Stablecoins are digital currencies pegged one-to-one to a "stable" fiat currency, such as the US dollar or another form of collateral. They are designed to minimize the volatility typically associated with cryptocurrencies and maintain a predictable fixed value over time. They are minted on the blockchain, so users can buy, sell, and trade them on exchanges, like any other cryptocurrency. However, because they are tied to a reserve of tangible assets, stablecoins are governed by a centralized system.
Stablecoins were created to bridge the gap between cryptocurrency and traditional fiat currency: they provide the privacy and security of cryptocurrency, as well as the flexibility and convenience of fiat currency for everyday goods and services payments.
Stablecoins vs. traditional cryptocurrencies
The biggest difference between stablecoins and traditional cryptocurrencies is in the name: stability. Cryptocurrency is subject to a high level of volatility, whereas stablecoins are designed to maintain a more fixed value in the unpredictable world of cryptocurrency. When using stablecoins, the underlying asset is tracked, ensuring that the stablecoin remains tied to that asset.
For example, if you were to buy Ether, a popular traditional cryptocurrency, and Tether, a popular stablecoin, you would notice a few differences. The value of your Ether coins may fluctuate slightly from day to day, whereas your Tether coins would remain worth $1 each. And while you can use both of these currencies to make transactions, you are more likely to spend your Tether, as its value is unlikely to change, whereas you may consider Ether coins as an investment and hope for their value to increase.
How do stabelcoins work?
In general, you can buy, sell, and trade stablecoins on an exchange, just like any other digital currency. Stablecoins can be stored in your digital wallet, just like cryptocurrencies. Any stablecoin holder can redeem their tokens at any time at a 1:1 ratio. For example, one stablecoin backed by the US dollar will always be equal to 1 fiat US dollar. Stablecoins can simplify digital transactions due to their stable value. If you use US dollars to buy stablecoins worth $1000, you will have 1000 stablecoin tokens. These tokens can be used to purchase goods and services worth $1000 or exchanged for cryptocurrency or other fiat currency.
Types of Stablecoins
There are several different types of stablecoins available. The difference between them lies in the way they maintain a stable value and whether they are controlled by a centralized or decentralized system. Fiat-backed and commodity-backed coins rely on a centralized system, while crypto-backed coins rely on a decentralized system. Alternatively, algorithmic coins use an in-network algorithm to facilitate changes in supply and demand of the stablecoin and the cryptocurrency backing it.
The asset to which a stablecoin is tied is its collateral, which serves to stabilize and ensure its value.
- Stablecoins backed by fiat (centralized): these stablecoins are pegged 1:1 to national fiat currency to provide their value. Thus, for every circulating stablecoin backed by the US dollar, there is $1 in reserve, either in cash or its equivalents. These reserves are regularly audited by independent custodians. Tether and TrueUSD are the two most popular fiat-backed stablecoins in circulation.
- Commodity-backed stablecoins (centralized): these stablecoins are backed by physical assets such as precious metals, oil, and real estate. The value of commodity-backed stablecoins is likely to fluctuate depending on the market value of these underlying assets. Gold is the most popular commodity-backed asset, with each stablecoin token representing an equal real-world value in gold. PaxGold and Tether Gold are currently the two most liquid gold-backed stablecoins.
- Cryptocurrency-backed stablecoins (decentralized): also known as "overcollateralized" stablecoins, they are backed by other cryptocurrencies. They are usually less stable than fiat-backed stablecoins because the value of the underlying cryptocurrency can fluctuate. For example, a cryptocurrency-backed stablecoin pegged to $1 could be backed by a cryptocurrency worth $2 or $3. If the underlying cryptocurrency loses value, the stablecoin has a safety net that allows it to remain at the $1 level. Cryptocurrency-backed stablecoins include DAI and Wrapped Bitcoin, which is backed by bitcoins.
Algorithmic stablecoins maintain their 1:1 peg with certain pieces of code that dictate the process, also known as smart contracts. Algorithmic stablecoins require both stablecoin tokens and native cryptocurrency to support the stablecoin. They do not have reserve assets to back up the stablecoin value, so the smart contract algorithm regulates the relationship between the stablecoin and its native cryptocurrency. TerraUSD and Magic Internet Money (MIM) are two examples of algorithmic stablecoins.
Advantages of Stablecoins
There are several potential advantages to buying stablecoins instead of traditional cryptocurrencies, especially for those who are unfamiliar with the world of cryptocurrencies. Less volatility and a 1:1 peg to underlying assets can make stablecoins less risky in the vast world of digital currencies.
- Stablecoins backed by fiat currency retain the same value as their fiat currency.
- Stablecoins are less affected by the market because they are tied to more stable assets.
- They retain the benefits of cryptocurrency, such as privacy, security and low transaction fees.
There are also several risks and drawbacks to consider when investing in stablecoins. Like all forms of cryptography, security breaches are possible. And a more centralized system, which may seem appealing to some investors, may be perceived as a disadvantage by others.
- Stablecoins are designed to maintain price stability, not value growth, so profits are less likely.
- New technology means more potential bugs and vulnerabilities, including fraud.
- There is currently a high level of regulatory uncertainty regarding stablcoins.
- There are more parties involved in each transaction, including the bank holding the reserves and the party issuing the stable coin.