Simply Explained: Stablecoins
A stablecoin is a coin whose value is pegged to a “stable” fiat currency like the US dollar or the euro to stabilise its price. Cryptocurrencies like BTC and ETH offer a host of benefits. However, their prices are unpredictable and volatile, meaning they're not the best choice for day-to-day purchases. Would you want to buy a coffee with your BTC if it's down 50%? Let’s take a closer look at stablecoins and how they work.
How do they work?
Stablecoins aim to resolve price volatility by pegging the value of cryptocurrencies to fiat currencies. They enable users to quickly and cheaply transfer value around the world while ensuring price stability is maintained.Cryptocurrencies like Bitcoin and Ethereum are known for their volatility, making them risky investments and often unsuitable for payments. When a transaction is completed, coins can be worth much more or less than when they were sent.
Stablecoins offer a more reliable, usable solution for making payments as they experience negligible price fluctuations and closely follow the value of the reserve asset they are pegged to.
Typically, the stablecoins will be backed by a 'reserve’ where the asset or assets backing the stablecoin are stored. For example, $1 million to back up 1 million stablecoin units. The money in the reserve acts as collateral for the stablecoin. Some cryptocurrencies are also tied to other real-world assets, like precious metals.
Types of stablecoins
There are a few different types of stablecoins, we’ll discuss some of the most common ones below.Fiat-backed
Fiat-backed stablecoins are the most popular. They are pegged to a fiat currency with a 1:1 ratio. We also refer to these as fiat-collateralised stablecoins. A central bank or issuer stores a reserve amount of fiat currency and issues a proportionate number of tokens.For example, the bank may hold 100,000 dollars and issue 100,000 tokens, each worth one dollar. Participants can freely trade these tokens and redeem them for their equivalent value in USD. However, this type of stablecoin is not without risk, as it is necessary to trust that the issuer is holding funds in reserve.
Crypto-backed
This is a more complex type of stablecoin. Here, cryptocurrency, rather than fiat currency, is used as collateral. And, as crypto is digital, smart contracts issue stablecoin tokens. Here, you trust the network participants rather than a single issuer.Algorithmic
Algorithmic stablecoins are not backed by crypto or fiat currencies. They are pegged to algorithms and smart contracts. Put simply, this stablecoin will reduce (burn) or increase the token supply to ensure the coin’s value remains in line with its target price.How are they used?
The combination of the flexibility of digital assets and the stability of traditional assets has made stablecoins an extremely popular concept. Popular stablecoin uses include performance measurement, exchange, value storage, pegged lending, and smart insurance.What are the benefits of stablecoins?
The USDC stablecoin, for example, can be traded for the US dollar on a 1:1 ratio on exchange platforms. Like many stablecoins, USDC operates on the Ethereum blockchain.Stablecoins are significantly less volatile and more predictable than non-pegged cryptocurrencies. This makes them a useful solution for integrating crypto with traditional financial markets.
They possess many of the beneficial properties of cryptocurrencies. They are open and accessible to anyone who has access to the internet. They’re also secure, fast, and cheap. Users don’t need a band account to hold stablecoins, and they’re easy to transfer. There are also simple ways to earn interest on stablecoin investments.
Top stablecoins by market cap
As of December 13, 2021, the top stablecoins (by market cap) are:Tether (USDT): is an example of a cryptocurrency whose tokens are backed by an equal amount of US dollars.
USD Coin (USDC): is a USD-backed stablecoin.
Binance USD (BUSD): is a USD-backed stablecoin.
Dai (DAI): is a decentralised stablecoin that runs on Ethereum and aims to maintain a value of $1 USD. Unlike centralised stablecoins, DAI isn’t backed by US dollars in a bank. Rather, its backed by collateral on the Maker platform.
How to earn interest on stablecoins
Platforms like Hodlnaut, YouHodler and Celsius offer opportunities for investors to earn up to 10% interest on stablecoins. You can earn interest by holding your stablecoins long-term. But as always, make sure to do your own research.Disclaimer: NOT FINANCIAL NOR INVESTMENT ADVICE. Only you are responsible for any capital-related decisions you make and only you are accountable for the results.
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