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What Are Stablecoins and How Do They Work?

What are Stablecoins?

Stablecoins play an important role in the crypto space as they serve as a link between traditional fiat currencies and crypto. These digital assets are designed to be price-stable, combining the reliability of fiat with the flexibility of cryptocurrencies. Stablecoins help greatly in dealing with the mercurial volatility of cryptocurrencies.

Stablecoins are pegged to more secure traditional currencies, such as the USD, to achieve stability. This connection allows stablecoins to be used as cryptocurrencies while eliminating the unpredictable price swings often associated with digital tokens.

Unlike cryptocurrencies like Bitcoin, which can experience substantial fluctuations in market value, stablecoins are immune to market conditions. This stability is similar to traditional fiat currencies like the USD or GBP, which don’t undergo the same level of price volatility as their crypto counterparts.

To put it simply, stablecoins can be envisioned as digitized versions of fiat currencies. For instance, a stablecoin tied to the American dollar operates as a token on a blockchain, consistently trading at a value equivalent to one USD.

How Does Stablecoins Work?

To understand how stablecoins operate, it’s important to recognize their role in mitigating market uncertainties. At its core, a fiat-backed stablecoin, the most common type in the market, maintains a straightforward mechanism. A crypto exchange supporting a USD-backed stablecoin will deposit a dollar for every stablecoin it puts out in circulation. This deposit pegs the stablecoin to its native currency, allowing holders to theoretically exchange their stablecoins for fiat currency on a one-to-one basis.

While the majority of stablecoins are fiat-backed, alternatives also exist. Some stablecoins are pegged to tangible assets like gold or other precious metals, while others find their anchor in different cryptocurrencies such as Dai. Additionally, there’s a category known as Algorithmic Stablecoins or Non-Collateralized Stablecoins. More on that later.

While different stablecoins work differently, the main goal is the same, which is to provide holders with a high level of certainty regarding the value of their assets. When users convert their digital assets into stablecoins, they don’t have to worry about market volatility anymore.

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Types of Stablecoins

As mentioned above, stablecoins come in different forms and can be pegged to different assets. There are four types of stablecoins currently in the crypto market.

  • FIAT-Backed Stablecoins
  • Crypto-Backed Stablecoins
  • Commodity-Backed Stablecoins
  • Algorithmic Stablecoins

FIAT-Backed Stablecoins

FIAT-backed stablecoins represent the most widely accepted type of stablecoins that maintain a direct 1:1 peg to fiat currency. In this case, the collateral supporting the stablecoin isn’t another cryptocurrency or a volatile asset but trusted fiat money. This categorizes FIAT-backed stablecoins as off-chain assets, with the fiat collateral securely held in reserve by a central issuer or financial institution.

The fiat collateral must align proportionately with the number of stablecoin tokens in circulation to ensure stability and transparency. For instance, if an issuer holds $50 million in fiat currency, they can only release 50 million stablecoins, each valued at one dollar. These stablecoins are backed by the actual FIAT in the reserve basket. Without reserves, these types of cryptocurrencies will be worthless.

The responsibility of protecting these reserves falls on independent custodians, and regular audits are conducted to maintain trust and accountability. Tether (USDT) is a prime example of a FIAT-backed stablecoin, anchored to US dollar reserves and maintaining a one-to-one value parity. As of January 2024, Tether (USDT) has a market cap of $95 billion and has established itself as the most widely utilized stablecoin.

Fiat-back stablecoins

Crypto-Backed Stablecoins

As the name suggests, crypto-backed stablecoins find stability through another cryptocurrency used as collateral. Unlike FIAT-backed stablecoins, this process takes place on-chain and utilizes smart contracts. This means there is no need for a central issuer.

When you acquire this type of stablecoin, you lock your cryptocurrency into a smart contract, receiving tokens of equivalent value in return. The reverse process allows you to reclaim your original collateral by returning the stablecoin to the smart contract. DAI stands out as the main example of employing this mechanism.

One distinctive thing about crypto-collateralized stablecoins is that they implement an over-collateralization strategy to safeguard against price fluctuations in the cryptocurrency used as collateral. For instance, if you intend to purchase $5,000 worth of DAI stablecoins, you would need to deposit $10,000 worth of ETH, establishing a 200% collateralized ratio. This excess collateral acts as a safety net, preserving the stability of DAI’s price even if the market price of ETH experiences minor fluctuations above a set threshold. However, if the price of ETH drops below a specified threshold, collateral is utilized to liquidate the Collateralized Debt Position (CDP) through the smart contract.

