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What Are Stablecoins and Why Should You Care About Them?

  • Stablecoins are digital currencies with a stable price.
  • They are alternatives to traditional money when switching between volatile cryptos.
  • Stablecoins are backed by relatively stable underlying assets; they come in four types.
  • Stablecoins can be used to earn interest and stake.

Imagine the crypto you hold just reached an all-time high. Naturally, this is a good time to sell it, take a profit and rebuy after the coin’s price drops again.

The problem is most crypto exchanges do not allow trading digital coins to traditional money directly. Selling them to another volatile crypto is not an option if you aim to preserve value. This is where stablecoins help.

What Are Stablecoins?

Stablecoins are digital currencies with a stable price. Their value is tied to other assets that are more or less stable. Usually, this more stable asset is traditional currency, a commodity or another digital coin.

The value of stablecoins is fixed, so they can be used as a practical alternative to traditional money when switching between volatile cryptos. Moreover, they could become a faster and cheaper alternative to payment transfers. However, since their return rate is low, stablecoins are not an investment option.

How Do Stablecoins Work?

Stablecoins are backed by more stable underlying assets. Simply speaking, stablecoins have anchors that allow them to manage price volatility while maintaining stability.

This is possible because of collateralization. For example, in taking out a loan one needs to collateralize some property in order to receive it. Collateral offers security to the lender and as such, assets secured by collaterals are supposed to involve less risk.

The same is true with stablecoins; they are backed by the reserves of different underlying assets which gives them price stability. According to the types of these underlying assets, stablecoins are divided into four categories.

The Four Types of Stablecoin

1. Fiat-Backed Stablecoins

The most common type of stablecoins. These stablecoins are tied to traditional fiat currencies and rely on their value in order to compensate for any possible volatility. Usually, they are pegged to the United States dollar in a 1:1 ratio.

  • Pros:
    Operate off-chain.
    Easy to understand.
  • Cons:
    Require management by a central entity.
    Require auditing if the token is still collateralized.
    Require third-party custody.
    Underlying assets at risk of inflation.
  • Examples:
    Tether (USDT), USD Coin (USDC), TrueUSD (TUSD), Gemini Dollar (GUSD), Pax Dollar (PAX aka USDP).

2. Commodities-Backed Stablecoins

Commodity-backed stablecoins rely on the value of precious metals, oil or real estate.

Gold is the most common physical reserve asset to which stablecoins are pegged. Such stablecoins are usually fixed to the value of a certain quantity of precious metal, for example, one troy ounce of gold.

  • Pros:
    Value fixed on a stable amount of commodity.
    Commodities have high demand and are liquid assets.
  • Cons:
    Commodities still fluctuate in value.
    Require third-party custody.
  • Examples:
    Tether Gold (XAUT), Paxos Gold (PAXG), Gold Secured Currency (GSX),  Digix Gold Token (DGX).

3. Crypto-Backed Stablecoins

Stablecoins can be tied to other cryptocurrencies like Bitcoin or Ethereum, or as a basket of them. The key difference from fiat-backed stablecoins is the decentralization and usage of smart contracts. In this case, keeping the stable value is harder, as cryptos are highly volatile assets. However, the currency used as collateral is set to always have a higher value than stablecoins. For example, the ratio is usually 1:2 in favor of stablecoins over crypto (e.g. $100 of DAI stablecoins = $200 of ETH).

  • Pros:
    Decentralization; smart contracts are not related to central authorities.
    No custodian is required.
  • Cons:
    Harder to keep the price stable.
    Over-collateralized (1:2 ratio).
    Complicated structure.
  • Examples:
    DAI, EOSDT.

4. Algorithmic Stablecoins

Algorithmic stablecoins are the most recent and rare form of stablecoins. They are not tied to any other reserve asset (fiat, gold or crypto). Instead, their price stability depends on smart contract algorithms.

Algorithms track the demand for the stablecoin and adjust its supply accordingly. This allows the modification of the stablecoin’s value to keep it stable.

  • Pros:
    No collateral is required.
    Most decentralized stablecoins.
  • Cons:
    Risk of manipulation.
    Algorithms may fail.
  • Example:
    CryptoSaga (SAGA),  FRAX, Fei Protocol (FEI), Empty Set Dollar (ESD).

How to Use Stablecoins

1. For Payments

Volatility is one of the biggest obstacles to greater cryptocurrency adoption. No one wants to use cryptos as means of payment when their price may significantly change in an hour.

Coins with a stable value provide stability and they are a much easier payment method to use for daily purchases.

2. To Transfer Funds

Blockchain allows direct transactions that bypass third parties such as banks. This makes money transfers cheaper and faster. Coins with a stable value can be sent anywhere in the world instantly, while traditional bank payments may take days to be completed.

3. As a Safe Place in Volatile Markets

Stablecoins are a safe place to survive severe market swings without exiting the crypto exchange. When the market sinks, one may simply switch from volatile crypto to stablecoin and wait for better times.

Stablecoins are like jumping to fiat but with the benefits of cryptocurrency:

  • Conversion rates from cryptos to stablecoins are lower than changing directly to fiat.
  • Stablecoins are tradable; it’s easy to exchange them into other cryptos or traditional money if needed.

How to Make Money With Stablecoins?

1. Use to Earn Interest

Various cryptocurrency lending platforms allow users to earn interest on stablecoins. The working model is simple: you lend your stablecoins and in return, receive a settled rate of annual interest. The annual rate might come in double digits percentages, making stablecoin lending a more attractive option than keeping fiat funds in savings accounts.

2. Stake

Staking is a widely used method to earn passive income from digital currencies. Simply speaking, it is the process of being rewarded for locking assets on specific decentralized platforms.

Staking is slightly different from lending. When staking coins, they are locked on a blockchain network. When hundreds of people do the same, they create a liquidity pool. The large number of coins are then used to validate transactions and make the whole network work. All users are then paid for their contributions, mostly in the form of digital tokens.

On The Flipside

  • Stablecoins have a stable value, but also some of the risks of cryptocurrencies: regulatory uncertainty, cybersecurity, custodians and possible manipulation risks.
  • The main idea behind cryptocurrencies is decentralization, transparent, immutable transactions, and no control from third parties. Stablecoins are usually issued and operated by a centralized entity. Their underlying assets (fiat currencies, commodities) rely on centralized bodies.

Why You Should Care?

Stablecoins play an important role in crypto space, USDT and USDC are among the TOP-10 biggest and most used cryptocurrencies. They provide stability and thus are the popular low-risk asset shelter in highly volatile crypto markets. Both experienced traders and crypto newcomers appreciate the ability to safely park their assets when the market gets shaky.

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    This article is for information purposes only and should not be considered trading or investment advice. Nothing herein shall be construed to be financial legal or tax advice. Trading Forex, cryptocurrencies, and CFDs poses a considerable risk of loss

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    Author

    Simona is a fintech journalist and content editor at DailyCoin Academy, which focuses on educating new crypto investors. She entered the crypto space in early 2018, got burned, but discovered a passion for trading, and now it’s her hobby. Simona covers crypto and blockchain-related topics and takes a deeper look at what lies behind the latest industry trends.