One of the earliest conceptions about cryptocurrencies was the high volatility of their prices in the market, as they were able to either multiply their value or plummet within days. Unfortunately, this longstanding issue of the high volatility of digital assets cannot be changed because the value of crypto depends on its demand.
Stablecoins were introduced as an answer to the high volatility of cryptocurrencies. As their name implies, they maintain a near-stable value by being pegged to a fiat currency such as the U.S Dollar, the Euro, and the Pound, which are less volatile. In some cases, the value of Stablecoins has been pegged to precious metals such as gold or silver.
A Stablecoin is a form of cryptocurrency that promises price stability and is backed by a reserve asset. They are often pegged 1:1 with the asset in their reserves. For example, 10 USD Coin (USDC) is equivalent to $10. Stablecoins were created to bridge the gap between volatile cryptocurrencies like Bitcoin and real-world assets like fiat currency.
By using Stablecoins instead of fiat currency like U.S dollars, you can have your transactions within cryptocurrency exchanges, which can save you from the fees that would be incurred in the traditional financial industry. In addition, the use of Stablecoin instead of other cryptocurrencies like Bitcoin or Ethereum saves you from the risk of volatility Crypto can bring up at any time.
How Does a Stablecoin Work?
Stablecoins function differently based on the type of Stablecoins that are being used. There are basically four types of Stablecoins, which are:
1. Traditional Collateral (Off-Chain) Stablecoins
These are the most common type of Stablecoins in the crypto market. They are backed 1:1 by fiat currency, most often the U.S. Dollar (USD), as a means of collateral to stand for issuing a reasonable amount of the digital asset.
Fiat-collateralized Stablecoins are known to have minimal fluctuations compared to other cryptocurrencies. Tether (USDT) is known to be the first and the largest Stablecoin created in 2014. As time went by, other Stablecoins started emerging like USD Coin (USDC), which was launched in 2018 by Circle, one of the popular large cap Stablecoins, along with Binance USD (BUSD).
While dollar-backed stableoins are undoubtedly the most popular, there are Stablecoins backed by other fiat currencies. For example, STASIS Euro (EURS) is backed by the Euro, and the Binance GBP is backed by the British Pound.
2. Commodity-Collateralized Stablecoins
As the name implies, these Stablecoins are backed by commodities like precious metals, oil, and real estate. The most common commodity that has been used as collateral by cryptocurrencies is gold.
For example, Tether Gold (XAUT) and Paxos Gold (PAXG) are two of the most liquid gold-backed Stablecoins. The reason is that gold remains a very important asset that has been in use for a long time to protect the stock market against volatility and inflation.
Because the prices of commodities (gold, oil, silver, and real estate) have the tendency to fluctuate, the value of the commodity-collateralized Stablecoins moves more than the other types of Stablecoins.
3. Cryptocurrency-Collateralized (On-Chain) Stablecoins
Cryptocurrency-collateralized Stablecoins use other crypto assets (hence the name on-chain) like Bitcoin (BTC) or Ethereum (ETH) for their collateralization. Because this form of Stablecoins is vulnerable to volatility, it uses over-collateralization to ensure the stability of the value. This typically means that any Crypto that would be used would be much greater in worth than the Stablecoin used.
For instance, a $1,000 cryptocurrency-collateralized Stablecoin may be pegged to underlying crypto worth $2,000 and above. If the underlying crypto loses its value, it won’t fall below the Stablecoin to still make the Stablecoin valuable. Once the underlying crypto falls below the Stablecoin, the Stablecoin becomes useless.
To make use of this Stablecoin, one must continually keep an eye on the performance of the crypto being used to see that the value of the crypto is not falling more than expected. Therefore, this type of Stablecoin is less stable compared to that of fiat-collateralized and precious metal-collateralized Stablecoins. The most popular Stablecoin that uses crypto as collateral is Dai (DAI).
4. Algorithmic Stablecoins
These are non-collateralized Stablecoins. Algoritmic Stablecoins don’t use any reserve but implement a working mechanism like the central bank does by printing more banknotes to retain a stable price. A dollar-pegged basecoin uses a consensus mechanism to increase or decrease the circulation of tokens whenever needed.
Stablecoins have proven to be an essential asset for investors who want to indulge in cryptocurrencies but avoid their high volatility. Moreover, when compared to fiat currencies, Stablecoins are much easier, faster, and cheaper to exchange. As such, Stablecoins offer the best of both worlds – the stability of traditional assets and the speed and decentralization of digital assets.