Cryptocurrencies are extremely volatile, and it’s not uncommon to see large price fluctuations every day.
Your assets could pull a 100% gain or loss in hours, and this high volatility is one of the main reasons many are scared of investing in crypto.
Also, it makes them unsuitable for everyday use for the purchase of goods and services.
For example, if you’re a seller, by the time you receive a cryptocurrency payment, the value could be anywhere far above or below the cost of what you sold.
And that’s where stablecoins come in.
What are stablecoins?
Stablecoins are cryptocurrencies with a fixed value that is pegged to a fiat currency such as the USD, EURO, YEN, etc.
They’re usually backed by fiat or other reserve assets, such as gold, real estate, other cryptocurrencies, etc.
This means that for every stablecoin in circulation, there is an equivalent amount of fiat currency or other assets held in reserve.
Stablecoins provides you with the best of the worlds of cryptocurrencies and traditional fiat.
First, they enable you to make instant, secure, and anonymous payments anywhere in the world like any other crypto.
And secondly, like fiat, they preserve the face value of your money and protect you from the extreme volatility of cryptocurrencies.
But all stablecoins are not equal.
Categories of stablecoins
There are 4 different types of stablecoins, based on how they work to maintain their stable price.
- Fiat-backed stablecoins
- Crypto-backed stablecoins
- Algorithmic stablecoins
- Commodity-backed stablecoins
Let’s examine each of them below.
1. Fiat-backed stablecoins
These stablecoins were the first to emerge in the market and their values are pegged to one or more fiat currencies such as the USD, and Euro on a 1:1 basis.
For fiat-backed stablecoins, the amount of the coin in circulation must be exactly what it has in its fiat currency reserves.
Otherwise, it risks de-pegging in the event of a bank run.
If you want 1,000,000 USDT coins, you give Tether (the issuing company) $1,000,000 and they mint them for you.
If you need your money back in USD, you return the 1,000,000 USDT to Tether, they burn or destroy it and give you back your $1,000,000.
So, for every USDT minted, $1 USD is held in reserve either as cash, treasury bills, fiduciary deposits or other liquid assets.
2. Crypto-backed stablecoins
Crypto-backed stablecoins such as Dai (DAI) are backed by other cryptocurrencies such as Bitcoin, ETH, USDC, etc.
For example, to mint 1,000,000 DAI tokens, you must deposit $1,000,000 or more of ETH on MakerDAO.
The value of your ETH deposit will be used as collateral to back the DAI you have minted.
And if the value of your ETH deposit falls below $1,000,000, then the MakerDAO protocol will sell your ETH to pay for the DAI.
This is because the MakerDAO protocol requires that the value of your collateral be at least equal to the value of the DAI you have minted.
This is called liquidation and is designed to protect the stability of the DAI system and ensure that there is always enough collateral to back the DAI in circulation.
How do crypto-backed stablecoins maintain their value?
The value of crypto-backed stablecoins is maintained through a process called arbitrage.
This means that if the price of the stablecoin falls below its $1 peg, traders can buy the stablecoin at a discount and then redeem it for the underlying cryptocurrency, e.g. ETH.
This would increase the demand for the stablecoin and drive the price back up to its $1 peg.
Similarly, if the price of the stablecoin rises above its $1 peg, traders can sell the stablecoin for a profit and then buy the underlying cryptocurrency, e.g. ETH.
This would increase the supply of the stablecoin and drive the price back down to its $1 peg.
Here is a simple illustration of how arbitrage works to maintain the value of a crypto-backed stablecoin such as DAI:
- Imagine that the price of DAI falls to $0.90.
- Traders will see this as an opportunity to buy DAI at a discount.
- They will buy DAI for $0.90 and then redeem it for ETH, which is currently worth $1. (Remember, 1 DAI is worth $1 of ETH).
- This will increase the demand for DAI and drive the price back up to $1.
The same principle applies if the price of DAI rises above $1.
Traders will sell DAI for a profit and then buy ETH, which will increase the supply of DAI and drive the price back down to $1.
Arbitrage is a powerful force that helps to maintain the value of crypto-backed stablecoins.
