain an overcollateralized position to counter underlying asset volatility.
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Seigniorage-style stablecoins
These stablecoins rely on algorithms or processes rather than an asset or currency, governed by smart contracts on decentralized platforms.
Top stablecoins you should know about
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Tether (USDT)
A stablecoin tied to the value of the US dollar, known for its security and seamless integration but facing risk due to past controversies.
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USD Coin (USDC)
A stablecoin backed by Coinbase, the largest bitcoin broker.
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Binance USD (BUSD)
A stablecoin pegged to the US dollar operating on the Binance Smart Chain network.
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True USD (TUSD)
A liquid stablecoin fully backed by the US dollar offered by TrustToken, also offering stablecoins tied to other major currencies.
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Origin Dollar (OUSD)
A stablecoin backed by top stablecoins, providing diversified risk and the ability to earn interest directly from the wallet.
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Paxos Standard (PAX)
A stablecoin aiming for a 1:1 parity with the US dollar, created in response to controversies surrounding Tether.
Final thoughts on stablecoins
Stablecoins represent an intriguing evolution in the cryptocurrency market.
They offer investors an avenue to engage with new stablecoins without facing volatile price swings.