Stablecoins are cryptocurrencies whose value is tied to that of a fiat currency, commodity, or any other financial instrument.
They are tokens used to bridge the gap between fiat currencies like the US dollar or Euro and cryptocurrencies.
This article has everything that you need to know about stablecoins. We will look at what they are, how they work, and the different types of stablecoins that are currently available in the market.
What Are Stablecoins?
Stablecoins are a type of cryptocurrency that peg their market value to an asset with a stable value, like other fiat currencies, cryptocurrencies, or commodities such as gold. They are mainly used as a medium for exchanging the highly-volatile crypto assets.
Since these price-stable digital assets behave somewhat like a fiat currency and, at the same time maintain the mobility and utility of a cryptocurrency, stablecoins offer a novel solution to crypto volatility. The price stability mechanism is built directly into their algorithm.
Stablecoins pursue price stability by maintaining reserve assets as collateral or through algorithmic formulas that are intended to control their supply.
How Do Stablecoins Work?
Cryptocurrencies like Bitcoin (BTC) or Ethereum (ETH) tend to suffer from high price volatility or exchange rates.
Even though this volatility can be great for traders, it can be difficult for buyers and sellers who use it for everyday transactions like transfers or purchases.
To serve as a medium of exchange, any currency that is not legal tender must remain relatively stable.
This way those who accept the token can be assured that it will sustain purchasing power in the short term.
In the case of fiat currencies, which are known to be stable assets, a daily move of even 1% in forex trading is extremely rare.
Stablecoins are digital currencies minted on a blockchain and are identifiable by one of four underlying collateral structures: fiat-backed, crypto-backed, commodity-backed, or algorithmic stablecoins.
While their underlying collateral structures can vary, stablecoins strive to achieve price stability at all times.
Types of Stablecoins
There are four main types of stablecoins, and they are the following:
- Fiat-backed Stablecoins
These are most popular type of stablecoins, where the assets are backed 1:1 by a fiat currency.
These tokens maintain a reserve of a fiat currency, such as the dollar, as collateral to maintain its stable value.
The US dollar is the preferred collateral asset for most fiat-backed stablecoins. Tether (USDT), USD Coin (USDC), Gemini Dollar (GUSD), True USD (TUSD), and Paxos Standard (PAX) are some of the most popular stablecoins that have dollar reserves and are denominated in parity with the greenback.
USDT is the world’s largest stablecoin with a market cap exceeding $80 billion. It is also the most traded token in the crypto market due to it being the preferred medium for exchanging cryptocurrencies.
- Crypto-backed Stablecoins
As the name suggests, these stablecoins are backed by other cryptocurrencies. Since their reserve assets are cryptocurrencies, which are prone to high volatility, crypto-backed stablecoins are overcollateralized.
Meaning the value of the underlying cryptocurrency held in reserves exceeds the value of the stablecoins that are issued.
When purchasing these stablecoins, one has to lock the cryptocurrency required as collateral into a smart contract to obtain tokens of equal value.
To withdraw the collateral asset, they have put the stablecoin equivalent to its value into the same smart contract.
MakerDAO’s DAI is the most prominent crypto-backed stablecoin.
Although its value is pegged to the dollar, it is backed by Ethereum (ETH) and other cryptocurrencies that are worth 150% of the total number of DAI in circulation.
- Algorithmic Stablecoins
The case with algorithmic stablecoin is that they may or may not hold reserve assets, whether it is fiat or other cryptocurrencies.
It functions in a somewhat similar way to central banks, where they leverage specialized algorithms and smart contracts instead of relying on a reserve asset to maintain value.
Algorithmic stablecoins reduce the number of tokens in circulation when its market price falls below the price of the fiat currency it tracks.
On the other hand, if the price of the token exceeds the price of the fiat currency backing it, new tokens are issued to maintain parity.
TerraUSD (UST) was one of the most popular algorithmic stablecoins in the market until its crash in 2022.
The token plunged more than 60% after losing its entire peg to the US dollar as the price of the Luna (LUNA), the cryptocurrency backing it, had slumped more than 80%.
- Commodity-backed Stablecoins
Commodity-backed stablecoins are backed by physical assets like precious metals, oil, or real estate. Gold is the most popular commodity to collateralize these cryptocurrencies.
The most popular commodity-backed stablecoins in the market are Tether Gold (XAUT) and Paxos Gold (PAXG), which are pegged to the value of liquid gold. However, commodities are prone to price fluctuations and therefore have the potential to lose value from time to time.
Commodity-backed stablecoins facilitate investments in assets that may be out of reach in certain markets.
In some countries, obtaining a gold bar and finding secure storage for it may be complex and expensive. As a result, holding the physical commodity in hand may not be a realistic proposition.
During these times, a stablecoin backed by an underlying commodity like gold can be exchanged for cash as it holds the same value as the reserve asset.
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