The cryptocurrency market is notoriously volatile. As a result, even experienced investors can find it difficult to predict what crypto prices will do next.
This volatility can discourage people from adopting cryptocurrency as a payment method or investment asset. After all, if you’re unsure what your money will be worth a day from now, you might not see a value in using cryptocurrency at all.
Furthermore, it can be inconvenient to move fiat into and out of cryptocurrency. So if you’re a frequent trader or want to cash out when a coin hits a new all-time high, you need a fast, reliable method of exchanging your crypto for fiat.
That’s where stablecoins come in. They’re meant to fulfil the need for a price-stable asset that can be used efficiently within the crypto market.
Understanding stablecoins
Stablecoins are different from other cryptocurrencies. Instead of deriving their value from their utility or market demand, their value is directly pegged to the fiat currencies behind them.
For example, two of the most widely used stablecoins are Tether (USDT) and US Dollar Coin (USDC). Each coin’s value is pegged to the dollar in a 1:1 ratio.
The goal of stablecoins is to provide more stability, transparency, and lower fees. For example, in a period of high market volatility, investors can trade other coins for stablecoins instead of cashing out into fiat.
Let’s say you want to sell an obscure altcoin that has skyrocketed in value. Depending on the exchange, it can be difficult to cash out into fiat. Without stablecoins, you might have to trade the altcoin for a more popular coin and transfer it to a larger exchange where it could be cashed out.
In contrast, stablecoins simplify swapping cryptocurrency coins or tokens for stable assets to preserve their value.
How do stablecoins work?
While all stablecoins are created to provide price stability, they achieve this goal through different methods. There are four main categories of stablecoins. They’re grouped according to their underlying assets or stability mechanisms.
Fiat-backed stablecoins
The most common example of stablecoins is fiat-backed stablecoins. These coins are backed 1:1 by fiat currency located in physical reserves. In theory, the reserves should have equal dollars to the number of stablecoins in circulation.
The reserves must be managed by a centralized custodian responsible for maintaining the equivalent amount of fiat and should be audited by third parties to ensure compliance. Some stablecoin issuers such as Tether have come under criticism regarding whether they consistently hold the amount of fiat required to back issued USDT.
Examples of fiat-backed stablecoins include:
· Pax Dollar (USDP)
· Binance USD (BUSD)
Asset-backed stablecoins
Just as the dollar used to be backed by gold reserves, asset-backed stablecoins are tied to the value of gold or other commodities such as precious metals or real estate. These stablecoins rely on centralized organizations to hold and maintain the equivalent value in their reserves. In some cases, such as in PAXG, you can exchange your stablecoins for physical gold bars.
However, asset-backed stablecoins have the potential for price volatility if the commodity backing the stablecoin experiences price fluctuations in the market.
Examples of asset-backed stablecoins include:
· Digix (DGX)
· CACHE Gold (CACHE)
· Paxos Gold (PAXG)
Crypto-backed stablecoins
These stablecoins are not backed by physical fiat reserves. Instead, they use other cryptocurrencies as collateral to maintain a stable value. Smart contracts are used to lock in the value of your crypto, and you receive stablecoins of equal value in return.
To provide a buffer against price volatility, crypto-backed stablecoins are over-collateralized. This means that a larger number of cryptocurrency, such as ETH, is held in reserve to issue a smaller number of stablecoins, such as DAI.
The advantages to crypto-backed stablecoins are that they are more decentralized, require no external auditing, and have higher liquidity than fiat-backed stablecoins.
Examples of crypto-backed stablecoins include:
· Dai (DAI)
· EOSDT (EOSDT)
· Wrapped Bitcoin (WBTC)
Non-collateralized stablecoins
Also known as algorithmic stablecoins, these stablecoins don’t require fiat reserves or cryptocurrency as collateral. Instead, they rely on complex algorithms to manage the stablecoin supply and ensure price stability.
When the price of a dollar-pegged non-collateralized stablecoin rises above the price of a dollar, the algorithm releases more stablecoins into circulation, bringing the price back down.