It ensures that the price of the stablecoin always stays close to its $1 peg, even if the price of the underlying cryptocurrency fluctuates.
3. Algorithmic stablecoins
Algorithmic stablecoins are not backed by any underlying assets like fiat or crypto but rely on algorithms to maintain their $1 peg.
These stablecoins work by creating a system of incentives that encourage users to buy and sell the stablecoin when its price deviates from its $1 peg.
For example, if the price of an algorithmic stablecoin falls below its peg, then the algorithm will incentivize users to buy the stablecoin by increasing the rewards for doing so.
This will increase the demand for the stablecoin and drive the price back up to its $1 peg.
Similarly, if the price of the stablecoin rises above its $1 peg, then the algorithm will incentivize users to sell the stablecoin by decreasing the rewards for doing so.
This will increase the supply of the stablecoin and drive the price back down to its $1 peg.
Frax (FRAX) is a good example of a functioning algorithmic stablecoin. Another example was the TerraUSD which failed spectacularly in May 2022.
Algorithmic stablecoins are very risky and prone to sharp, irrecoverable collapses if trust in the system is broken or the protocol is exploited.
4. Commodity-backed Stablecoins
Commodity-backed stablecoins are a type of stablecoin that is backed by a physical commodity, such as gold, silver, or oil.
This means that the value of the stablecoin is pegged to the price of the underlying commodity instead of $1 (like the other stablecoins discussed above)
How do commodity-backed stablecoins work?
Commodity-backed stablecoins are minted by depositing the underlying commodity into a trust.
The trust then issues tokens that represent ownership of the commodity. These tokens can then be traded on exchanges or used to purchase goods and services.
The value of commodity-backed stablecoins is maintained by the trust. The trust will redeem tokens for the underlying commodity at a fixed price.
This ensures that the value of the tokens always stays close to the price of the underlying commodity.
For example, Paxos Gold (PAXG) is a gold-backed stablecoin created by Paxos, a financial technology company based in New York.
Each PAXG token is backed by one fine troy ounce of gold, which is stored in Brink’s vaults in London.
The value of PAXG is pegged to the price of gold, meaning that one PAXG token is always worth approximately the same as one ounce of gold.
How can I get stablecoins?
You can buy any stablecoin from cryptocurrency exchanges using fiat or any other crypto, or mint them directly on their respective platforms.
Direct dealing with stablecoin issuers like Tether (USDT) or Circle (USDC) is usually done by institutional investors and registered dealers.
What are Stablecoins used for?
Stablecoins are used for a variety of purposes, including:
- As a store of value: Stablecoins are designed to be less volatile than other cryptocurrencies, making them a good option for investors who are looking for a way to store their wealth without having to worry about wild price swings.
- As a medium of exchange: Stablecoins can be used to buy and sell goods and services, just like traditional currencies. This makes them a convenient option for merchants who want to accept cryptocurrency payments without having to worry about the volatility of other cryptocurrencies.
- As a hedge against inflation: Stablecoins are not subject to the same inflationary pressures as traditional currencies, making them a good option for investors who are looking to protect their wealth from inflation.
- For margin trading: Stablecoins can be used as collateral for margin trading, which allows traders to borrow money to increase their trading positions. This can be a risky strategy, but it can also be a way to generate profits from small price movements.
- For staking or lending: Stablecoins can be staked or lent to earn interest, which can be a passive way to generate income in crypto.
Overall, stablecoins offer a number of benefits that make them a valuable tool for investors, traders, and merchants.
As the cryptocurrency market continues to grow, it is likely that stablecoins will become even more widely used.
What are the best stablecoins?
The “best” stablecoins are the ones that function as designed or serve the purpose they’re created.
Overall, a good stablecoin should maintain its peg, be easily accessible or tradeable, and have some utility in DeFi.
On that note, some of the best and most popular stablecoins you can consider are:
- Tether (USDT)
- USD Coin (USDC)
- Dai (DAI)
- Frax (FRAX)
- Pax Dollar (USDP)
- Pax Gold (PAXG)
Now over to you, which are your favourite stablecoins?