What are stablecoins?

If you're new to the cryptocurrency market or just new to stablecoins, in this piece we're covering everything you need to know about this digital currency market. As we dive into what's a stablecoin, we're going to look at their use cases within the financial market and at some popular options currently being traded. 

While stablecoins are not designed to provide returns, they provide a means of hedging against losses when the market drops, allow users to tap into the benefits of crypto (that fiat currencies can not otherwise provide), and can still create a significant market cap.

While some might expect the regulation for stablecoins to be different from that of cryptocurrencies, the truth is that they currently both fall under the same (digital asset) umbrella. There are currently motions in place to regulate stablecoin issuers.

Below you'll find a stablecoins definition and everything else you need to know when it comes to stablecoins explained.

What are stablecoins?

A very good place to start - what is a stablecoin, exactly? Crypto stablecoins are digital currencies that are pegged to another currency, meaning that the stablecoin price will always reflect the currency that they are pegged to.

This version of digital money is designed to offer a "stable" market in an industry that is known to be rather volatile. Stable cryptocurrencies allow business firms and banks to tap into the benefits of crypto without falling victim to price volatility or being exposed to counter party risk.

While they don't provide returns typically associated with the crypto industry due to their stable price, stablecoins provide investors with a strategy to hedge against volatile markets. With a number of stablecoin cryptocurrencies on the market, users can simply choose one based on its leadership, reputation, and use case. 

There are two main types of stablecoins, these include fiat collateralized and crypto collateralized. Also mentioned below is algorithmic stablecoins and commodity-backed stablecoins.

Fiat collateralized stablecoins (fiat currencies)

Fiat collateralized stablecoins are pegged to a government-issued fiat currency, such as the United States dollar. These currencies are backed on a 1:1 basis, meaning that the central authority holds one unit of the reserve currency for each stablecoin issued in their bank account.

Some examples of stablecoins in this category include Tether (USDT), Paxos Standard Token (PAX), and USD Coin (USDC). All of these coins are pegged to the U.S dollar and the stablecoin issuers are required to hold an equivalent amount in a reserve account.

Crypto collateralized stablecoins (crypto)

A slightly less common version of stablecoins is the crypto collateralized stablecoin meaning these digital assets remain the same value as the underlying tokenized asset that they are pegged to and do not rely on third parties to hold the correct amount of stablecoin reserves.

DAI is a prime example of this, a crypto-backed stablecoin created when users send ETH to an Ethereum-based smart contract. 

Algorithmic stablecoins (smart contracts)

Algorithmic stablecoins are pegged to other digital assets' values via smart contracts and work hand in hand with another cryptocurrency. If the algorithmic stablecoin trades above its peg, new coins (of the other crypto) enter circulation, reducing its value; if it trades below its peg, coins are destroyed, thereby increasing the price.

Investing in non-collateralized stablecoins, e.g. an algorithmic stablecoin, is considered to be high risk as any failures in the algorithmic stablecoin system can result in dramatic value losses, as was witnessed with the Terra LUNA crash in 2022.

Other Stablecoins

There are also commodity-backed stablecoins that are backed by commodities and precious metals, such as gold-backed stablecoins. Popular stablecoins among the commodity-backed stablecoins pegged to precious metals include Paxos Gold (PAXG) and Tether Gold (AUXt).

Some stablecoins backed by nothing at all are still pegged to fiat values. These are called central bank digital currencies and are issued by banks to provide a digital version of their local fiat currency. 

How do stablecoins work?

Stablecoins are typically built on blockchain networks that facilitate the functioning of the coin. For example, the most popular token standard for stablecoins is Ethereum's ERC-20 token. These tokens function as any other cryptocurrency, only they use the Ethereum blockchain to facilitate the transactions and maintain the network.

The stablecoin issuer will then be responsible for ensuring that the correct amount of fiat currency or cash equivalents are held in reserve, based on what currency it is pegged to (i.e. the U.S dollar or euro). In the case of commodity-backed stablecoins, the equivalent amount of the commodity will need to be held in physical vaults.

