What is a Stablecoin

Extreme volatility is synonymous with most cryptocurrencies. This volatility creates a high risk/high reward scenario for those investing in different cryptocurrencies.

This volatility works for the investor looking to make a quick buck, but makes it harder to use some cryptocurrencies as a formal payment method. While not as popular as cryptocurrencies such as Bitcoin and altcoins like Ether and Solana, stablecoins are rising as a different type of cryptocurrency, designed to provide a steady price and value.

Let’s dive deeper into what stablecoins are.

What are Stablecoins

Stablecoins are a type of digital whose value is pegged on an underlying asset to maintain relative price stability. They can be pegged on fiat currency, exchange-traded commodities such as industrial or precious metals, or another cryptocurrency.  USD Coin (USDC) is one example of a trending stablecoin which is pegged to the U.S. dollar.

How do Stablecoins Work?

When Bitcoin was established, the goal was to create a decentralized financial system based on blockchain technology. However, due to their susceptibility to market forces, bitcoin and other crypto assets have remained volatile and unreliable storage of value, resulting in the innovation of digital assets with inbuilt price stability.

Stablecoins offer the same privacy and fast processing of cryptocurrencies while providing the stable valuations of fiat currencies. This stability has been a factor behind the rapid explosion of stablecoins, which have a market cap of about $172 billion as of September 2024.

If you look at many cryptocurrencies such as Render, you’ll notice high volatility in price. For example, in January 2024, Render was worth $3.80 before rising to $13,15 by March and then plummeting to $4.92 at time of writing, according to Binance. These price fluctuations can also be seen in a single trading day where prices take swings in either direction.

The high volatility in the crypto ecosystems makes stablecoins a great utility asset for investors to move their money in and out of crypto ecosystems.

Stablecoins tend to remain stable over a long time. For example, the price of Tether (USDT) has remained relatively stable throughout the past two years, with slight fluctuations by a few cents.

Types of Stablecoins

There are two main types of stablecoins:

• Backed Stablecoins
• Algorithmic Stablecoins

Backed stablecoins

Backed stablecoins are the most common and popular stablecoins. They can be backed by fiat currency such as the U.S. dollar, with their prices pegged to one or more currencies at a fixed ratio.

Some of the fiat-backed (or off-chain) stablecoins include USDC, and USDT. 

Fiat-backed stablecoins require the issuer to deposit the equivalent collateral through financial institutions, which regularly audit the collateral to ensure that it is at the stated value.

Stablecoins could also be backed by cryptocurrencies. Unlike fiat-backed stablecoins, crypto-backed or on-chain stablecoins are collateralized on the blockchain using smart contracts.

In addition to relying on cryptocurrencies, crypto-backed stablecoins use other supplementary instruments to achieve price stability. DAI is one of the popular crypto-backed stablecoin that uses several crypto assets. DAI is also backed by Ethereum and pegged to the U.S dollar.

Due to the volatility of cryptocurrencies, crypto-backed stablecoins are collateralized with more valuable crypto assets for low value stablecoins. They also require regular audits to ensure that the collateral covers the stablecoins.

The third type of backed stablecoins is commodity-backed stablecoins whose value is pegged to precious metals, real estate, oil, or industrial metals. Tether Gold is an example of a gold-backed stablecoin.

Algorithmic stablecoins

Algorithmic stablecoins are not backed by any collateral. They rely on algorithms to control the supply of stablecoins. For instance, when an algorithm-backed stablecoin is in surplus, the algorithm destroys some coins, similar to what central banks do. Algorithm-backed stablecoins are less popular compared to crypto and fiat-backed stablecoins.

The Need for Stablecoins

Why are stablecoins important?

One look at the crypto markets can discourage a conservative investor from taking a second look at cryptocurrencies. Their volatility and lack of an underlying asset make them vulnerable to sudden (often huge) swings in prices.

This volatility makes them a less than ideal currency for real-world applications. Stablecoins were established to provide price stability and a steady valuation.

Price stability and steady valuation encourage spending of crypto coins as opposed to holding them as is currently common for cryptocurrencies.

The adoption of stablecoins is seen as a catalyst to the adoption of cryptocurrencies as a medium of exchange for everyday transactions. Investors can lock the value of their crypto assets by converting them to stablecoins.

Top Stablecoins by Market Capitalization

Today’s financial system uses the US dollar as the reserve currency, making stablecoins that peg to the U.S dollar the most commonly used.

USDT

Tether is the leading stablecoin with a market capitalization at $118.78 billion. Tether has previously come under fire for its inability to provide audits of its reserves.

Its most recent report shows that Tether has reserves in the form of commercial paper, cash, and bank deposits, reverse repo notes, treasury bills, secured loans, corporate bonds, funds and precious metals, and other investments, including digital tokens.

USDC

Circle’s USDC has a market capitalization of $35.61 billion. It has gained popularity following claims by its founding member Coinbase, that the stablecoin meets regulatory compliance. The USDC is a popular stablecoin used by the largest cryptocurrency exchanges as well as in decentralized finance, and DApps.

DAI

DAI is a crypto-backed stablecoin with a market capitalization of $5.37 billion. The stablecoin has many applications in DeFi protocols.

Final Word

Stablecoins are cryptocurrencies seeking to provide more price and value stability in the short- and long term. They hold the key to the wide adoption of cryptocurrencies as they provide less volatility and more liquidity in cryptocurrency markets.

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