If you’re not completely new in the world of cryptocurrencies, you’ve probably heard about stablecoins before. As the name suggests, a stablecoin is a cryptocurrency that has a stable price, a price that always remains [relatively] the same. We have many competing stablecoins in the market right now. And each of them uses a different method to keep its price stable. In this post, we’re going to discuss these methods and learn more about stablecoins, how they work and why they are necessary.
What Are Stablecoins?
Stablecoins are a type of cryptocurrency that have their prices pegged to a fiat currency or another asset like gold. This means that a stablecoin’s price isn’t volatile and doesn’t move like other cryptocurrencies. For example, a stablecoin that is pegged with a 1:1 ratio to the US dollar, will always be priced at one dollar. So its price remains relatively the same, in relation to its peg or outside reference.
Why Were Stablecoins Created?
In order to understand stablecoins, you have to remember that crypto market hasn’t been around that long. And even now, many crypto exchanges aren’t regulated. This means that buying crypto with a fiat currency and selling it for a fiat currency isn’t that simple.
For example, if you’re day-trading the Bitcoin/USD pair and want to buy and sell multiple times a day, you can’t have the dollars in your bank account and your bitcoins on the exchange wallet after every transaction.
And although right now it is possible to buy crypto with fiat on more platforms than ever, many of the crypto exchanges don’t want the hassle of paying you in fiat when you withdraw your funds from their platform. This is mainly for legal reasons.
At the beginning of crypto, we had few trading pairs. Mostly you could buy bitcoin with fiat and then buy other cryptocurrencies with bitcoin. Meaning bitcoin was paired with dollars or euros, etc. and other cryptocurrencies were mainly paired with bitcoin.
But due to bitcoin’s volatility and the growing interest in buying other coins and tokens without involving bitcoin, the need for dollars and other fiat currencies in crypto increased very quickly.
On the other hand, crypto market was very young and its market cap was nothing compared to other major financial markets. So the prices were very volatile. Even bitcoin wasn’t safe from fluctuations. So traders needed protection against this volatility. They needed a way to control their risk and preserve their capital (or its worth measured in fiat).
So these were the two main reasons for the birth of stablecoins: huge volatility in the market and a lack of access to regular banks with regular dollars
Why Do We Need Stablecoins Right Now?
The reasons for the creation of stablecoins are still valid for the most part. Crypto market is still involved in regulation wars and we still have volatility in price action.
But even if the first problem was taken care of, we would still have stablecoins. Because in the centralized exchanges, using them would probably still be easier than going full fiat in the pairs. And because we have decentralized exchanges in DeFi sector that can’t be regulated and many people, including me, don’t want them to be regulated by governments. So the need for stable coins will probably always be there in DeFi.
The only thing I can see that may eliminate the need for stable coins, is bitcoin becoming a true and steady store of value. In a very long run, it can happen. For example, we may get a bitcoin in the future that doesn’t go up or drop by more than a 0.1% in a day.
In a case like this, I don’t see any more need to use stable coin pairs. We can trade in bitcoin and preserve our capital in bitcoin. Of course this can happen with another cryptocurrency as well. But right now, bitcoin has the highest chance of achieving such a status.
What Are the Advantages?
In addition to protecting crypto investors and traders against volatility and making the buying of crypto with fiat a bit easier, stablecoins can offer these advantages too:
- They can be a bridge to bring fiat users into the crypto market
- They can be censorship resistant if they are truly decentralized (because of the blockchain technology)
- Can offer lower cost transactions and transfers in comparison to banks without accepting the risks that come with crypto like market volatility
- Can be used as collateral to secure loans (banking with crypto without some of the risks of crypto)
- Can be used to provide liquidity for the crypto market
- Can be used to earn passive income (earning a return by lending or contributing stablecoins to provide liquidity)
How Do Stablecoins Work?
According to blockchain research institute in their “Introduction to Stablecoins” paper, we have 3 types of stablecoins that are actively being used in the crypto market right now.
1. Asset or Fiat Collateralized
These stable coins are collateralized by a fiat currency, another cryptocurrency or some other asset like gold or bonds. The organizations that issue or mint these tokens, essentially work like a central bank. And that’s one of the reasons central banks hate them going unsupervised.
In this type of stablecoin, every bit of digital asset that you buy or sell as a cryptocurrency is backed by the same amount in real life. For example, the organization that mints 1 million worth of 1 dollar tokens, should have 1 million real dollars (or its equivalent) to back it in reserve.
Of course proving that they actually have the amount required to back all their issued tokens is not easy. And that’s part of the problem with some of the stablecoin companies.
These types of stablecoins are mostly centralized (especially the ones backed by fiat) but there are some decentralized examples backed by crypto collateral as well.
2. Non-collateralized or Algorithmic
This type of stable coin is not backed by any other asset. So the only thing you have is the trust you’ve put in the people behind it. These stablecoins keep their peg by an algorithm that reacts to different market situations by minting more or burning tokens.
If you know about the law of supply and demand, you already understand the basic theory behind this kind of algorithm. And if you don’t, you should read our guide on it.
3. Hybrid (A Mix of Both)
These stable coins are partly backed by some kind of collateral and also utilize an algorithm to keep their peg.
List of Top Stablecoins
Right now, these are the top stablecoins by market cap:
– USDT (Tether)
– USDC (USD Coin)
– BUSD (Binance USD)
The only decentralized stablecoin in this list is DAI. They are all collateralized, first three by fiat and the last one with other cryptocurrencies.
Do you use stablecoins? For what purpose? Which one is your favorite? Share your thoughts in the comments below.
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