Stablecoin

What is a Stablecoin?

A stablecoin is a type of cryptocurrency whose value is tied to another asset that acts as collateral. The asset could be a fiat currency like the U.S. dollar, a commodity like gold or silver, a different cryptocurrency, or an algorithm that continuously matches the coin’s supply with real-time demand.

Stablecoins are typically issued as tokens on a blockchain platform and are traded on decentralized exchanges (DEXs) or used within decentralized applications (dApps). Beginner traders often purchase this type of digital currency because it provides a reliable, low-risk way for newbies to enter the decentralized finance (DeFi) market.

How Stablecoins Works

The process of issuing stablecoins involves a number of different steps. Initially, a company issues stablecoins, backing each coin with an equivalent value in a specific currency. This is how the company links the value of its stablecoin to the value of something else.

Once issued, stablecoins are distributed to the public via a ledger, which records all transactions and ownership details. This ledger is important for the transparent transfer of stablecoins between users.

Digital wallets are a necessary component of stablecoins. These wallets, available as smartphone apps or other digital solutions, allow users to store, send, and receive stablecoins seamlessly. Beyond everyday transactions, users can also invest their stablecoins through various platforms known as exchanges, seeking returns on their digital assets.

Types of Stablecoins

Unlike traditional cryptocurrencies, stablecoins are distributed and governed by a central authority called the issuer.

The buyer has to trust that the coin’s issuer has a sufficient amount of the asset the coin is pegged to. If the issuer doesn’t have enough reserve assets to back the coins in circulation, the stablecoin will lose its peg, and its value will become unstable.

Although different coins use different approaches to achieve stability, there are four primary types of stablecoins: fiat-backed, commodity-backed, algorithmic-backed, and crypto-backed.

Fiat-Collateralized

This type of stablecoin is backed by a reserve of a fiat currency and maintains its value by being redeemable at a fixed exchange rate (typically 1:1). Well-known examples of fiat-collateralized coins include Tether, USD Coi, and TrueUSD.

Here is how a fiat-collateralized stablecoin works:

Fiat-collateralized stablecoins are popular because their values are easy to understand. To provide an additional layer of security, some fiat-collateralized coins maintain a reserve that exceeds the total value of the issued coins. This ensures the digital currency is always fully backed, even when the value of the reserve assets decreases.

Commodity-Collateralized

This type of stablecoin is tied to a physical commodity like gold or a financial instrument that represents the commodity, such as gold-backed exchange traded funds (ETFs).

Gold is not the only commodity that can be used as collateral, but it is arguably the most popular because, throughout history, it has been used as a store of value during times of economic uncertainty. Well-known examples of gold-collateralized coins include PAX Gold (PAXG) and Tether Gold (XAUT).

Here is how a gold-collateralized stablecoin works:

Commodity-collateralized coins are popular because they can provide investors with a hedge against inflation and other types of economic instability. To accommodate potential fluctuations in market conditions, most commodity-collateralized stablecoins maintain a reserve that exceeds the total value of the issued coins.

Crypto-Collateralized

Crypto-collateralized stablecoins are increasingly becoming important within the DeFi ecosystem. These stablecoins are backed by other cryptocurrencies. Users lock their crypto assets in smart contracts to receive stablecoins, which can later be retrieved by repaying the stablecoins into the contract.

sUSD (Synthetix USD) and LUSD (liquity USD) are two of the more popular crypto-collateralized stablecoins. sUSD is a stablecoin within the Synthetix protocol, which allows users to create and trade synthetic assets. LUSD, on the other hand, is a decentralized, crypto-collateralized stablecoin developed by the Liquity protocol.

Here is how a crypto-collateralized stablecoin works:

Notably, the over-collateralization and the use of smart contracts provide a buffer against price fluctuations, maintaining a stable value. This is necessary in order to enable a consistent market price and facilitate various financial activities even at times of extreme volatility.

Algorithmic Stablecoins

Algorithmic stablecoins use algorithms and smart contracts to regulate the coin’s supply in response to changing market demands. This type of stablecoin, which is typically backed by a reserve of another cryptocurrency, will automatically mint or burn coins to maintain a stable value.

Popular algorithmic stablecoins include DAI, Frax (FRAX), and Magic Internet Money (MIM).

Here is how an algorithmic stablecoin works:

While algorithmic stablecoins offer a more scalable solution than asset-backed or crypto-collateralized coins, they require a high degree of technical expertise and understanding to properly design and implement. Experts recommend that investors carefully assess the risks and benefits of using algorithmic stablecoins before relying on them for financial transactions or investments.

How to Buy and Sell Stablecoins

The first thing someone needs to do before making a purchase is to research the most popular stablecoins and decide which option best suits their needs. If they don’t have a personal digital wallet, now is the time to get one.

After the decision has been made about what to buy, the purchaser will need to find a reputable cryptocurrency exchange that supports their selection. Factors to take into consideration include security, fees and usability.

Once they’ve decided which exchange to use, the buyer will need to create an account on the exchange and complete the required verification processes to activate the account.

From here, the buying process is pretty straightforward:

To sell stablecoins, the process is similar:

By following these steps, even those with limited experience in the world of cryptocurrency can easily buy and sell stablecoins, taking advantage of the benefits they offer within the financial ecosystem.

Stablecoin Uses

Stablecoins can be used for various purposes. However, they often serve three primary use cases: medium of exchange, store of value, and trading asset.

Role in DeFi

Stablecoins are typically used to facilitate trades on crypto exchanges. Their relatively consistent value makes them an attractive option for low-stake remittances.

Instead of buying Bitcoin directly with fiat currency (like the US dollar, for example), a trader might exchange some fiat for a stablecoin – and then trade the stablecoin for another cryptocurrency like Ethereum (ETH).

Other popular uses for this type of digital currency include:

Stablecoins Pros and Cons

Stablecoins offer several advantages that make them valuable tools in both the cryptocurrency ecosystem and broader financial markets. However, they also come with certain disadvantages and risks.

Stablecoins Regulations and Compliance

Although stablecoins are often used as safe-haven asset during times of high volatility in the decentralized finance ecosystem, they have been controversial because there is no way to know whether the issuers actually hold the necessary assets to back up their coins in circulation.

To ensure the stability of the market and protect the interests of investors, regulators are looking at ways to provide clear guidance and oversight for the market in regard to the following concerns:

The Bottom Line

Stablecoins, meaning cryptocurrencies pegged to another asset, have evolved to become an essential tool in the cryptocurrency ecosystem, offering stability in a volatile market.

However, their advantages must be weighed against potential risks, particularly related to centralization and reserve management.

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