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What Are Stablecoins and How Do They Work?
What Are Stablecoins and How Do They Work?
To combat high volatility and increase participation in a larger community, crypto projects are incorporating price stability directly into their digital assets, bringing about a whole new subset of cryptocurrencies in stablecoins.
As their name suggests, stablecoins are intended to be volatility-minimized assets whose price mirrors fiat currencies such as the U.S. dollar. To fully understand the potential of stablecoins and how they work in tandem with more volatile cryptocurrencies, we need to dive a little deeper.
What is a stablecoin?
A stablecoin is a type of cryptocurrency whose value should tie to another relatively “stable” asset like the U.S. dollar, euro, or gold.
Most largest cryptocurrencies by market-cap, on the other hand, are volatile. Many argue that these assets are difficult to use as a means of payment because of this volatility. For example, the value of one Bitcoin at one point could only buy a candy bar in 2010, but the same Bitcoin today may be equivalent to the price of a car. There are other cryptocurrencies whose value has decreased by as much as Bitcoin's value has risen. This volatility can be difficult because, as a purchaser, you want some stability in the asset you transact.
Stablecoins offer an alternative option by reducing this volatility, potentially making them more suitable for regular use. Borderless payments, low transaction fees, self-custody options, and a combination of conventional fiat currency stability with digital asset flexibility make stablecoins appealing to millions. To understand why, we must first know how stablecoins work.
Is Bitcoin a stablecoin?
Bitcoin (BTC) is not a stablecoin. Stablecoins aim to maintain a stable value through fiat currencies or other assets like gold. Bitcoin’s value is volatile in comparison. To learn more about Bitcoin click here.
What can we do with stablecoins?
Stablecoins seem to be a promising asset on paper, but what can we do with them? Are they practical enough for real-life use? The answer is yes. Here are a few ways we can use stablecoins:
- Store value: In comparison to traditional cryptocurrencies, which are volatile, stablecoin value usually remains consistent to the asset they are pegged to - this allows stablecoin holders to store value.
- Trade assets: When trading cryptocurrencies, users can use stablecoins as trading pairs, which helps them maintain value and have a more practical correlation of the cryptocurrency's value.
- Earn interest: By lending stablecoins, users can earn interest. It should be noted that these staking services are often risky and not permitted in some countries - make sure to assess any risks before using such products.
- Transfer money at low costs: Users don’t need to pay large transfer fees to send money cross-border. With stablecoins operating on low-fee chains, the price of transacting can be less than a few cents. In addition, stablecoins don't require a bank account to send money worldwide.
- Send money internationally: Low transaction fees and quick processing mean that one doesn’t have to wait to send or receive money across borders. Stablecoins offer a fast and affordable way to send money globally without hassle. Sending $200 cross-border in stablecoins can cost less than $0.10, compared to the global average charge of $12 through traditional methods.
How do stablecoins help as a hedge against inflation?
Many traditional fiat currencies are prone to inflation, especially in economies with high interest rates. On the contrary, currencies like the US dollar or the euro have been more resistant to inflation in the past 20 years. Stablecoins like Tether and USDC are pegged to the US dollar, meaning they may inflate less than local currency. Individuals can exchange their money for stablecoins and get exposure to US dollar inflation, allowing their money to maintain more of its value.
As a result, stablecoins enable users to have the same store of value opportunity as US Dollar holders, no matter where they are from. Any individual with internet access can use stablecoins to transact daily.
What are the types of stablecoins?
Stablecoins come in various types. Each employs a mechanism to stabilize their value.
Fiat-backed stablecoins aim to maintain a reserve ratio of 1:1 with its respective currency. For example, Tether is pegged to the US dollar at a 1:1 ratio, meaning that one unit of tether should be backed by one unit of US dollar, and the total market cap of tether should be backed 1:1 with assets.
A central bank digital currency (CBDC) is an electronic version of a fiat currency. The key difference between existing cryptocurrencies and CBDCs is that the latter is government-backed and issued by a country’s central bank. CBDCs are tied to the value of the central currency of the issuing government.
Let’s look at the different types of stablecoins to understand how they’re backed:
- Fiat-collateralized stablecoins – Fiat-collateralized stablecoins keep a reserve of a fiat currency like the US dollar as collateral to ensure the value of a stablecoin remains stable.