Crypto-backed stablecoins

Commodity-Backed Stablecoins

Commodity-backed stablecoins are connected with tangible assets such as precious metals and oil. These stablecoins open doors for investments in assets that might be challenging to access locally. For example, acquiring gold can be complex and costly in many regions of the world. However, commodity-backed stablecoins provide a solution for those wishing to exchange tokens for cash or claim ownership of the tokenized asset.

Among commodity-backed stablecoins, gold takes the lead as the most popular collateralized asset. Tether Gold (XAUT) stands out as one of the most liquid gold-backed stablecoins. Holders of Tether Gold can redeem XAUT tokens for physical gold, provided they complete the TG Commodities Limited verification process and possess a minimum of 430 XAUT (430oz LBMA gold bar). Once redeemed, holders can gain possession of their physical gold.

It’s important to remember that while the ability to redeem gold-backed stablecoins for physical gold is pretty common, other commodity-backed stablecoins might not offer the same utility. For instance, an oil-backed stablecoin cannot be redeemed for a barrel of oil. It depends completely on the commodity in consideration.

Commodity-backed stablecoins

Algorithmic Stablecoins

Algorithmic stablecoins are unique and may or may not rely on holding reserve assets. What sets them apart is their reliance on an algorithm to control the supply and maintain the stable value of a stablecoin. Unlike other stablecoins, they are not pegged to a fiat or crypto in a direct way.

In some respects, this strategy mirrors central banks, which also stabilize the value of the currency they issue without necessarily depending on reserve assets. However, the difference lies in transparency and credibility. Central banks, like the US Federal Reserve, openly set and communicate monetary policy based on well-understood parameters. They are trusted by the government and are considered too big to fail.

In comparison, algorithmic stablecoin issuers lack the same advantages and are considered riskier, especially in times of crisis. A notable example is the case of Terra-USD (UST), which experienced a significant drop, losing more than half its value in a single day in May 2022. This incident shows how risky algorithmic stablecoins can be.

Algorithmic stablecoins

Where to Buy Stablecoins?

Stablecoins, particularly the widely used USDT, are easily accessible on top reputable cryptocurrency exchanges. The main platforms that support stablecoins include:

  • Binance
  • BITFLEX
  • Coinbase
  • Bybit

You can buy stablecoins on these exchanges by exchanging them for another cryptocurrency or any other supported payment method on the platform.

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Top Stablecoins in the Market

Tether (USDT)

Tether (USDT) is known for being the world’s pioneer stablecoin, showcasing the largest market capitalization and serving as the most frequently traded stablecoin. Maintaining a fixed peg to the US dollar at a one-to-one ratio, Tether claims that its coin is fully backed by a diverse range of assets, the details of which are available for inquiry on its website. Most exchanges trade crypto like Bitcoin and Ethereum with USDT pairs.

USD Coin (USDC)

USD Coin (USDC) holds the position as the second-largest stablecoin based on market capitalization. Tied to the US dollar at a one-to-one ratio, USDC states that it is supported by US dollar assets securely held in financial institutions regulated within the United States. It has an excellent reputation and is among the most trusted stablecoins in the market.

Dai (DAI)

Dai (DAI) is the third largest stablecoin in terms of market capitalization, maintaining a one-to-one peg to the U.S. dollar. In contrast to the stablecoins mentioned earlier, DAI takes a different approach. It is not backed by US dollars directly but relies on a combination of different crypto assets. Specifically, DAI is categorized as a crypto-backed stablecoin and commonly utilizes Ethereum as collateral.

Conclusion:

Stablecoins are an important part of the crypto ecosystem as they bring stability to a highly volatile market. While their common goal is to maintain a fixed ratio with a specific fiat currency, the choice of collateral assets becomes a defining factor in the stability of their pegs. Each stablecoin type, whether backed by fiat, crypto, commodities, or using algorithmic mechanisms, has its own benefits and shortcomings and could be useful in a different way. However, it is still advised that you exercise caution while dealing with stablecoins, as the crypto market can be highly unpredictable.

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