A new era of digital transactions has begun with the introduction of bitcoin and blockchain technology. Today, thousands of different cryptocurrencies have established a revolutionary virtual payment system through a distributed network with no middlemen. Cryptocurrencies, with their decentralized ledgers and transaction verification methods, have found widespread adoption across a wide range of markets.
However, the volatility of cryptocurrencies has slowed the industry’s use of cryptocurrency for payments. As such, proponents of blockchain technology continue to propose novel solutions to emerging problems. Stablecoins are one such innovation. Stablecoins aims to mitigate the risks and price swings with cryptocurrency transactions. As a result, stablecoins are becoming increasingly popular among investors and cryptocurrency users. Let’s take a closer look.
What are stablecoins?
Stablecoins are a type of cryptocurrency pegged to the value of a traditional currency or another asset. You can get tokens backed by the dollar, euro, yen, or even gold and oil. A stablecoin lets users lock in profits and losses and move wealth at a steady value across blockchain networks.
Cryptocurrencies like Bitcoin (BTC), Ethereum (ETH), and others have a history of extreme price swings. While this opens up a lot of room for speculation, it does come with certain negatives. The heightened volatility associated with cryptocurrencies makes it difficult to use as a daily payment method. For instance, a shop can accept $5 in Bitcoin one day only to have its value drop by 30% the next. This complicates corporate planning and operation.
Previously, crypto traders and investors had to convert their holdings into fiat currency to lock in a profit or prevent price fluctuations. The introduction of stablecoins offered a straightforward resolution. Today, you can quickly get in and out of crypto volatility using stablecoins like USDT.
How do stablecoins work?
Various assets, such as fiat currencies, other cryptocurrencies, precious metals, and algorithmic functions, back stablecoins. However, the resilience of a stablecoin can vary depending on the asset backing it. For example, a fiat-backed stablecoin will be more stable since it is linked to a centralized financial system with a central authority (such as a central bank) that can step in and control prices when values are volatile. Stablecoins that are not tied to a centralized financial system, such as a stablecoin backed by bitcoin, are subject to rapid and unpredictable price fluctuations since there is no central authority dictating the value of the underlying asset.
What are the different types of stablecoins?
Stablecoins are blockchain-based digital currencies distinguished by their collateral structure, which might be fiat-backed, crypto-backed, commodity-backed, or algorithmic. Although the nature of the stablecoin’s underlying collateral structure can change, its primary objective remains unchanged. Let us have a look at the four main categories of stablecoins.
Asset-backed stablecoin (Off-Chain)
Most stablecoins are pegged one-to-one with fiat currency. Such stablecoins are off-chain assets since the underlying collateral is not another cryptocurrency. Centralized issuers or financial institutions hold fiat collateral in an amount equal to the total number of stablecoin tokens in circulation.
For instance, if an issuer holds $10,000,000 in fiat currency, it can only mint $10,000,000 in stablecoins, each worth $1.00. Some of the largest asset-backed stablecoins by market value include Tether (USDT), Gemini Dollar (GUSD), True USD (TUSD), and Paxos Standard (PAX).
Crypto-collateralized stablecoins (On-Chain)
Crypto-collateralized stablecoins, as the name suggests, are backed by another cryptocurrency. In place of a central issuer, smart contracts are used in this system, which operates on the blockchain. You can buy stablecoins by securing your cryptocurrency in a smart contract in exchange for tokens with a fixed value. After that, you can return the stablecoin to the same smart contract and get back the initial collateral amount. To date, DAI is the most well-known stablecoin that uses this method. DAI is minted using a collateralized debt position (CDP) via MakerDAO to safeguard assets on the blockchain.
Over-collateralization is another feature of crypto-collateralized stablecoins that serves to protect holders from the risk of price swings in the underlying cryptocurrency collateral asset. For instance, a deposit of $2,000 in ETH is required to purchase $1,000 in DAI stablecoins, which is a 200% collateralized ratio. The extra collateral cushions DAI’s price to preserve stability if the market price of ETH lowers to a certain threshold. If ETH falls below the predetermined threshold, collateral is returned to the smart contract to liquidate the CDP.
In contrast to traditional stablecoins, algorithmic stablecoins do not back their value with any other currency or cryptocurrency. Instead, using dedicated algorithms and smart contracts to control the issuance and distribution of tokens, they ensure that their value remains relatively constant. When the value of the tokens it tracks drops below the value of the fiat currency it tracks, the algorithmic stablecoin system will lower the supply of the tokens in circulation to preserve the value of the stablecoin. If the stablecoin’s price rises above the fiat currency it pegs, fresh tokens are issued to bring it back down to parity.
