Gone are the days when the first and probably the only thing that comes to people’s minds when they hear the word cryptocurrency is Bitcoin. Gone are the days too when most of everyone scratches their heads, wondering what in the world cryptocurrency is.
With the crypto market boom, more and more people are getting into it. Now, there are things like altcoins, meme coins, and even stablecoins as well. What is a stablecoin and what can I do with it?
Let’s define a stablecoin first. A stablecoin is a digital currency that is pegged to a “stable” reserve asset like the U.S. dollar or gold. Stablecoins are designed to reduce volatility relative to unpegged cryptocurrencies like Bitcoin. Because they are price-stable digital assets that behave somewhat like fiat but maintain the mobility and utility of cryptocurrency, stablecoins are a novel solution to crypto volatility: price stability is built directly into the assets themselves. The most immediately apparent advantage of stablecoin technology is its utility as a medium of exchange, effectively bridging the gap between fiat and cryptocurrency. By minimizing price volatility, stablecoins can achieve a utility wholly separate from the ownership of legacy cryptocurrencies. Stablecoins point the way toward integrating traditional financial markets with the quickly evolving decentralized finance (DeFi) industry. As a force for market stability, stablecoins present a primary vehicle for cryptocurrency adoption in loan and credit markets, while inheriting much of the utility previously reserved for only fiat currency.
The combination of traditional-asset stability with digital-asset flexibility has proven to be a wildly popular idea. Billions of dollars in value have flowed into stablecoins like USD Coin (USDC) as they’ve become some of the most popular ways to store and trade value in the crypto ecosystem. In 2020–21, the stablecoin market exploded, its market cap expanding by almost three times.
There are four primary stablecoin types, identifiable by their underlying collateral structure: fiat-backed, crypto-backed, commodity-backed, and algorithmic. But, what precisely is driving this appeal?
Fiat Backed Stablecoin (off chain)
The most popular stablecoins are backed 1:1 by fiat currency. Because the underlying collateral isn’t another cryptocurrency, this type of stablecoin is considered an off-chain asset. Fiat collateral remains in reserve with a central issuer or financial institution, and must remain proportional to the number of stablecoin tokens in circulation.
For example: If an issuer has $10 million of fiat currency, it can only distribute 10 million stablecoins, each worth one dollar. Some of the biggest stablecoins in this category by market value include Tether (USDT), the USDC (USDC), True USD (TUSD), and Paxos Standard (PAX).
Crypto Backed Stablecoin (on chain)
As the name implies, crypto-collateralized stablecoins are backed by another cryptocurrency as collateral. This process occurs on-chain and employs smart contracts instead of relying on a central issuer. When purchasing this kind of stablecoin, you lock your cryptocurrency into a smart contract to obtain tokens of equal representative value. You can then put your stablecoin back into the same smart contract to withdraw your original collateral amount. DAI is the most prominent stablecoin in this category that makes use of this mechanism. This is realized by utilizing a collateralized debt position (CDP) via MakerDAO to secure assets as collateral on the blockchain.
Crypto-collateralized stablecoins are also over-collateralized to buffer against price fluctuations in the required cryptocurrency collateral asset. For example, if you want to buy $1,000 worth of DAI stablecoins, you would need to deposit $2,000 worth of ETH — this equates to a 200% collateralized ratio. If the market price of ETH drops but remains above a set threshold, the excess collateral buffers DAI’s price to maintain stability. However, if the ETH price drops below a set threshold, collateral is paid back into the smart contract to liquidate the CDP.
Commodity Backed Stablecoin (on chain)
Commodity-backed stablecoins are collateralized using physical assets like precious metals, oil, and real estate. The most popular commodity to be collateralized is gold; Tether Gold (XAUT) and Paxos Gold (PAXG) are two of the most liquid gold-backed stablecoins. However, it is important to remember that these commodities can, and are more likely to, fluctuate in price and therefore have the potential to lose value.
Commodity-backed stablecoins facilitate investments in assets that may otherwise be out of reach locally. For instance, in many regions, obtaining a gold bar and finding a secure storage location is complex and expensive. As a result, holding physical commodities like gold and silver isn’t always a realistic proposition. However, commodity-backed stablecoins also afford utility to those that want to exchange tokens for cash or take possession of the underlying tokenized asset. Holders of Paxos Gold (PAXG) stablecoins can sell them for cash or take possession of the underlying gold. However, because London Good Delivery gold bars range from 370-to-430 per ounce, and each token represents 1 ounce, users must hold a minimum of 430 PAXG to execute token redemption. Once redeemed, token holders can take possession of their gold at vaults throughout the UK. Although the ability to redeem gold-backed stablecoins for physical gold is universal across active platforms, other commodity-backed stablecoins lack the same utility. For example, Venezuela’s exploratory Petro stablecoin isn’t redeemable for a barrel of oil. While stablecoins backed by other commodities like real estate have made headlines in recent years, a lack of active projects makes it difficult to draw further comparison.
Algorithmic Stablecoins
Algorithmic stablecoins do not use fiat or cryptocurrency as collateral. Instead, their price stability results from the use of specialized algorithms and smart contracts that manage the supply of tokens in circulation. An algorithmic stablecoin system will reduce the number of tokens in circulation when the market price falls below the price of the fiat currency it tracks. Alternatively, if the price of the token exceeds the price of the fiat currency it tracks, new tokens enter into circulation to adjust the stablecoin value downward.
Why are stablecoins important?
The USDC stablecoin, for example, is backed by dollar-denominated assets of at least equal fair value to the USDC in circulation in segregated accounts with US regulated financial institutions. Such accounts are attested to (i.e. verified publicly) by an independent accounting firm.
Like many other stablecoins, USDC currently operates on the Ethereum blockchain. Stablecoins are free from the volatility of non-pegged cryptocurrencies, while inheriting some of their most powerful properties:
- Stablecoins are open, global, and accessible to anyone on the internet, 24/7
- They’re fast, cheap and secure to transmit
- They’re digitally native to the Internet and programmable
What can you do with stablecoins?
- Minimize volatility. The value of cryptocurrencies like Bitcoin and Ether fluctuates a lot — sometimes by the minute. An asset that’s pegged to a more stable currency can give buyers and sellers certainty that the value of their tokens won’t rise or crash unpredictably in the near future.
- Trade or save assets. You don’t need a bank account to hold stablecoins, and they’re easy to transfer. Stablecoins’ value can be sent easily around the globe, including to places where the U.S. dollar may be hard to obtain or where the local currency is unstable.
- Earn interest! There are easy ways to earn interest (typically higher than what a bank would offer) on a stablecoin investment.
- Transfer money cheaply. People have sent as much as a million dollars worth of USDC with transfer fees of less than a dollar!!
- Send internationally. Fast processing and low transaction fees make stablecoins like USDC a good choice for sending money anywhere in the world.
Stablecoins allow you to earn interest while you learn the crypto market. Do your research, look for assets that offer utility and have a user base, and then let the investing begin!
At the time of this article the writers were actively using Coinbase, FTX, Metamask, Trust Wallet, Crypto.com, Binance, Robinhood, Webull, KuCoin, Voyager and Hotbit. They also own currencies: BTC, ETH, USDC, SOL, AVAX, ALGO, MATIC, CRO, ENS, DOT, XLM, MANA, RARI, ENJ, XRP, FIL, SAND, HNT.
