What Are Stablecoins? A Comprehensive Guide
A stablecoin is a form of crypto asset created to maintain a stable value by pegging it to a reserve of commodities like gold, fiat currencies like USD, or another cryptocurrency. The concept is rapidly gaining ground in the global economy as it provides a trusted store of value and is barely influenced by price fluctuation, unlike bitcoin and other crypto assets.
Stablecoins are often used for transactions, as a hedge against crypto market volatility, and in various blockchain-based financial applications. In this article, we will discuss the mechanism by which stablecoins work and the types and benefits of stablecoins.
How do stablecoins work?
All stablecoins have similar mechanisms with other forms of cryptocurrency assets as they are primarily minted for users to sell, buy, and trade on crypto exchanges. Also, you can store your stablecoin holdings in a cold storage or hot storage, your preference, just like you would store your bitcoin or altcoin holdings.
However, stablecoins are more stable in value, unlike other crypto assets, as they are pegged to a reserve of extrinsic assets such as stacked traditional currency or commodities such as gold. Usually, firms that issue stablecoins have a personal reserve that has equivalent value to the value of their stablecoin in circulation. This mechanism ensures that stablecoin holders can swap a coin for 1 dollar at any time.
The Types of Stablecoins
Fiat-backed stablecoins
These are the most common stablecoins as they are supported by traditional currencies, mainly USD. Examples include USDC and USDT, which are pegged to the United States Dollar on a 1:1 ratio. Nonetheless, some other fiat-backed stablecoins linked to Chinese RMB, Japanese Yen, British Pound, and Euro.
Crypto-backed stablecoins
Crypto-backed stablecoins are those coins whose value depends on the value of another more stable crypto token, which it was pegged to. MakerDAO is a popular example, and it utilizes smart contracts to pool together sufficient Ethereum which serves as its collateral reserve.
Commodity-backed stablecoins
As the name implies, the values of this type of stablecoin are pegged to the prices of commodities such as industrial metals, real estate, oil, or precious metals. It is commonly patronized by commodity investors as it enables investment in gold without necessarily owning one. A typical example is the XAUT (Tether gold) stablecoin, which is supported by a gold reserve vault situated in Singapore. One XAUT has the value of 1 ounce of gold.
Algorithmic stablecoins
Algorithm stablecoins are not backed by physical assets but by algorithms that regulate their supply to match their market demand. Whenever their level deviates in the market, the algorithm adds or removes tokens to conserve stability. Nonetheless, these algorithms are not always efficient and error-prone; for instance, Terra’s UST collapsed due to the inability of the algorithm to cope with the massive market swing.
The Benefits of Stablecoins
- Price Stability: Stablecoins are built to maintain a stable value, often pegged to a fiat currency like the USD. This stability reduces the volatility typically associated with cryptocurrencies.
- Efficient Cross-Border Transactions: Stablecoins facilitate quick and cost-effective cross-border transactions, eliminating the need for traditional banking intermediaries and currency conversion.
- Risk Mitigation: Traders and investors use stablecoins to hedge against the volatility of other cryptocurrencies. They can quickly move funds into stablecoins during market downturns.
- Accessibility: Stablecoins provide access to cryptocurrencies for individuals and businesses in regions with limited access to traditional banking services, opening up financial inclusion opportunities.
- Reduced Transaction Costs: Transactions with stablecoins often have lower fees compared to traditional financial systems, making them attractive for both small and large transfers.
- Transparency: Many stablecoin issuers publish regular audits and reports on their reserves, providing clarity and confidence to users about the backing of the stablecoin.
- Smart Contracts and DeFi: Stablecoins are widely used in decentralized finance (DeFi) applications and smart contracts, enabling various financial services like lending, borrowing, and yield farming.
These benefits make stablecoins a valuable tool in the world of cryptocurrencies and blockchain technology.
How do you pick the right stablecoin?
There are many stablecoins in the crypto industry with similar features, making it difficult for individuals to pick which to invest in, especially newbies. However, cross-checking the intrinsic component of a stablecoin would give you a hedge towards choosing a viable coin. When selecting a stablecoin to invest in, analyze factors such as availability, market cap, audit transparency, minting platform, circulating supply and maximum supply.
DISCLAIMER: It's important to know that the stories on this blog are not meant to serve as, nor should it be construed as, advice in legal, tax, investment, financial, or any other professional context. You should only invest an amount that you are prepared to lose, and it's advisable to consult with an independent financial expert if you're uncertain. For more information, kindly consult the terms of service and explore the assistance and support areas provided by the issuing or advertising entity. Our website is dedicated to accurate and unbiased reporting, but it's important to note that market circumstances may change rapidly. Additionally, please be aware that some (but not all) articles on our site are sponsored or paid posts.
