Exploring the benefits of cryptocurrencies backed by real-world assets.
We all know that feeling: you just got a new job, and you’re getting settled in, but you’re finding it challenging to learn the ins and outs of the industry.
Cryptocurrencies are relatively the same—the sheer number of coins and tokens on the market can be daunting for the newcomer. There are layer-one blockchains, blue chips, utility coins, and pump-and-dump schemes. But there’s one type of coin that every tried-and-true cryptocurrency investor has used. These cryptocurrencies are called “stablecoins.”
Stablecoins are a class of cryptocurrencies designed to provide stability and reduce volatility in the cryptocurrency market. They are becoming increasingly popular as they help mitigate market volatility risk.
Let’s dive into the world of stablecoins and explore how they work, what they are, and why they are gaining popularity.
What are stablecoins?
Stablecoins are a type of cryptocurrency pegged on a 1:1 basis to a stable asset, such as the US dollar or gold, to reduce volatility and provide stability to their value. For instance, if there are 1,000 of the stablecoin XYZ in circulation, the issuer of XYZ must hold $1,000 or more of an asset in their reserve, be it cash, other cryptocurrencies, commodities, or cash equivalents.
Stablecoins provide a less volatile cryptocurrency than other cryptocurrencies, such as Bitcoin or Ethereum. You can think of stablecoins as digital tokens backed with fiat currencies like US dollars or other stable assets. They both retain their value as they’re supported by a reserve: an entity (in this case, the government), precious
metals, etc. Without a reserve asset, stablecoins and US dollars would hold no value.
How do stablecoins work?
Stablecoins operate by pegging themselves to an underlying asset and maintaining a reserve of the asset. For instance, a stablecoin pegged to the US dollar will have a reserve of US dollars to support its value. When the demand for the stablecoin increases, the price does not increase, but the reserve of underlying assets also increases, and vice versa.
During market changes or economic fluctuations, this helps to maintain the stability of the stablecoin. Additionally, stablecoins can be traded on crypto exchanges and used for transactions, just like any other cryptocurrency.
Types of stablecoins
There are three main types of stablecoins: fiat-collateralized, crypto-collateralized, and algorithmic.
Fiat-collateralized stablecoins
Fiat-collateralized stablecoins have a fiat currency reserve backing, such as the US dollar, and the value of the stablecoin and the value of the underlying reserve are directly linked.
The most popular fiat-backed stablecoins are USDT, USDC, and BUSD. USDT, also known as Tether, is the most popular stablecoin with a market cap of over $68 billion. Tether’s assets are primarily held in cash or cash equivalents by its issuer, iFinex.
Fiat-collateralized stablecoins are integral to merging traditional finance and banking with the cryptocurrency world. The fiat collateral is often locked up in the issuer’s bank account, not in a smart contract like its crypto and algorithmic counterparts.
Crypto-collateralized stablecoins
Crypto-collateralized stablecoins have a reserve and backing of another cryptocurrency, such as Ethereum or Bitcoin. The value of the stablecoin and the underlying reserve are linked.
Unlike fiat-collateralized stablecoins, in which the issuer keeps the reserves off-chain, crypto-collateralized stablecoins use smart contracts to lock up collateral tokens in exchange for issued stablecoins.
In the pursuit of a completely decentralized financial ecosystem, DeFi traders, liquidity miners, and yield farmers use crypto-collateralized stablecoins such as MakerDAO (DAI) to keep the value of their profits.
Algorithmic stablecoins
Algorithmic stablecoins differ drastically from fiat- and crypto-collateralized stablecoins because their complex algorithms can use a burn/mint mechanism with a sister cryptocurrency to retain the stablecoin’s value. Others use an elastic supply which algorithmically adjusts the total supply based on market supply and demand.
For example, if the price of the cryptocurrency ABC sits at $4, a trader can issue or “mint” one stablecoin XYZ by “burning” or taking four ABCs out of circulation. In this case, XYZ is worth ¼ of ABC. Algorithmic stablecoins aimed to improve decentralization. However, time and time again, they prove to be a risky asset class. On May 7, 2022, the prominent algorithmic stablecoin Terra (UST) de-pegged and ultimately spiraled out of control due to the mass withdrawal of LUNA by a handful of wealthy UST holders.
Why are stablecoins popular?
Stablecoins have become increasingly popular due to their numerous use cases. For one, by providing stability in a relatively new and unregulated market known for its volatility, stablecoins offer an attractive and stable crypto asset class.
Stablecoins are:
- A relatable currency without the inherent risk of losing value due to market fluctuations.
- Offering convenience for trading cryptocurrencies.
- Swapping tokens.
- Sending money internationally.
The crypto community has embraced stablecoins to bring traditional finance into the cryptocurrency ecosystem. They provide a bridge between the conventional financial system and the crypto world, facilitating a seamless transfer between the two.
Final Thoughts
Stablecoins are a promising development in the world of cryptocurrency. They offer stability, versatility, and a bridge to the traditional financial system. Stablecoin transfers are instantaneous, sending funds across the globe in seconds. It provides an alternative option to wire transfers and other slower money transfer services. Market volatility risk mitigation is hard to ignore. Overall, stablecoins are a revolutionary technology that will evolve and grow for years.
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