What Are Stablecoins: Understanding The Basics And Benefits

In the world of cryptocurrency, volatility is the norm. Prices can fluctuate wildly in hours, making it difficult for investors to hold onto their assets for a significant time. This is where stablecoins come in.

Storing Value with Cryptocurrency: The Challenges and Possibilities

A currency has several uses. Primarily, it serves as a unit for exchanging goods and services for payment. Secondarily, it is a stable unit where economic value can be safely stored over time. For a currency to be suitable for storing value, one should be sure that the value remains stable and predictable over time.

Cryptocurrencies have proven to be a poor alternative to the latter. One cannot store value effectively when prices fluctuate up to 20% on a typical day. Nonetheless, people refer to Bitcoin as “the digital gold,” implying that you should be able to store value in Bitcoin just as you have with gold for ages.

A stablecoin, designed to maintain a stable value, is often pegged to a fiat currency or a commodity. The main goal of stablecoins is to reduce the volatility commonly associated with other cryptocurrencies like Bitcoin and Ethereum. With the growth of decentralized finance (DeFi), stablecoins are becoming increasingly important in the cryptocurrency market.

Exploring the Different Types of Stablecoins

There are three main types of stablecoins: fiat-collateralized, crypto-collateralized, and non-collateralized. 

Fiat-Collateralized

A reserve of fiat currency, such as the US dollar, backs fiat-collateralized stablecoins. It means that for every stablecoin in circulation, there is a corresponding amount of fiat currency held in reserve (at least, they say). Fiat-collateralized stablecoins were designed to maintain a 1:1 peg with the fiat currency they are backed by. For example, 1 USDT (Tether) is meant to be equal to 1 US dollar. Other examples are BUSD, USDC, and GUSD.

Crypto-Collateralized

On the other hand, crypto-collateralized are backed by a reserve of cryptocurrency, such as Ethereum. These stable assets are designed to maintain a value relative to the cryptocurrency backed by them. For example, 1 DAI is worth $1 of Ethereum. Examples are MakerDAO and DAI. 

Non-Collateralized

Non-collateralized stablecoins, not backed by any physical asset, use algorithmic mechanisms to maintain their value. They are stablecoins that use a combination of smart contracts, central bank-like operations, and other algorithmic measures to maintain their weight. Examples are Basis and Carbon

Stablecoin Failure: The Collapse of Terra and Luna

Unfortunately, not all stablecoins are created equal. One of the most high-profile failures occurred in May 2022 when Terra’s algorithmic stablecoin, UST, crashed. The crash was primarily because the stablecoin was not backed by any non-crypto collateral, instead relying on a pairwise token system that allowed users to swap Luna tokens for UST tokens at a guaranteed price of $1. Unfortunately, this system was weak and easily manipulated by an attacker, leading to a massive selloff and the collapse of both Terra and Luna. 

The fallout from the collapse of Terra and Luna has been immense, with billions of dollars lost and reputations ruined. However, it has also allowed the crypto industry to learn from its mistakes and develop more robust systems to withstand extreme economic shocks. As such, it is essential to understand the differences between various types of stablecoins, their advantages and disadvantages, and the associated risks.

Benefits of stablecoins

• They provide a stable store of value for investors as their value is pegged to a fiat currency or commodity.
• They are gaining significance in the DeFi ecosystem as they serve as a base currency for lending, borrowing, and trading on decentralized exchanges (DEXs).
• It is an excellent option for long-term investors looking for a stable store of value and for traders looking to take advantage of the DeFi ecosystem.
• It’s becoming a fundamental part of the crypto ecosystem, providing liquidity and collateral for different financial protocols.
• They are also valuable tools for people in countries with untrustworthy banking systems.

Understanding the Risks of Stablecoins

Risk of collateral failure

The value of the assets used to back stablecoins, such as fiat currency or cryptocurrency, can decrease over time, leading to a decrease in the stablecoin’s value. A collateral failure can occur when the stablecoin is no longer fully backed by the underlying assets.

Regulation concerns

Several countries have yet to determine the regulatory status of stablecoins, a relatively new technology. This can lead to worries about regulating stablecoins and whether they will be subject to the same regulations as traditional financial assets.

Risk of centralization

Centralized organizations operate many stablecoins, which may raise concerns about transparency and security. Because these organizations control the supply and distribution of stablecoins, they have significant power over the stablecoin’s value. 

Risk of counterparty

Stablecoins can be subject to counterparty risks, the chance that the issuer or the entity that holds the assets backing the stablecoin may not fulfill its obligations

Risk of hacking or security breaches

Like any digital asset, stablecoins are vulnerable to hacking and security breaches. This can lead to a loss of support for investors. 

Risk of market manipulation

Stablecoins can be subject to market manipulation. Some entities may have more information or control over the stablecoin’s value, leading to potential manipulation and lack of transparency.

Navigating the World of Stablecoins: Finding the Right One for You

There are many stablecoins to choose from, and the best one for you depends on your specific needs and preferences. Some of the most popular stablecoins include:

• Tether (USDT): Tether Limited issues the most commonly used, which is pegged to the U.S. dollar and backed by reserves of U.S. dollars.
• USDC: USDC is pegged to the U.S. dollar. The CENTRE Consortium, a joint venture between Circle and Coinbase, issues it.
• DAI: DAI is a crypto-collateralized coin pegged to the U.S. dollar—MakerDAO, a decentralized platform that employs smart contracts, issues DAI.
• Binance USD (BUSD): Binance USD is pegged to the U.S. dollar. Binance issues it, and reserves of U.S. dollars support it.
• TrueUSD (TUSD): TrueUSD is pegged to the U.S. dollar, issued by TrustToken, and backed by reserves of U.S. dollars.

These are some of the most popular stablecoins. However, many others are available, such as Paxos Standard (PAX), GUSD, etc. Researching and comparing different stablecoins is vital to find the one that best suits your needs. It is also essential to check their validity, transparency, and reserve mechanism.

Summary

Stablecoins are a type of cryptocurrency that aims to maintain a stable value, often pegged to a fiat currency or a commodity. These coins are designed to minimize the volatility usually linked with cryptocurrencies such as Bitcoin and Ethereum.

There are three main types: fiat-collateralized, crypto-collateralized, and non-collateralized. A reserve of fiat currency backs fiat-collateralized coins, a reserve of cryptocurrency backs crypto-collateralized stablecoins, and non-collateralized coins rely on algorithmic mechanisms to maintain their value.

The growth of decentralized finance (DeFi) makes stablecoins increasingly crucial in the cryptocurrency market. Understanding the variations between stablecoins, their pros and cons, and the related risks is crucial, as not all stablecoins are equal.