Commodity-based stablecoins are backed by physical assets like gold, oil, and real estate. Gold is the most often used collateral asset, with Tether Gold (XAUT) and Paxos Gold (PAXG) being two of the most liquid gold-backed stablecoins. However, keep in mind that the value of these commodities can still decrease due to market fluctuations.
Stablecoins backed by commodities make it possible to invest in assets that are difficult to access on a community scale. For example, acquiring a gold bar and securing a suitable storage facility can be difficult and costly in many parts of the world. Therefore, storing precious metals in their physical form is not always practical. Stablecoins backed by commodities can be converted into fiat currency or physically redeemed for the tokenized asset they represent. Paxos Gold (PAXG) stablecoins can be exchanged for fiat currency or physically redeemed for gold by their holders. To redeem tokens, users must have a minimum of 430 PAXG, where 1 token represents 1 ounce. The tokens can be redeemed at any of the U.K.’s vaults and then picked up by the token’s owner.
In contrast to gold-backed stablecoins, which can be exchanged on all operating systems for the precious metal itself, stablecoins backed by other commodities are less widely interchangeable. For instance, you can not exchange Venezuela’s experimental Petro stablecoin, backed by oil, for actual oil. Even while stablecoins backed by assets like real estate have garnered a lot of attention in the past several years, it is hard to establish meaningful comparisons between them and other cryptocurrencies since so few projects are actually underway.
Can stablecoins make you money?
While stablecoins aren’t the ideal asset to trade, mainly because they have minuscule price movements, they do allow traders to lock in on their profits in times of market volatility.
What are the advantages of using stablecoins?
Stablecoins are widely used as a medium of exchange for cross-border transactions by both individuals and businesses. Here are some of the most significant advantages that stablecoins offer:
The reliability of blockchain technology
The primary advantage of stablecoins is that they are managed using blockchain technology, allowing instant and cheap international transactions. These currencies are significant for cross-border transactions because of the short time it takes to settle them. Moreover, they are simple to use since they can be stored and transferred via digital wallets, just like standard cryptocurrencies.
Shield from Volatility
Stablecoins are stabler than other cryptocurrencies since they are tied to a fiat currency or commodity and thus seldom, if ever, experience the high volatility trading periods that plague other digital currencies. This factor is pertinent to increasing its adoption.
Hedge against Market Downturns
Stablecoins are often used by traders as a hedge against the price volatility of other cryptocurrencies. Stablecoins enable traders to instantly liquidate their digital assets and readily re-enter the market once the price has stabilized.
A cryptocurrency for day-to-day use
Stablecoins, in contrast to conventional crypto coins, are not subject to market swings and may be used as a stable medium of exchange in everyday life, such as shopping and in-app purchases.
What are some of the most popular stablecoins?
While there are many stablecoins in existence, with new ones emerging every so often, here is a list of stablecoins that are most widely used:
In addition to being one of the most recognized stablecoins, USDT is the third most valuable cryptocurrency by market cap. The stablecoin is compatible with several blockchains, including Ethereum, TRON, EOS, Algorand, Solana, OMG Network, and Bitcoin Cash (SLP). Fiat currencies, commercial paper, and bonds back the USDT.
MakerDAO’s DAI is an overcollateralized stablecoin built on Ethereum and pegged to the U.S. dollar. In terms of market capitalization, it is the second-largest decentralized stablecoin.
USD Coin (USDC)
USDC was created with the help of Coinbase and is backed by the U.S. dollar. Because of the developers’ dedication to compliance and reserve transparency, it has gained a reputation as one of the most reliable stablecoins.
Binance USD (BUSD)
BUSD is a U.S. dollar-pegged stablecoin launched by a crypto exchange. It was created by the exchanges Paxos and Binance, which regularly audit their coin supplies to demonstrate their reliability.
USDD is one of the youngest stablecoins released in 2022 by Tron. It combines features of an algorithmic stablecoin with an overcollateralized reserve of multiple crypto assets to create a new hybrid model. The TRON DAO manages the USDD reserves.
How many stablecoins are there?
There are approximately 200 stablecoins in existence as of 2022.
It is hard to predict what the future holds for blockchain technology, but stablecoins can play a role in bringing cryptocurrencies to a broader audience. Major financial services players like JPMorgan and payments network Visa are already showing support for stablecoin technology through strategic collaborations and in-house R&D.
Every stablecoin has its advantages and disadvantages, and none of them is without flaws. However, they can cause a stir because of the convenience and security they bring to consumers and businesses throughout the globe by supporting innovative financial applications and improving access to established national currencies.
The widespread use of digital currencies will be contingent on whether they can be practically implemented on a day-to-day basis. There is little doubt that stablecoins represent a major step in this direction.
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