Stablecoin

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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.

What is a Stablecoin?

Key Takeaways

  • In simple stablecoin definition, it is a type of cryptocurrency whose value is tied to another asset, such as fiat currency.
  • Stablecoins are issued by companies that back each coin with an equivalent value in a specific asset.
  • There are four primary types of stablecoins: fiat-backed, commodity-backed, algorithmic-backed, and crypto-backed – each using different methods to maintain stability.
  • Stablecoins are used for a wide range of purposes, including as a medium of exchange, store of value, and trading assets.
  • While stablecoins offer advantages like price stability, they also come with risks such as de-pegging, centralization, and reserve management issues.

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

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.

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 Coi, 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.

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:

  1. Users deposit their cryptocurrency into a smart contract on the blockchain. This deposited crypto acts as collateral to back the stablecoin.
  2. Based on the value of the deposited collateral, the smart contract mints a corresponding amount of stablecoins.
  3. To get their collateral back, users need to repay the stablecoins into the smart contract.

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:

  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 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:

  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.

    Stablecoin Uses

    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.

    Medium of Exchange

    Stablecoins are used for a wide range of payments, from everyday purchases like coffee to cross-border remittances and settling large trades.

    In developed countries, where services like Apple Pay and Venmo are prevalent, the advantages of stablecoins may seem limited. However, in developing nations, where access to reliable payment systems is restricted, stablecoins offer a valuable alternative, often tied to more stable currencies like the US dollar.

    Store of Value
    In countries with unstable local currencies or restrictive financial systems, stablecoins provide a safe haven for preserving wealth. For example, in places with high inflation or stringent capital controls, stablecoins offer a means to hold value in a more stable currency.

    Trading Asset

    Within cryptocurrency exchanges, stablecoins are often used as quote assets across various trading pairs. In DeFi, they are essential for yield farming and arbitrage opportunities.

    Furthermore, traders leverage the interest rate differences between traditional financial systems and decentralized platforms, such as borrowing at lower rates from traditional lenders and lending stablecoins on platforms like Compound or Aave for higher returns.

    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
    Highly-rated 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.

    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.

    Pros

    • Price stability
    • DeFi integration
    • Liquidity

    Cons

    • De-pegging risk
    • Centralization risks
    • Reserve management

      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:

      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.

      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.

      FAQs

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      Ruholamin Haqshanas
      Crypto Journalist
      Ruholamin Haqshanas
      Crypto Journalist

      Ruholamin is a crypto and financial journalist with over three years of experience. In addition to Techopedia, he has been featured in major media outlets including Cryptonews, Investing.com, 24/7 Wall St, The Tokenist, Business2Community, and has also worked with some prominent crypto and DeFi projects. He holds a bachelor's degree in Mechatronics. Ruholamin enjoys reading about technological developments, writing and observing nature.