You may be familiar with volatile cryptocurrencies like Bitcoin and Ethereum – but did you know there are some coins whose prices don’t fluctuate? These are called stablecoins, an important bridge between TradFi and the crypto world.
In a market known for volatility, stablecoins provide price stability by tying their value to fiat currencies (like the US dollar), playing a crucial role in reducing risks for investors.
Let's get into what makes this possible.
What Are Stablecoins?
Stablecoins, like their name may suggest, are cryptocurrencies designed to have a stable value, rather than fluctuate. Most stablecoins are linked to the US dollar and aim to have a 1:1 ratio, which helps protect against the ups and downs within the market.
Stablecoins really come in handy for traders when crypto prices crash, because they can quickly move funds into stablecoins to keep their money safe – and when prices boom, money can flow back into cryptocurrencies to take advantage of the gains.
Lots of platforms that deal with lending, borrowing, and trading cryptocurrencies depend on stablecoins to make transactions smooth and provide liquidity. Without them, the world of crypto would be much tougher to navigate.
How Do They Maintain Stability?
There are a few methods that help stablecoins keep their value pegged to USD or other fiat currency:
Asset Collateral - The stablecoin is backed by reserves of an asset like cash, short-term government bonds, or commercial paper. The issuing company takes care of these reserves.
Crypto Backing - Instead of fiat currency, stablecoins are backed by reserves of cryptocurrencies, like Ethereum.
Algorithmic - There are no real currency reserves. The supply is automatically adjusted by the protocol's algorithm to maintain stability.
Major Types of Stablecoins
The stablecoin market can be divided into three main groups based on how they keep their value stable:
Centrally Issued Stablecoins
These stablecoins are the most common and are issued by a central entity that holds reserves of assets to back the stablecoin's value.
Tether (USDT) - One of the first and largest stablecoins, claims to be fully backed 1:1 with USD reserves. However, the reserves consist of many types of assets, not just cash.
USD Coin (USDC) - Issued by Circle and Coinbase, backed by cash, US bonds, and other low-risk assets held with regulated financial institutions.
Binance USD (BUSD) - Issued by Paxos for the Binance exchange and approved for use in New York. Recently faced regulatory issues over reserve concerns.
Decentralized Stablecoins
Decentralized stablecoins are issued via blockchain protocols rather than a centralized entity. Instead of a company, smart contracts control the reserves.
Users can mint coins by locking up crypto as collateral in the protocol's smart contracts. The system aims to keep a stable value by adjusting how many coins are made or removed.
MakerDAO (DAI)
The most popular decentralized stablecoin with around $5 billion market cap.
Users lock ETH, USDC and other crypto in Maker's smart contracts as collateral.
They can mint DAI up to 66% of their collateral's value.
DAI aims for a $1 peg via supply/demand dynamics.
If DAI drops below $1, demand to buy it increases. If above $1, supply increases as users mint and sell.
Relies heavily on USDC collateral, raising decentralization questions.
TerraUSD (UST)
Was an algorithmic stablecoin for Terra blockchain, minted by burning LUNA.
Dramatically lost its $1 peg and collapsed in May 2022.
Did not have adequate collateral backing.
Frax (FRAX)
Originally a partially collateralized stablecoin with algorithmic supply adjustments.
Now fully collateralized after abandoning algorithmic model.
Algorithmic Stablecoins
Instead of using reserves, algorithmic stablecoins use built-in protocols to maintain their stable value. Supply is automatically expanded and contracted to balance with demand – but algorithmic stablecoins have struggled to maintain long-term pegs.
TerraUSD (UST) was the largest algorithmic stablecoin before its collapse in 2022. UST tried to peg to $1 by minting/burning LUNA. But it lost its peg and cratered the Terra ecosystem.
Other algos like Basis Cash have failed to gain traction – now, most experts see algorithmic stablecoins without collateral as fundamentally flawed.
Conclusion
Without stablecoins, the world of crypto wouldn’t be what it is today. Centralized coins like USDT and USDC are the powerhouse for most trading on exchanges, while decentralized stablecoins offer transparency and an innovative edge.
Looking ahead, there is a bright future for stablecoins to grow alongside crypto adoption – we’re still early, after all.
Exploring Crypto with OpenWorld
Start earning passive income in crypto with #OpenWorld. OpenWorld allows you to easily diversify your portfolio across the crypto world.
Coming soon on ow.finance