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What is a Stablecoin?
Stablecoins are a class of cryptocurrencies that are backed by a reserve asset. They offer safe-haven price stability in a market known to be volatile.
Stablecoins are designed to provide users with the security of cryptocurrency while also removing the volatility usually associated with cryptocurrency.
It is common for a stablecoin, like USD Coin (USDC), to be pegged 1:1 to the United States dollar, meaning for everyone USDC that is minted, there is $1 behind it that is redeemable.
Stablecoins are for crypto what money market funds are for traditional finance: highly liquid assets ready to be put to work at a moment’s notice.
Additionally, some crypto platforms allow users to stake their stablecoins and earn interest on them, typically between 3% and 11% depending on the platform and the type of crypto.
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We’ve seen bitcoin flash crash more than $10K in a single day in the past. It is impossible to know bitcoin’s future price action in the next week, hour, day, or second.
Stablecoins are a solution to this short-term volatility. They are used to maintain purchasing power with the lowest level of inflation possible.
A crypto trader anticipating a crash might sell his BTC and convert it into USDC. He waits patiently for the crash, and his USDC maintains its value as he waits.
Then, BTC falls like he predicted, and he buys the dip, converting his USDC back into BTC to ride the next wave.
Converting to a stablecoin like USDC keeps his capital in the crypto space and allows him to be agile.
If he were to convert his BTC to U.S. Dollars, he might be forced to wait two days to make another trade depending on his crypto exchange and bank.
Stablecoin Special Considerations
Stablecoins are currently a better medium of exchange than other cryptocurrencies because their value stays relatively the same over a long period of time.
Also, bitcoin isn’t backed by anything other than the collective belief in its value, while stablecoins are backed by the dollar — an asset that is valuable because of the U.S. military.
A fiat currency is valuable because a given government says it is valuable. Throughout history, money has transitioned from gold to paper claims on gold to just paper.
Now, the dollar’s purchasing power is controlled by central bankers and politicians, who toggle economic levers to increase or decrease its value by manipulating its supply and changing interest rates.
Regardless of their financial engineering, one dollar is one dollar. It just might buy you way less goods and services ten years from now due to inflation.
When inflation runs rampant, central bankers can intervene and take actions to combat it to return some purchasing power to the dollar.
Cryptocurrencies like bitcoin lack this third-party oversight. Traders in the space actually welcome these free-market consequences because it allows for organic price discovery.
There aren’t circuit breakers in the crypto market, and no politician can change bitcoin’s supply rate.
Stablecoins attempt to bridge these gaps between fiat and crypto.
What Are Some Examples of Stablecoins?
There are several well-functioning stablecoins. Some are just more transparent than others. Here are some of the most well-known stablecoins in circulation:
- Tether (USDT): This is the third-largest cryptocurrency in the world based on market value. This coin is quite different from other coins because it is a stablecoin. Tether is tied to the U.S. dollar. Therefore, its price is usually equivalent to a single dollar. However, in the past, the value of tether has been out of alignment with the dollar. Tether concerns some people because they have more than $60 billion worth of tokens currently in circulation, a portion of which might not be backed 1:1 to the dollar.
- Gemini Dollar (GUSD): Gemini stablecoin or the Gemini Dollar (GUSD) is one of the first stablecoins to gain approval from a U.S. regulatory body. The coin is backed by the U.S. dollar, making it one of the least volatile stablecoins available. This coin is also regulated thoroughly. It is subject to New York banking laws and the regulatory authority of the New York State Department of Financial Services (NYDFS). This stablecoin is fully backed at a 1:1 ratio with the U.S. dollar. Therefore, the number of GUSD tokens in circulation is equal to the number of U.S. dollars held in a bank in the U.S. The system is also insured with pass-through FDIC deposit insurance, which is a security measure that protects against money laundering, theft, and other illicit activities.
- USD Coin (USDC): USD Coin is a stablecoin created by Circle and Coinbase. It is backed by fully reserved assets. This means each USDC token is backed by one dollar or an asset with equivalent fair value. These assets are held in accounts with U.S.-regulated financial institutions. USDC is powered by Ethereum, meaning you can store it in any Ethereum-compatible wallet. The benefit of using USDC is that you can easily perform transactions across the globe without worrying about using confusing fiat currency exchanges.
Types of Collateralized Stablecoins
In general, volatility prevents most cryptocurrencies from being used as money. The price fluctuates so often that the tokens are rarely effective as a means of exchange, a unit of account, and sometimes even a store of value over short periods.
