What is a Stablecoin?

In a nutshell;

• A stablecoin refers to a cryptocurrency that is tied to the value of another asset, like fiat currencies or precious metals.

• Stablecoins aim to ensure a steady price, protecting users from the fluctuations commonly seen in the cryptocurrency markets.

• There are three categories of stablecoins: those backed by fiat, cryptocurrencies, and algorithm-based ones.

• Given their practicality and significant market capitalization, regulators are increasingly scrutinizing stablecoins.

Introduction

Not all cryptocurrencies are subject to wild fluctuations. Stablecoins, in particular, are created to uphold a steady value. In a market where coins and tokens can experience sudden crashes, there is a considerable desire for currencies that offer the advantages of blockchain technology while being tied to a more stable asset. If you haven't already explored stablecoins for your trading or investment activities, it's essential to educate yourself on their features, advantages, and potential drawbacks.

What Is a stablecoin in cryptocurrency?

Stablecoins are digital assets that mirror the value of fiat currencies or other assets. For instance, tokens linked to the dollar, euro, yen, or even commodities like gold and oil can be acquired. These stablecoins enable users to preserve profits and mitigate losses, facilitating value transfers at a steady price on blockchain networks.

Cryptocurrencies such as Bitcoin (BTC), Ether (ETH), and altcoins have a history of being highly volatile. While this volatility offers speculative opportunities, it also comes with drawbacks. The fluctuating value makes using cryptocurrencies for day-to-day payments challenging. Merchants accepting crypto payments may receive $5 worth of BTC for a coffee one day, only to find that the same BTC is worth 50% less the next, making it difficult to run a business based on crypto payments.

In the past, crypto investors and traders had no means of locking in profits or avoiding volatility without converting crypto back into fiat. However, the introduction of stablecoins provided a straightforward solution to these challenges. Presently, individuals can easily navigate crypto volatility by using stablecoins like TrueUSD (TUSD) to enter and exit the market.

How do stablecoins work?

A pegging mechanism is essential to develop a coin that mirrors the price or value of another asset. Various approaches can be used, with many relying on another asset as collateral.

While certain methods have demonstrated greater success than others, achieving a fully guaranteed peg remains elusive.

Fiat-backed stablecoins

A fiat-backed stablecoin maintains reserves of a fiat currency like USD or GBP. For instance, every TUSD token is backed by $1 held as collateral. Users have the option to convert their fiat currency to stablecoin and vice versa at the fixed exchange rate.

Crypto-backed stablecoins

Crypto-backed stablecoins operate similarly to fiat-backed stablecoins, but instead of using traditional currencies as reserves, they utilize cryptocurrencies as collateral. Due to the highly volatile nature of the crypto market, crypto-backed stablecoins often over-collateralize their reserves as a precaution against price fluctuations.

The management of minting and burning in crypto-backed stablecoins is facilitated through smart contracts, ensuring transparency and allowing users to independently audit the contracts. Some of these stablecoins are governed by Decentralized Autonomous Organizations (DAOs), where the community can participate in voting for project changes, thereby giving users a chance to engage in decision-making or trust the DAO for optimal choices.

For example, to generate 100 DAI, which is pegged to USD, a user needs to provide $150 worth of crypto as 1.5x collateral. Once acquired, DAI can be freely utilized, transferred, invested, or held. If the user wishes to retrieve their collateral, they must repay the 100 DAI. However, if the collateral's value drops below a specified ratio, or the loan's value, it will be subject to liquidation.

In cases where the stablecoin falls below $1, incentives encourage holders to return their stablecoin for the collateral, reducing the coin's supply and raising the price back to $1. Conversely, if the stablecoin exceeds $1, users are incentivized to create the token, increasing its supply and lowering the price. While DAI is just one example, all crypto-backed stablecoins rely on a combination of game theory and on-chain algorithms to incentivize price stability.

Algorithmic stablecoins

Algorithmic stablecoins diverge from other types by eliminating the requirement for reserves. Instead, they rely on algorithms and smart contracts to control the issuance of tokens. This approach is less common than crypto or fiat-backed stablecoins and is more complex to operate successfully.

In an algorithmic stablecoin system, the token supply decreases when its price falls below the value of the tracked fiat currency. This can be achieved through methods such as locked staking, burning, or buy-backs. Conversely, if the stablecoin's price exceeds the fiat currency's value, new tokens are introduced into circulation to reduce the stablecoin's value.

What are the advantages of Stablecoins?

Stablecoins possess diverse and potent capabilities that cater to the needs of investors, traders, and cryptocurrency users. Their key advantages encompass the following:

1. Stablecoins offer a practical solution for day-to-day transactions, appealing to both businesses and individuals seeking stability. Unlike volatile cryptocurrencies, stablecoins, especially larger ones with a proven track record of maintaining their peg, are well-suited for regular use.

2. The blockchain-based nature of stablecoins allows for seamless global transactions. Users can send stablecoins to anyone with a compatible crypto wallet, which can be easily created in a matter of seconds. Additionally, the inherent security of blockchain technology virtually eliminates the risks of double-spending and false transactions, making stablecoins remarkably versatile.

