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.

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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.

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:

Lending and borrowing: DeFi platforms like Aave and MakerDAO offer stablecoin lending and borrowing services. Users can lend their coins to earn interest or use them as collateral to borrow other assets. Similarly, borrowers can take out stablecoin loans to access liquidity without needing to sell other crypto assets.

Yield farming: Stablecoins are used in yield farming, an investment strategy in which users stake or provide pools with liquidity to earn governance tokens or other rewards.

Insurance: Some DeFi insurance platforms use stablecoins to provide users with a reliable and transparent medium for purchasing insurance coverage or paying out claims.

How Different Types of Stablecoins Work

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.

Stablecoin Asset Tethered To
Tether (USDT) U.S. Dollar
USD Coin (USDC) U.S. Dollar
Binance USD (BUSD) U.S. Dollar
Dai (DAI) Collateralized by a basket of cryptocurrencies (mainly Ethereum)
TrueUSD (TUSD) U.S. Dollar
Tether Gold (XAUT) Each XAUT token represents one troy ounce of gold held in a secure vault.
Reserve Rights (RSV) U.S. Dollar
Perth Mint Gold Token (PMGT) Each PMGT token is backed by one troy ounce of gold held by the Perth Mint in Australia.

 

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 Coin and TrueUSD.

Here is how a fiat-collateralized stablecoin works:

  1. The issuer of the coin creates a reserve of the fiat currency the stablecoin is pegged to. The reserve is held by the issuer or a trusted third-party custodian, such as a bank or another financial institution.
  2. The issuer mints a fixed number of coins that corresponds to the amount of fiat currency held in reserve.
  3. The stablecoins are released into circulation through direct purchases or through exchanges and dApps.

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:

  1. The coin’s issuer creates a reserve in the form of physical gold bars stored in secure vaults or shares of gold-backed ETFs or similar financial products.
  2. The issuer mints a fixed number of coins corresponding to the amount of gold held in reserve.
  3. The stablecoins are released into circulation through direct purchases or through exchanges and dApps.

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.

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:

  1. The coin’s issuer selects a stable value relative to a specific asset as a peg.
  2. The issuer builds their coin on a blockchain platform that supports smart contracts. The smart contracts contain the rules and algorithms that govern the coin’s supply in response to demand.
  3. If the market price deviates from the peg, the smart contract algorithms automatically adjust the supply of stablecoins to restore the coin’s value to the target peg.

While algorithmic stablecoins offer a more scalable solution when compared to 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 is 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 straight-forward:

  1. Deposit funds into the exchange account. Depending on the exchange’s supported options, this can be done by using a bank transfer, a credit card or by depositing other cryptocurrencies.
  2.  Navigate to the exchange’s trading platform. Purchase the desired stablecoins from the available trading pairs.
  3. Store the coins securely, either in a wallet provided by the exchange or by transferring them to a personal hardware or software wallet.

To sell stablecoins, the process is similar:

  1. Deposit stablecoins into the exchange account.
  2. Navigate to the exchange’s trading platform. Review the available trading pairs and decide whether to exchange the stablecoins for fiat currency or trade them for other top cryptocurrencies.
  3. Withdraw the proceeds and store them in a bank account or personal digital wallet, depending on the options provided by the exchange.

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.

Regulations and Compliance

Although stablecoins are often used as a 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 regards to the following concerns:

Anti-Money Laundering (AML) and Know Your Customer (KYC) — AML and KYC regulations require stablecoin issuers and exchanges to verify the identity of their customers and monitor transactions for potential money laundering or terrorist financing activities.

Securities Laws — In some cases, stablecoins can be considered securities and may be subject to securities laws and regulations. The determination of whether a stablecoin is a security depends on several factors, including its underlying structure.

Consumer Protection Laws — Stablecoins can also be subject to consumer protection laws, which require issuers and exchanges to disclose information about their products and services to consumers, and protect them from fraud and other deceptive practices.

Tax Regulations — Stablecoin transactions can be subject to tax regulations — including capital gains tax, sales tax and value-added tax, depending on the jurisdiction and the type of transaction involved.

Payment Services Regulations — Stablecoins that are used for payment services can be subject to payment services regulations, which require issuers and exchanges to obtain licenses and comply with regulations related to payment processing.

 

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Margaret Rouse
Technology Expert

Margaret is an award-winning technical writer and teacher known for her ability to explain complex technical subjects to a non-technical business audience. Over the past twenty years, her IT definitions have been published by Que in an encyclopedia of technology terms and cited in articles by the New York Times, Time Magazine, USA Today, ZDNet, PC Magazine, and Discovery Magazine. She joined Techopedia in 2011. Margaret's idea of a fun day is helping IT and business professionals learn to speak each other’s highly specialized languages.