The Definitive Guide To Stablecoins
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Stablecoins are a type of cryptocurrency whose prices are pegged to a reference asset. They can minimize volatility and can be easily transferred.
Despite the TerraUSD (UST) crash that happened earlier this year, there are still many developments going on with stablecoins. Not only are individual investors eager to enter the market, but large financial institutions are also demonstrating their interest in the decentralized finance markets.
It is thus essential to understand the basic concepts of stablecoins, what they are, what the difference is among various types of stablecoins, and what changes they have brought to the crypto market.
Total Stablecoin Supply, data was updated on September 27, 2022. Resource: The Block.
What Are Stablecoins and How Do They Work?
Stablecoins are a type of cryptocurrency whose prices are pegged or tied to a reference asset, such as another currency, commodity, or financial instrument.
First issued in 2014, stablecoins offer the speed and security of a blockchain, but are designed to reduce the high volatility of traditional cryptocurrencies and can thus be used as a better medium of exchange.
Different Types of Stablecoins
Stablecoins are a type of cryptocurrency whose prices are pegged or tied to a reference asset, such as another currency, commodity, or financial instrument.
There are different types of stablecoins, depending on whether the stablecoins maintain their reserve assets as collateral or through algorithmic formulas. Below we will explain the difference between the four different types of stablecoins.
Fiat-backed Stablecoins
Fiat-backed stablecoins are cryptocurrencies pegged to the value of real-world currencies. In the case of stablecoins backed by the U.S. dollar, such as USDC, the stablecoin will keep its value as long as the cryptocurrency is redeemable for the U.S. dollar.
One stablecoin pegged to the U.S. dollar should be worth one dollar. The mechanism of fiat-backed stablecoins is that the company keeps the fiat money in a bank account, and the financial reserves are audited so that people can trust that the company actually has the fiat money or cash equivalents that they claim to have to back the cryptos.
Crypto-backed Stablecoins
Crypto-backed stablecoins are those backed by other cryptocurrencies. Compared to fiat-backed stablecoins, crypto-backed stablecoins feature a higher level of decentralization as there is a decentralized protocol managing the pegging process.
These stablecoins are often overcollateralized to maintain their peg due to the volatility of the crypto market. Frequent audits and monitoring tools can also help maintain the stability of the stablecoins.
Commodity-backed Stablecoins
Commodity-backed stablecoins are backed by physical commodities, such as precious metals, crude oil, or even real estate.
These blockchain-based representations of commodities make it easier to invest in assets that might otherwise be out of reach in certain regions. However, the price fluctuation of the commodities can also affect the value of the stablecoins.
Algorithmic Stablecoins
Algorithmic stablecoins are uncollateralized, and they rely on an on-chain algorithm to adjust the supply and demand of the tokens and further maintain the price stability of the stablecoins, similar to what central banks do to defend the peg of their currency in the market.
An algorithmic stablecoin system will lower the number of currencies in the market when the price falls below the fiat currency’s price, and vice versa. In this way, algorithmic stablecoins manage to maintain their price stability without needing a physical reserve or collateral.
The Importance and Use Cases of Stablecoins
The simplest way to understand why stablecoins stand out in the financial markets is that they combine characteristics of fiat currencies and cryptocurrencies.
Stablecoins are free from the volatility of traditional non-pegged cryptocurrencies while inheriting many benefits, such as transaction speed, accessibility, security to transmit, and programmability.
Stablecoins v.s. Traditional Cryptocurrencies
Stablecoins can be used as an ideal medium of exchange to bridge the gap between fiat currencies and cryptocurrencies, and they are primarily used to purchase cryptocurrencies on trading platforms that do not offer fiat currency trading pairs.
Meanwhile, they have also been widely used throughout the DeFi space and in decentralized exchanges (DEX). Stablecoins can also be utilized to pay salaries in cryptocurrency as they make it cheaper to move money across borders.
Source: Cointelegraph. Own Illustration.
However, there are still a few limitations of stablecoins that are worthy of attention. Stablecoin users have to trust the central entities that issue the cryptocurrencies, and this leads to greater centralization.
Moreover, due to the wide adoption of stablecoins, their increasing influence, and the fact that they are pegged to fiat currencies, stablecoins have caught the attention of regulators.
For example, the Bank for International Settlements (BIS) proposed the implementation of the “same risk, same regulation” legal framework for stablecoin arrangements in July 2022.
For a more detailed discussion about stablecoins and the possible trends for stablecoins in the upcoming years, you can watch the panel discussion “Stablecoins, Stability and CBDCs” from the European Blockchain Convention 2022, or join the European Tech School to learn from the best and kickstart your blockchain career!
