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What Are Stablecoins?
Stablecoins are cryptocurrencies that aim to maintain a stable value. While Bitcoin and Ethereum —as well as the majority of other digital currencies— are known for their volatility, stablecoins are pegged to the value of a fiat currency, commodity, or another real-world asset for relative stability.
In this guide, we’ll dive into the different types of stablecoins available, examine the risks and benefits, and discuss the current state of the market.
Why are stablecoins important?
A stablecoin is a type of cryptocurrency that is pegged 1:1 to the value of an asset, such as the US dollar, in order to reduce its volatility and provide stability. The aim is to create a digital currency with low price volatility, making it more usable for transactions and avoiding the large price swings often seen in other cryptocurrencies.
Stablecoins can be transferred across borders much more easily than traditional currencies. They also offer lower fees and faster processing times. In short, you get a perfect mixture of the convenience of cryptocurrency with the stability of a fiat currency.
Why should I know about the different forms of stablecoins?
Knowing the different types of stablecoins allows you to understand the benefits and drawbacks of each specific type and make more informed decisions regarding the usage and potential investment as you navigate the crypto market.
Different forms of stablecoins
A fiat-backed stablecoin is backed 1:1 by a corresponding amount of fiat currency held in reserve. For instance, If a coin is pegged to the US dollar, whoever issues it must hold an equivalent amount of US dollars or treasury bills in reserve to back it.
- Reduced volatility- Since the value of a fiat-backed stablecoin is pegged to a fiat currency, it’s less susceptible to price fluctuations. This is a big plus in the event of a crypto collapse.
- Simplicity- With the value tied to a fiat currency, stablecoins are much more likely to be accepted by businesses.
- Stability- You can predict the value of a fiat-backed stablecoin much easier.
- Centralization- Such stablecoins are often issued by centralized organizations, which isn’t the most ideal scenario in the crypto community.
- Highly regulated- Some countries have strict regulations on the issuance and use of stablecoins. If you want to exit the stablecoin, you’ll need to wire money or mail checks, which isn’t the fastest (and cheapest) process.
Tether (USDT) is among the most widely used stablecoins along with USD Coin (USDC). Both are pegged to the US dollar, while USDC is issued by Circle and used in DeFi.
Crypto-backed stablecoins are stablecoins that are collateralized or backed by a reserve of cryptocurrencies, such as Bitcoin or Ethereum, rather than a fiat currency like the US dollar. The idea behind this is that the reserve of cryptocurrencies acts as a guarantee for the value of the stablecoin, helping to keep its value stable. The stability of the stablecoin’s value is maintained by adjusting the supply in response to changes in demand so that it remains pegged to the value of the underlying assets. These stablecoins can be used for transactions and as a store of value, just like any other cryptocurrency.
- Decentralized- You can use them for cross-border transactions and trading, as well as purchasing goods and services.
- Transparent- Easy for anyone to inspect the collateralization ratio of the stablecoin.
- Can be auto-liquidated- When there’s a price crash, which can happen spontaneously, the stablecoin can be destroyed. Also, there’s a risk that the issuer of the stablecoin becomes insolvent.
- Less stable- They’re tied to the health of a particular cryptocurrency, which makes them dependent on the security of the underlying blockchain and smart contract technology.
- Limited utility- Not all businesses accept crypto-backed stablecoins yet.
DAI is backed by Ethereum and other cryptocurrencies held in a decentralized collateral pool. It is designed to maintain a stable value relative to the US dollar and is used as a medium of exchange on decentralized platforms.
This one is also pretty straightforward: commodity-backed stablecoins are tied to the value of a commodity, such as gold or oil, held in a secure storage facility.
Since they’re backed by a physical asset with a relatively stable value, such coins are designed to reduce volatility and provide another option to diversify.
- Security- Commodity-backed stablecoins are pegged to tangible assets, so they provide a sense of security for investors.
- Low volatility– Less volatile than other types of stablecoins.
- The ability for diversification- They can be used as a hedge against inflation.
- Counterparty risk- There’s always the risk that the issuer may default or become insolvent.
- Less transparency- It may be difficult for holders to verify that the stablecoin is truly backed by the commodity it claims to be.
- Regulations- Governments may always impose regulations on either stablecoins or the underlying commodity.
Some examples of commodity-backed stablecoins include DigixDAO (DGX), which is backed by gold and supported by Ethereum, and Tiberius coin (TCX), which is pegged to a basket of metals, including gold, silver, copper, and palladium.
An algorithmic stablecoin is a type of stablecoin that uses complex algorithms and smart contracts to maintain its stability, rather than being collateralized or backed by a reserve of assets. The value of an algorithmic stablecoin is kept stable through dynamic adjustment of supply, driven by a set of rules encoded in its underlying smart contract. The rules may include adjusting the token’s supply based on changes in demand, as well as other factors like interest rates or inflation.
- Reduced counterparty risk- Algorithmic stablecoins don’t rely on external assets to maintain their value.
- Flexibility- There’s more room for precise control over the value of the coin, which, in turn, helps to minimize the risk of large price fluctuations.
- Transparency- Since they’re built on blockchain, it’s easier to see how the coin’s value is maintained.
- Decentralization- Since algorithmic coins aren’t controlled by any single entity, the risk of censorship is highly reduced.
- Oracle-dependent- As the coin may rely on external data providers, there’s a risk that the oracles fail to give accurate data.
- Code dependency- makes the coins vulnerable to hackers, bugs, and errors. Algorithmic coins are built on complex code, which, in turn, can be vulnerable to system malfunction, hacking, and theft.
- Market manipulation- The market is very young and the trading volume isn’t high enough, potentially luring large holders and whales.
CBDCs, or Central Bank Digital Currencies, are digital versions of fiat currencies issued and backed by a central bank. These currencies are similar to good old physical banknotes and coins, which gives them the same level of security and trust. CBDCs offer the following potential benefits:
- Improved Financial Inclusion: CBDCs can potentially provide access to financial services to those who are currently unbanked or underbanked.
- Increased Efficiency: CBDCs can offer faster and cheaper cross-border payments and reduce the need for intermediaries.
- Enhanced Security: CBDCs can reduce the risk of fraud and counterfeiting and improve the security of payment transactions.
- Increased Transparency: CBDCs can provide better tracking of transactions and enable central banks to better monitor and regulate the financial system.
Jamaica, the Bahamas, and China have all launched fully-fledged CBDCs with Sweden, Japan, and the EU still in phases ranging from experimentation to pilots.
CBDCs vs Stablecoins
While CBDCs and stablecoins are both digital currencies, they have some key differences.
CBDCs are issued and backed by central banks, designed to be a medium of exchange with the same level of security and trust. Stablecoins, on the other hand, are cryptocurrencies pegged to the value of a fiat currency, commodity, or other asset and can be used as both a medium of exchange and a store of value. Like CBDCs, stablecoins can be centralized like Tether, but there are also decentralized coins, like Dai.
CBDCs are typically accessible to any holder of an account of a national financial institution. If you want to buy stablecoins, all you really need is access to the internet and a digital wallet. Plus, stablecoins are already in the market, while CBDCs are largely still in the experimental phase.
There’s no doubt that stablecoins are critical to the future of crypto, although crypto has taught us that the future is highly unpredictable. We might know for sure, though, that stablecoins have the potential to revolutionize money.
Of course, a perfect coin just doesn’t exist. Like with most technologies, including blockchain, the best option is always to study and eventually accept the risks.
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