What are stablecoins used for?

While the world slowly integrates other cryptocurrencies into its financial landscape, stablecoins provide a simple and easy means to integrate the crypto world with traditional financial products.

As a rule of thumb, stablecoins provide the benefits of digital currency without the volatility, empowering the crypto ecosystem to better integrate into everyday life.

What are the risks of stablecoins?

There has been some speculation over the companies that have created stablecoins and their methods of securing the reserve asset. Typically, a stablecoin needs to hold an equal amount of the pegged currency (for instance, the U.S dollar or gold for commodity-backed stablecoins) in reserves relative to the number of coins in circulation.

What is the purpose of stablecoins?

While you might be asking yourself why anyone would want to purchase a digital asset that is unlikely to bring about any profits, stablecoins present a number of benefits in the crypto ecosystem. 

Hedge against volatility

For starters, they provide protection against market volatility. As they are pegged to an underlying asset and relatively stable (when compared to more volatile cryptocurrencies) they can provide a hedge against bear markets.

Should a cryptocurrency suddenly be exposed to price fluctuations, moving your funds to a stablecoin can help protect against any losses in value or purchasing power. The funds can easily be moved back once the market has corrected. Instead of liquidating your assets, you can simply move them to another blockchain-powered asset until the market settles. 

Price stability (similar to fiat currency)

Stablecoins also provide a safe means of trade for merchants using crypto in terms of price stability. When sticking with a predominately stable cryptocurrency they omit the chance of their $2 transaction for a coffee being worth $1 at a moment's notice. This mitigates the risk for payment-driven businesses and provides innovation within the finance sector.

Remittance market

Another area that stablecoins provide a valuable service is for cross-border money transfers. Stablecoins bridge the gap of getting funds from one location to another and incur a fraction of the time and costs of fiat transactions. 

Popular stablecoins in the crypto market

Stablecoins went from being relatively controversial to featuring in the top 5 biggest cryptocurrencies by market capitalization. Below are a few of the top stablecoins on the market.

Tether (USDT)

Arguably the most popular stablecoin, Tether is currently listed in the top 5 biggest cryptocurrencies. While the stablecoin has seen its fair share of controversy (in terms of how many actual dollars are held in reserves) compared to other stablecoins, the coin remains a firm favorite amongst organizations, investment managers, and crypto investors alike. 

The coin was first released in 2014 under the name Realcoin and was designed to provide a second layer on top of the Bitcoin network. Later, the coin was created using the ERC-20 token standard and became operable on the following blockchains: Ethereum, EOS, Tron, Algorand, and OMG. 

Dai (DAI)

Dai started out as an earlier version known as Single-Collateral DAI (SAI) which was pegged to a single cryptocurrency. In 2019, the multi-collateral DAI was created and soft-pegged to the U.S dollar, maintaining this value by collateralizing other cryptocurrencies using stablecoin technology, most notably an Etheruem-based smart contract.

The stablecoin is managed by the Maker Protocol and the MakerDAO (decentralized autonomous organization). Such stablecoins also allow holders to earn interest based on their stake. 

USD Coin (USDC)

Another one of the top fiat-backed stablecoins but with a slightly less controversial back story, the USD Coin is currently ranked within the top 10 biggest cryptocurrencies. The company behind the asset, the Centre Consortium, holds $1 in reserves for every 1 USDC that enters circulation.

The reserves are held in cash and short-term U.S. Treasury bonds. The company's goal is to "create an ecosystem where USDC is accepted by as many wallets, exchanges, service providers and dapps as possible" to facilitate cashless and international transactions.  ‍

Acquiring stablecoins

The stablecoin market is notorious for its ability to maintain price stability and protect against market price falls and price fluctuations. Providing inherently stable assets in a world of other cryptocurrencies.

If you are looking to integrate stablecoins into your business or portfolio, acquiring stablecoins will require you to make use of a cryptocurrency exchange. Always ensure that the platform has the necessary licencing and regulation before making use of its services.
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