In a market characterized by extreme volatility, stablecoins have gained significant interest. But what exactly are stablecoins, and can they be trusted? This guide provides an overview of the different types of stablecoins available and their role in blockchain ecosystems, particularly as asset-backed cryptocurrencies.

Stablecoins:

Stablecoins are a type of cryptocurrency that are specifically created to maintain a steady value, making them attractive to investors seeking to engage with digital assets while mitigating the volatility that often comes with cryptocurrencies.

Typically, stablecoins are pegged to another asset, such as gold, fiat currencies, or even other cryptocurrencies. Alternatively, their supply can be regulated by an algorithm. The ultimate goal is for the stablecoin's value to remain equal to that of the asset it is tied to.

Bringing Stability to Crypto Markets

In a market where volatility is the norm, stablecoins offer a sense of stability and security. These digital currencies are backed by real-world assets, providing a guarantee of value. The primary goal of stablecoins is to reduce the price volatility that is typically associated with cryptocurrencies, making them more reliable and accessible for wider adoption.

Stablecoins are collateralized by reserves, which ensure that the value of the coin remains stable. This backing makes them a trusted means of exchange, allowing them to be used for transactions without worrying about price fluctuations.

Stablecoins play a significant role in bridging traditional finance and digital assets. They offer a reliable solution for settling international payments, making cross-border transactions more efficient and cheaper. As a result, institutions consider stablecoins a universal solution to meet their payment needs.

Overall, stablecoins have become a critical part of the crypto ecosystem, providing stability and reliability to the market.

Varieties of stable cryptocurrency

There are different types of stablecoins that include:

1. Fiat-backed stablecoins

These are cryptocurrencies that are backed by fiat currencies and collateralized by equivalent reserves. This ensures that the value of the stablecoin remains stable. It is a straightforward 1:1 ratio where one stablecoin is equivalent to one currency unit. Regular audits are conducted by independent entities to ensure the legitimacy of these reserves. Although the most straightforward type of stablecoin, they are also the most centralized.

2. Algorithmic Stablecoins

The stablecoins that rely on algorithms to maintain their stability are known as algorithmic stablecoins. Unlike other stablecoins, these coins may or may not be backed by reserves. The coin's value is kept stable through a computer program that follows a pre-determined formula. The algorithm is responsible for controlling the supply and demand of the coin, which affects its value. Since these stablecoins do not rely on a centralized reserve, they are often referred to as decentralized. TerraUSD (UST) is a well-known example of an algorithmic stablecoin that lost its peg in 2022.

3. Commodity-Backed Stablecoins

Stablecoins that are commodity-backed derive their value from tangible assets such as precious metals like gold or silver. For instance, Paxos Gold (PAXG) is pegged to real gold reserves held by Paxos.

The creation of a token aimed to symbolize the cost of a single ounce of a gold bar provides clients with the chance to retain partial possession of tangible bars. Besides valuable metals, commodity-backed stablecoins also exist for commodities such as crude oil.

4. Crypto-Backed Stablecoins

Stablecoins that are backed by cryptocurrencies are issued to launch the underlying crypto assets on other blockchains. These stablecoins are over-collateralized to mitigate the risk of market volatility. In other words, the value of the cryptocurrencies held in reserve greatly exceeds the value of the stablecoins issued. This helps maintain stability in the market. For instance, DAI, a stablecoin by MakerDAO, is pegged to the USD but over-collateralized with ETH and other cryptocurrencies worth 150% of the DAI in circulation.

5. BUSD stablecoin

The BUSD stablecoin is a result of the collaboration between Binance and Paxos. It is backed by U.S. dollars that are held in bank accounts owned by Paxos. BUSD has gained approval from Wall Street regulators, but it has faced liquidity concerns and was delisted from Coinbase. Paxos is currently facing a lawsuit over allegations of violating investor protection laws, and the increasing SEC scrutiny has added to the project's troubles.

6. Tether USDT

Tether USDT, the largest stablecoin by market capitalization, was launched in 2014 and is widely used for transferring funds between exchanges. It claims to have a 1:1 ratio with the US dollar and is available on major crypto exchanges. However, it has faced controversy due to concerns about the transparency of its reserves. The company was fined $42.5 million by the U.S. Commodity Futures Trading Commission in October 2021 for lying about its reserves. Tether continues to deny allegations and defend its transparency amid regulatory scrutiny.

7. DAI Stablecoin

DAI is a stablecoin created by The Maker Foundation. Its purpose was to create a lending asset that is not volatile for businesses. It has since been given to MakerDAO for governance. DAI is unique as it is over-collateralized, meaning there is more collateral held in reserve than the value of DAI in circulation, safeguarding against market volatility. DAI is the most widely-used stablecoin for DApp integration, with support for over 400 DApps and wallets.

8. USD Coin - A Dollar-Backed Stablecoin

Circle and Coinbase introduced the USD Coin in 2018, a stablecoin pegged to the value of the U.S. dollar at a 1:1 ratio. Unlike Tether (USDT), it provides transparency by being an open-source protocol, allowing other entities to use it for their own projects. Due to its backing by U.S. dollar assets, USD Coin gained popularity as an alternative to USDT.

Comparing Stablecoins and Bitcoin

Bitcoin differs from stablecoins in that its value is not tied to another asset, resulting in its price being highly volatile. Bitcoin is mainly used as a store of value and for making purchases. Stablecoins, on the other hand, are created to bring stability to the market and make it easier and cheaper to move cryptocurrencies between exchanges. Stablecoin transactions are also faster than bitcoin transactions. Unlike stablecoins, bitcoin can be used for trading due to its volatile market, which provides traders with opportunities to profit.

The Safety of Stablecoins: A Closer Look

Stablecoins are often considered safer than other cryptocurrencies due to their lack of volatility. However, this assumption can be challenged if issuers engage in questionable practices and fail to demonstrate proof of reserves. The safety of a stablecoin depends on its issuer and the backing it receives, which can be subject to credit, market, and liquidity risks. While stablecoins are touted as more regulator-friendly, they still need to be regulated to avoid legal issues. The lack of regulation surrounding stablecoins has made it easier for issuers to make false claims regarding their backing. Therefore, it is advisable to choose stablecoins with a high market cap and established reputation. The recent depegging of Terra's algorithmic stablecoin UST highlights the importance of careful consideration before investing in stablecoins.

The Future of Stablecoins in Crypto

Stablecoins play a significant role in the evolution of cryptocurrencies. They provide faster and cheaper transactions, along with increased security in certain cases. With governments working towards regulating crypto assets, stablecoins can offer a viable solution for upgrading payment systems and enabling cross-border remittance. This highlights their potential to shape the future of finance.