3. Traders and investors find stablecoins valuable for hedging their portfolios. Allocating a portion of their holdings to stablecoins effectively mitigates overall risk. This strategic approach enhances portfolio resilience against market price fluctuations and provides readily available funds for seizing opportunities. During market downturns, one can convert crypto assets into stablecoins and reacquire them at lower prices, enabling convenient position management without the need to move funds off-chain.

What are the disadvantages of Stablecoins?

Although stablecoins hold promise in fostering broader cryptocurrency adoption, they do come with certain constraints:

1. There is no guarantee that stablecoins will consistently maintain their peg. While some well-established projects have demonstrated reliability, others have experienced failures. If a stablecoin faces persistent challenges in maintaining its peg, it may suffer significant value depreciation.

2. Transparency can be an issue with certain stablecoins. While some projects provide complete public audits, many offer only periodic attestations. These attestations are often conducted by private accountants on behalf of the stablecoin issuers.

3. Fiat-collateralized stablecoins tend to be more centralized compared to other cryptocurrencies. A central entity holds the collateral and may be subject to external financial regulations, granting them substantial control over the coin's operations. Users must also trust that the issuer genuinely possesses the claimed reserves.

4. Crypto-collateralized and uncollateralized stablecoins heavily rely on their communities to function. Many crypto projects have open governance mechanisms, granting users a voice in project development and management. In such cases, individuals must either actively engage in the project or trust the responsible handling of the project by its developers and community members.

Examples of stablecoins

Crypto-backed stablecoin: MakerDAO (DAI)

DAI is a cryptocurrency-backed stablecoin designed to mirror the value of USD on the Ethereum blockchain. The governance token MKR empowers the MakerDAO community to oversee the management of DAI. MKR token holders can propose and vote on changes to the project. To address the inherent volatility of cryptocurrencies, DAI is over-collateralized, and users engage in Collateralized Debt Positions (CDPs) to manage their collateral. The entire process operates through smart contracts, ensuring transparency and efficiency.

Fiat-backed stablecoin: TrueUSD (TUSD)

TUSD is an independently verifiable dollar-pegged stablecoin. It is the first stablecoin to programmatically control minting with instant on-chain verification of USD reserves held off-chain. TUSD's reserves are monitored using Chainlink Proof of Reserve so that holders can autonomously verify that their TUSD is backed by USD held in reserves.

Fiat-backed stablecoin: USD Coin (USDC)

USD Coin (USDC) is a digital currency supported by a reserve of U.S. dollar assets. Each USDC coin is tokenized to represent a 1:1 value equivalence with one U.S. dollar. The primary aim of USDC is to ensure stability, making it a stablecoin.

Fiat-backed stablecoin: Tether (USDT)

Tether (USDT) is a stablecoin in the cryptocurrency market, designed to be pegged to the U.S. dollar and fully backed by reserves held by Tether according to its website. iFinex, a Hong Kong-registered company, owns Tether and also operates the crypto exchange BitFinex. Originally operating on the Bitcoin blockchain, Tether now supports multiple protocols such as Omni, Liquid, Ethereum, TRON, EOS, Algorand, Solana, and Bitcoin Cash (SLP) blockchains.

As of January 2023, Tether holds the position of the third-largest cryptocurrency, following Bitcoin (BTC) and Ethereum (ETH). With a market capitalization reaching nearly $68 billion, Tether remains the largest stablecoin in the market. In 2022, Tether's USDT was the primary choice for trading on most exchanges, surpassing the value of Bitcoin in trading volume.

Commodity-backed stablecoin: Tether Gold (XAUT)

Tether, the entity responsible for the widely used USDT stablecoin, has introduced another stable digital asset called XAUT. This cryptocurrency is specifically designed to track the value of gold, offering a convenient and accessible means for individuals to invest in the precious metal. Each unit of Tether Gold (XAUT) is equivalent to the value of one troy fine ounce of gold, and these tokens are fully backed by physical London Good Delivery (LGD) standard bars. According to LGD guidelines, each bar must contain 400 troy ounces of gold.

Regulation of stablecoins

Stablecoins have garnered the attention of regulators worldwide because of their distinct blend of fiat and cryptocurrency features. Their primary purpose of maintaining a stable value makes them valuable beyond speculative purposes, enabling swift and cost-effective international transactions. In some nations, there are even explorations into developing their own stablecoins. However, since stablecoins are a form of cryptocurrency, they are likely subject to the same regulatory requirements as other cryptocurrencies in your local jurisdiction. Additionally, issuing stablecoins backed by fiat reserves may also necessitate regulatory approval.

In summary

In these times, it's rare to come across an investor or trader who hasn't had experience with stablecoins. These digital assets are commonly held in cryptocurrency exchanges, allowing traders to swiftly take advantage of emerging market opportunities. Their convenience extends to facilitating easy entry and exit from positions without the need to convert to fiat currency. Apart from their significance in trading and investment, stablecoins have proven valuable for making payments and conducting international transfers.

However, it's crucial not to overlook the risks associated with stablecoins. Some projects have encountered issues with maintaining their pegs, inadequate reserves, and legal disputes. While stablecoins offer exceptional versatility and have revolutionized the financial landscape, it's essential to recognize that they remain cryptocurrencies and carry inherent risks. Diversifying your investment portfolio can help mitigate risks, but conducting thorough research before investing or trading is imperative. Furthermore, it's wise not to invest more than you can afford to lose.

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