- Commodity-backed stablecoins – Commodity-backed stablecoins use collateral such as precious metals like gold and silver or commodities such as crude oil.
- Crypto-collateralized stablecoins – Crypto-collateralized stablecoins tie to other cryptocurrencies like Bitcoin or Ether. Reserve cryptocurrencies can be volatile, so their reserves must exceed the market cap of the stablecoin, leading to over-collateralization to ensure sound economic design.
- Algorithmic stablecoins – Algorithmic stablecoins use algorithms and economic design to maintain a consistent market value. These stablecoins are unproven and of highest risk today, and many have seen their values go to zero, destroying billions of dollars of value.
What are the most popular stablecoins?
Now that we’ve understood the different types of stablecoins and how they work, it’s time to look at the most popular stablecoins available on the market.
Tether (USDT)
With a market capitalization of around $65 billion, Tether is the world’s most popular fiat-backed stablecoin. It was also the first stablecoin on the crypto market and has the highest number of global transactions, making it the most liquid stablecoin. There have been accusations that USDT is not backed 1:1 like they claim, although this is yet to be proven.
USD Coin (USDC)
As the name suggests, USD Coin ties to the value of the US dollar. It is a fiat-collateralized stablecoin. This means one can buy one USDC for $1 or redeem one USDC for $1 at any given time. At the time of writing, a total of 55.8 billion USD Coins are in global circulation.
Binance USD (BUSD)
Currently the third-largest stablecoin by market cap at $17.5 billion, Binance USD is a fiat-backed stablecoin project initiated by the crypto exchange platform Binance in collaboration with Paxos. BUSD maintains a 1:1 ratio with the US dollar.
Dai (DAI)
MakerDAO launched Dai on the Ethereum blockchain in 2017. Dai, a cryptocurrency-backed stablecoin, uses ether (the cryptocurrency on Ethereum’s platform) as backing, while its value ties to the US dollar. Unlike other stablecoins, DAI is decentralized and uses smart contracts and incentives as the mechanism to maintain its peg.
TrueUSD (TUSD)
TrustToken’s TUSD is a fiat-collateralized stablecoin that exists on the Ethereum blockchain. Each TUSD token currently maintains a 1:1 ratio with the US dollar. Users can mint and redeem TUSD tokens on TrustToken's website.
What are the risks of stablecoins?
Stablecoins may seem like the best of both worlds. However, they carry their own risks.
- Depegging: Stablecoins aim to maintain a constant value backed by a fiat currency. Depegged stablecoins refer to stablecoins that fall from their intended value. Luna is the largest example of this, when its depeg lost investors tens of billions of value.
- Regulatory risks: Stablecoins, despite being pegged to fiat currencies, are still susceptible to regulatory risks. For example, Meta, the parent company of Facebook, initially planned to launch its own stablecoin, called Diem, in 2020. However, the company canceled the launch due to concerns and backlash from financial regulators.
- Some lack transparency: Ideally, currency reserves would back stablecoins with cash or other secure assets. However, without any oversight, it's difficult to know whether stablecoins receive as much support as they claim to. A lack of backing could lead to a dire situation like TerraUSD's collapse, in turn affecting the entire crypto market.
- Inflation of pegged assets: While stablecoins are meant to shield from inflation, they still inflate at the rate of their pegged assets. For example, if the US dollar’s inflation rate is more than 9%, the price of the asset increases, meaning what somebody could buy for $100 some time ago would now cost $109. A proposed solution to this is flatcoins, whose value would be backed by a basket of goods, thus not inflating. Although flatcoins are yet to be implemented, they could, one day, be the largest medium of exchange in the world.
Ready to buy?
Buying stablecoins is the gateway to most marketplaces. Rather than watching the fiat currency value of cryptocurrencies fluctuate while deciding on the next trade, stablecoins offer a way to ensure a purchase holds roughly the same value between trades. While this is a great shelter from volatility, it’s upside is capped at that of the pegged asset. Users may be protected from sharp decreases in value for the most part, but they can’t expect much in the way of increased returns, either.
Worldcoin, a new cryptocurrency but not a stablecoin, aims to give every human on Earth a free share without compromising privacy. At Worldcoin, we aim to increase individual empowerment and equality of opportunity globally. Subscribe to our blog for more news and information on the world of cryptocurrency!