When you first enter the fascinating world of crypto, you have to learn to navigate many concepts fast and accumulate knowledge about digital assets, the cryptocurrency market, play-to-earn crypto games, and all sorts of cryptocurrencies.
We've been talking lately about price volatility and how crypto volatility goes hand in hand with most digital currencies in the crypto markets. There is one type of crypto, though, that is specially designed to ensure price stability. We're talking about stablecoins, and in this article, we're going to cover them in depth:
- We will answer the question " What are stablecoins?" and see how exactly they work.
- We're going to learn that there are several types of stablecoins in the crypto ecosystem, classified depending on what asset class backs them up.
- We will look at the stablecoin regulation and different regulation proposals that politicians and other institutions are trying to enforce.
- We will check some of the most popular tokens in the stablecoin market. Finally, we'll be able to understand if stablecoins present any risks for potential investors.
Let's jump right in!
What is a stablecoin?
Stablecoins are cryptocurrencies designed to maintain a stable price over extended periods of time by being pegged to the value of an underlying asset. This asset can be fiat currency like the U.S. dollar, or it can be a commodity, a commercial paper, or a financial instrument. Stablecoins aim to combine the best of both worlds: they provide the benefits of cryptocurrencies but try to avoid the extreme price volatility characteristic of any digital currency altogether.
Even the biggest and most popular crypto coins like Bitcoin or Ethereum are affected by volatility and can experience major ups and downs. By keeping reserve assets on hand as collateral or by using supply-controlling computational algorithms, stablecoins aim to maintain price stability.
Fiat currencies like the U.S. dollar or the Euro don't experience such high price fluctuations. You can think of a stablecoin as a tokenized version of a fiat currency. Theoretically, stablecoins backed by the U.S dollar are tokens that reside on the blockchain and always trade for the same value: one dollar.
How do dollar-denominated assets work?
Let's explore further how stablecoins work. We've established earlier that this type of digital asset is backed up by the specific assets it is pegged to. They can be either fiat currencies or commodities like precious metals.
For example, stablecoin issuers set up a reserve at a financial institution holding the underlying tokenized asset. A stable currency might have a reserve of $100 million and generate 100 million coins with a fixed value of one dollar each. When a stablecoin holder wants to cash out the crypto tokens he has, the real money can be taken out from the reserve currency.
Other cryptocurrencies like Bitcoin don't benefit from the stablecoin technology, meaning they aren't backed by anything. That is why volatile cryptocurrencies fluctuate as the market price falls or rises. Hard assets back most stablecoins, but there are other stablecoins that use an algorithmic stablecoin system to keep the price of the stablecoin tokens at a fixed value.
Types of stablecoins
Stablecoins can be divided into several categories based on their collateral structure: fiat-backed, crypto-backed, commodity-backed, or algorithmic. We'll study each of these categories to understand the mechanism better:
Traditional collateral ( backed by fiat currency)
Fiat-collateralized stablecoins are the most popular, being backed entirely by fiat currencies. Because the underlying assets are an actual currency, these stablecoins are considered off-chain assets.
The cash equivalents of the stablecoins must be in reserve with the central issuer or financial institution, and the circulating supply of tokens should always be proportionate to the reserve currency.
Tether (USDT), the Gemini Dollar (GUSD), True USD (TUSD), and Paxos Standard (PAX) are some of the largest stablecoins in this category by market capitalization.
Crypto collateral (backed by another cryptocurrency via smart contracts)
Crypto-collateralized stablecoins are backed by another cryptocurrency as collateral. Instead of relying on a central issuer, these stablecoins employ smart contracts, and the whole process is on-chain. Purchasing such stablecoins implies locking your tokens into a smart contract to get coins of equal value. If you want to withdraw your original collateral amount, you can put your stablecoins back in the original smart contract.
Another feature of this type of stablecoins is that they are over-collateralized. The value of the cryptocurrency held in reserve is much greater than the value of the tokens issued. A cryptocurrency worth $2 million might be retained as a reserve in order to issue $1 million stablecoins, protecting against a 50% drop in the price of the reserve cryptocurrency.
The DAI stablecoins pertain to this category. DAI is pegged to the U.S. dollar and backed by ETH, Ethereum's cryptocurrency.