Collateralized stablecoins are posed as a solution to this issue. There are two types of collateralized stablecoins available: crypto-collateralized stablecoins and fiat-collateralized stablecoins.
Fiat-collateralized coins have their value stored in fiat currencies, such as the U.S. dollar or Euro.
This supports a relative level of stability, making it more likely that the coin can be adopted at large scales.
The downside to this type of stablecoin is that they must put trust into a centralized entity, like a bank.
In doing so, they risk destabilization due to geopolitical factors. Concerns about fiat stablecoins can be resolved by making assets auditable.
Users can determine whether a centralized entity has the assets required to cover their outstanding IOUs through an audit.
Crypto-collateralized coins are decentralized stablecoins that are backed by crypto assets. They rely on trustless issuance, which is also known as on-chain issuance.
They can maintain their 1:1 peg against assets using over-collateralization and other methods.
The risk with crypto-collateralized assets is that the collateral could potentially lose value, causing the system to become undercollateralized.
Because cryptocurrency is inherently volatile, many of these tokens require over-collateralization, so any unexpected fluctuations in collateral values can be absorbed efficiently.
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Non-collateralized stablecoins are backed by algorithms rather than currency. These systems have expansion and reduction mathematically determined by the algorithm. Therefore, there is no collateral backing issuance of tokens.
Wondering how this works?
Well, with algorithmic stablecoins, increased demand will cause the system to issue new tokens.
This increases supply and lowers the price back to the point that it is pegged at. This system works in the other direction too. Bonds can be used to remove coins from circulation when necessary.
If at any point the stablecoin is worth less than $1, the system begins to offer shares. To buy shares, stablecoins are necessary. Speculators purchase those coins at a price slightly below $1. In exchange, they are offered a small portion of future growth in the stablecoin’s market cap.
The risk with this model is that it relies on a promise of future growth in the market cap.
Similarly, it can be incredibly difficult to alter the supply while maintaining stability. If demand for one of these stablecoins is low, it likely won’t be able to maintain its peg.
>> More: How to Buy Ethereum
What Are the Advantages of Stablecoins?
Stable coins have a variety of advantages. They include:
- Faster transaction speed
- Lower fees
- Anonymous, borderless transactions
What Are the Disadvantages of Stablecoins?
Stablecoins aren’t perfect, and they have some inherent disadvantages. Disadvantages include:
- Requires trust from a centralized entity
- External audits are necessary
- Lower ROI than some other assets
- Regulation that involves fiat currencies
Why Are Stablecoins Important?
Stablecoins are important because they provide users with a safe way to store value without leaving the crypto ecosystem.
Using stablecoins, smart financial contracts that are enforceable over time can be created. If scaled across an entire population, this can open the door to various new opportunities, especially in the developing world.
What Can You Do with Stablecoins?
Stablecoins can be used for several different things. Here are some of the most common uses for stablecoins:
- Earn Interest – Stablecoins earn interest over time.
- Transfer Money – Stablecoins can be traded anonymously to anyone.
- International Transactions – Stablecoins allow cross-border transactions.
- Hedge Against Volatility – Stablecoins are less volatile than other crypto tokens.
Is bitcoin a stablecoin?
Bitcoin is not a stablecoin. A stablecoin must be backed by crypto assets, fiat currency, or an algorithmic system. Traders use stablecoins to purchase bitcoin.
Is a stablecoin a good investment?
Stablecoins are considered to be a great option for storing value within the crypto ecosystem in the short term.
This is especially true for people who wish to avoid losing their profits due to market volatility. You can earn interest on your stablecoins if you lend them to companies like Gemini or BlockFi.
However, stablecoins sitting in your trading account will appreciate as the same real rate as the U.S. Dollar, which has historically been -2% per year.
How is a stablecoin different from a cryptocurrency?
A stablecoin is a form of cryptocurrency, but it serves a different function than the cryptocurrencies we’ve come to know.
Stablecoins are backed by a reserve asset, unlike other cryptocurrencies, which are simply offered on blockchain platforms.
Stablecoins are not supposed to appreciate in value. They are the equivalent of the U.S. dollar but in the crypto space.
What are examples of Stablecoins?
Some noteworthy stablecoins include:
- True USD
- USD Coin
- Paxos Standard
- Gemini Dollar
Bottom Line: What Is a Stablecoin?
Stablecoins allow users to store value in the crypto space without encountering the common volatility of cryptocurrencies.
While earning interest on stablecoins is becoming more popular thanks to companies like BlockFi, they predominantly function the same way as a money market settlement fund.