Price volatility is a key characteristic of most cryptocurrencies, which can deter many investors. These big and often unpredictable price changes make it hard for cryptocurrencies to be used for everyday purchases. Generally, users and merchants hesitate to use crypto if its value changes significantly in just a day or two. As a result, there is a need to stabilize cryptocurrency.
This is where stablecoins come in, tying their value to stable assets like U.S. dollars or gold. They use various methods to maintain a steady value, regardless of the crypto market or economic conditions. This stability makes stablecoins a popular choice for crypto users to protect their holdings from market volatility.
This post will introduce you to stable coins: what they are, how they work, and also add a note on the available types. Let’s get right into it!
What are Stable Coins?
Stablecoins are a type of cryptocurrency that offers the flexibility of digital assets while maintaining the price stability of fiat currency. Issuers fix their value, usually on a 1:1 basis with the U.S. dollar. This means that a single unit of a stablecoin is always worth exactly one dollar. Hence, whenever there’s a threat to the price peg, the organization restores it to $1.00. These organizations use multiple methods to maintain the coin’s value.
Why are Stable Coins Important?
Volatility can benefit traders, but it turns routine transactions like purchases into risky speculation for both buyers and sellers. Investors holding cryptocurrencies for long-term appreciation avoid becoming infamous for paying huge amounts of cryptocurrency for basic items. Similarly, most merchants avoid taking a loss if the price of a cryptocurrency plummets after they receive payment.
For a currency that’s not legal tender to serve as a medium of exchange, it must remain relatively stable. This will assure those who accept it that it will retain purchasing power in the short term. Among traditional fiat currencies, daily movements of even 1% in forex trading are relatively rare.
How do Stable Coins Work?
Stablecoins peg their market value to an external reference, usually a fiat currency. Hence, they serve as a more useful medium of exchange than volatile cryptocurrencies. Issuers peg stablecoins to a currency like the U.S. dollar, the price of a commodity such as gold, or use an algorithm to control supply. They also maintain reserve assets as collateral or use algorithmic formulas to manage supply.
The following are the different mechanisms by which stablecoins remain stable:
Fiat-Collateralized
The issuer maintains stability by holding an equivalent amount of fiat currency in reserve. Consequently, this ensures that users can redeem their stablecoins for the corresponding amount of fiat currency at any time.
Crypto-Collateralized
Issuers maintain stability by over-collateralizing the stablecoin with cryptocurrency. In addition, they use smart contracts to manage the collateral and maintain the peg.
Commodity-Collateralized
Issuers maintain stability by holding the physical commodity in reserve, allowing stablecoin holders to redeem their tokens for the underlying asset.
Algorithmic
Algorithms maintain stability by controlling the supply of the stablecoin. If the price deviates from the target, the algorithm increases or decreases the supply to bring the price back to the peg.
Types of Stablecoins
There are several types of stablecoins, categorized based on the mechanism used to maintain their stability:
Fiat-Collateralized Stablecoins
Reserves of fiat currency, such as the U.S. dollar, back fiat-collateralized stablecoins, ensuring their value. Thereafter, independent custodians oversee these reserves and conduct regular audits. Examples of fiat-collateralized stablecoins like Tether (USDT) and TrueUSD (TUSD) tie their value to the dollar. As of 2023, Tether held the position of the third-largest cryptocurrency, valued at over $83 billion.
Crypto-Collateralized Stablecoins
Crypto-collateralized stablecoins rely on other cryptocurrencies for backing. As a result of the volatility of these reserve cryptocurrencies, such stablecoins are overcollateralized. The result of this is that the value of the reserves surpasses that of the stablecoins issued. For example, to hedge against a 50% decline in the reserve cryptocurrency’s price, $2 million worth of cryptocurrency could support $1 million in a crypto-backed stablecoin. MakerDAO’s Dai (DAI) stablecoin for example is a crypto-collateralized stablecoin tied to the U.S. dollar. It relies on Ethereum (ETH) and other cryptocurrencies valued at 150% of the circulating DAI stablecoin.
Algorithmic Stablecoins
Algorithmic stablecoins may or may not possess reserve assets. Their key feature is the approach of maintaining stability in the stablecoin’s value by managing its supply through an algorithm. This algorithm is essentially a computer program executing a predetermined formula.
For instance, if the stablecoin declines from the target price of $1 to $0.75, the algorithm automatically burns a portion of the coins. This is to increase scarcity and raise the stablecoin’s price. Perfecting this type of stablecoin protocol is challenging as seen by several failed attempts in recent years. Nonetheless, entrepreneurs persist in their endeavors.
The Most Popular Stablecoins
There are approximately 200 stablecoins today. However, some of the most popular examples include:
- Tether (USDT)
- USD Coin (USDC)
- Binance Dollar (BUSD)
- Dai (DAI)
- Pax Dollar (USDP)
- Gemini Dollar (GUSD)
- Paypal USD (PYUSD)
Final Thoughts
Stablecoins are popular in the cryptocurrency world for trading, lending, and borrowing. This is due to their ability to offer a steady way to exchange and store value. This stability is crucial for financial tasks that need consistent prices.
It is important to note that stablecoins serve more than just a financial function. They represent the fusion of traditional payment systems and unpredictable cryptocurrencies, forming a new type of digital currency. Governed algorithmically rather than by a central entity, they provide comparable monetary advantages to fiat currencies. Also, because they are inherently steady assets, stablecoins have the potential to cause a significant change in the payment landscape. They can pave the way for wider acceptance of digital assets in everyday transactions.
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