An algorithmic stablecoin does not use collaterals like the U.S. dollar, financial products, or cryptocurrencies. These tokens use an algorithmic stablecoin system that ensures price stability through circulating token supply management.
The system uses a smart contract that reduces the number of tokens in circulation when the market price declines to a level below the price of the fiat currency it tracks. On the other hand, if the token price is higher than the price of the actual dollars, the stablecoin issuer introduces new tokens into circulation.
This last type of stablecoins uses commodities as collateral. Physical assets such as precious metals, oil, and real estate are examples of commodities. Gold is the most popular commodity to be used as collateral, with both Tether Gold (XAUT) and Paxos Gold (PAXG) using it.
With commodity-backed stablecoins, token holders have the unique opportunity to exchange the stablecoins for the tokenized asset, such as a gold bar. This mostly applies to gold-backed stablecoins that can be used to redeem the physical gold.
Stablecoins are under quite some scrutiny from traditional financial system regulators and politicians as they have the potential to disrupt the financial markets. Last year, the International Organization of Securities Commissions(IOSCO) proposed that stablecoins be regulated like financial market infrastructure alongside payment systems and clearinghouses.
Regulators fear that these inherently stable assets have the ability to disrupt payment and settlement transactions. Since the cryptocurrency market is ever expanding, there have been increased calls for tighter regulation of stablecoins.
There are concerns that crypto trading with these coins can be risky for financial stability if, for example, way too many stablecoin holders try to cash out their coins at once.
The hard assets that back up stablecoins can lose value or liquidity in times of extraordinary market stress. As a result, pressure on these underlying assets could result from a run on the stablecoin, which would then affect the conventional financial system.
What are the most popular stablecoins?
There are many stablecoins available right now on the market, from algorithmic stablecoins to the ones pegged to gold or the U.S. dollar. We will check some of the most popular stablecoins based on their past performance, market cap, and longevity.
Tether (USDT) was launched in 2014 and is one of the oldest and most valuable stablecoins by market cap. USDT is mainly used to move money between exchanges fast when other cryptocurrencies have different prices on different exchanges. Based on this discrepancy, experienced traders base their financial decisions in order to make a profit.
Copyright © Tether
The USD coin or USDC was launched in 2018 in a joint effort by cryptocurrency companies Coinbase and Circle. This stablecoin is pegged to the U.S. dollar, and it's an open-source protocol, meaning anyone can use it to develop their own products.
DAI is a stablecoin running on the Ethereum blockchain, part of the MakerDAO protocol. DAI was created in 2015, and it is both pegged to the U.S. dollar and backed up by ETH, the native cryptocurrency of Ethereum.
MakerDAO's aim for DAI is to make it a fully decentralized coin, having no central authority or a qualified professional in control of the system. The job is done by a smart contract instead.
Copyright © DAI
Compared to more volatile cryptocurrencies, these coins present much lower risks, but that doesn't mean that they are utterly void of any typical crypto risks:
Security risk: Stablecoins need to be stored someplace, much like other cryptocurrencies, whether in your personal crypto wallet, with a broker, or on an exchange. If any of these platforms or systems have flaws or security risks, your crypto would also be compromised.
Counterparty risk: When it comes to this particular type of crypto, you are dealing with several parties involved, like the banks holding the reserve currencies or the organization that issued the stablecoin. Any issues these parties could have would directly affect the value of the stablecoin.
Reserve risk: The reserves that support a stablecoin are a crucial component of the stablecoin ecosystem. They are the final safeguard for a stablecoin's worth. Stablecoin issuers can't guarantee a fixed value without them.
Lack of confidence: A stablecoin can run the risk of losing its peg to the target currency if hard assets do not properly support it. Remember what happened to TerraUSD back in May this year? The stablecoin wasn't supported by fiat currency but by other crypto tokens. When token holders started to lose faith in its ability to maintain the peg, it all went downhill. TerraUSD's price collapsed and went on a downward spiral that nobody could have predicted.
Stablecoins provide some of the much needed stability that cryptocurrencies in general lack. However, they are not without risks, as we have just discovered. Before investing in a stablecoin, read the fine print on the issuer's statements. Check for the reserve reports and if they lack, proceed with caution. As always, we recommend DYOR!
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