Likewise, suppose the stablecoin falls below the dollar price. In that case, the algorithm reduces the number of stablecoins in circulation to adjust the price back up. In theory, this mechanism is best suited to dealing with sudden shocks in demand.
Examples of fiat-backed stablecoins include:
· Ampleforth (AMPL)
Examples of stablecoins
Here are some of the most popular stablecoins on the market:
Tether stands at the forefront of the stablecoin category. Launched in 2014, USDT currently has the largest 24h trading volume out of any cryptocurrency. It’s the most common way to transfer fiat-backed funds across different exchanges and send payments worldwide. However, while it enjoys mass user adoption, there is controversy around whether Tether has the fiat reserves to truly back USDT in a 1:1 ratio.
USDC was launched in 2018 by Circle in partnership with Coinbase, one of the world’s largest cryptocurrency exchanges. Like Tether, the value of USDC is also pegged to the dollar. However, it’s seen as a more trustworthy alternative to Tether. USDC is subject to regular audits and communicates with more transparency regarding its fiat reserves.
Dai (DAI)
Unlike USDT and USDC, DAI is a decentralized stablecoin backed by cryptocurrency instead of fiat. While its value is still pegged to the US dollar, smart contracts work in the background to manage the collateral and keep it stable. Since it’s not backed by physical fiat reserves, it relies on over-collateralized crypto reserves to accommodate swings in value.
Stablecoin advantages and disadvantages
Like any asset, stablecoins have certain advantages and disadvantages that people should know before using them.
Advantages
· Relatively stable. Compared to other cryptocurrencies, stablecoins offers investors a more stable digital asset that bridges the gap between fiat and crypto.
· Benefits of cryptocurrency. Just like other cryptocurrencies, stablecoins are fast, efficient, transparent, borderless, programmable digital assets.
· Easily exchanged for other cryptocurrencies. Unfortunately, it’s not always possible or straightforward to trade fiat for crypto. Stablecoins, on the other hand, represent fiat in the digital space and enable people to access the wider world of crypto.
Disadvantages
· More centralized. Centralized organizations often own Stablecoins. Their operations are subject to audits by third parties, which goes against crypto’s potential to replace intermediaries.
· Fiat reserves may not always back it in a 1:1 ratio. There is some controversy over whether stablecoins are genuinely backed by their claimed reserves. Tether recently paid a $41 million settlement to settle allegations that it made untrue statements about every USDT token being backed by US dollar reserves.
· Unclear regulations. Lawmakers have yet to establish official rules regarding stablecoins. The current regulations are vague and subject to change. Stablecoin usage may become more tightly controlled in the future.
Stablecoin use cases
Stablecoins have a wide variety of use cases. At their core, they provide a reliable way to move around cryptocurrency while maintaining a steady value. In addition, stablecoins are the best way to transfer crypto between exchanges since they represent fiat currency without involving the restrictions and fees associated with banks.
With stablecoins, people can make global transactions and money transfers quickly and easily. Moreover, personal data is kept private, and users can access an ecosystem of decentralized finance applications for loans without passing a strict approval process.
However, unlike other cryptocurrencies, they’re not usually viewed as investments. Due to their inherent stability mechanisms, they won’t gain value over time.
Stablecoin FAQs
· How many stablecoins are there?
Coinmarketcap lists 70 different stablecoins at the time of writing.
· How are stablecoins different from bitcoin?
Bitcoin’s price can be volatile depending on demand and other market conditions. In contrast, stablecoins are tied to other assets and are less volatile.
· What are the regulations around stablecoins?
There is still a lack of consensus regarding stablecoin regulation. Many governments are attempting to bring stablecoins under stricter control by requesting regular audits. However, each stablecoin may be subject to different regulations.
· Are stablecoins securities?
Regulators are still debating whether to classify stablecoins as securities. Some stablecoins, such as USDC and Tether, are backed by assets that fall under the securities classification.
· Where can I buy stablecoins?
You can buy stablecoins on almost any major cryptocurrency exchange. For Canadians, NDAX is the best exchange to buy stablecoins, offering convenient bank integrations, low fees, and a user-friendly trading platform.