TL;DR
A stablecoin is a cryptoasset pegged to an asset that has a stable price, such as a fiat currency or precious metal. Stablecoins were developed to avoid the high levels of volatility common in the cryptocurrency market.
There are three types of stablecoin: fiat-backed, crypto-backed, and algorithmic. Fiat-backed stablecoins, like BUSD, are pegged to traditional fiat currencies. They maintain a peg by keeping fiat reserves that can be exchanged for the stablecoin. Crypto-backed stablecoins (such as DAI) over-collateralize their tokens to factor in crypto price volatility, and algorithmic stablecoins control supply without the need for reserves.
Due to their practical use and large market capitalization, regulators are beginning to take a closer look at stablecoins. Some governments are even creating their own to maintain control over the currency.
Introduction
Cryptocurrencies aren’t all about volatility. In fact, some of them are specifically designed to maintain a fixed price: stablecoins. In an industry where coins and tokens can crash overnight, there is a massive demand for currencies that mix blockchain benefits with the ability to track a more stable commodity. If you haven’t started using stablecoins while trading or investing, it’s worth learning more about them as well as the benefits and drawbacks they bring.
What is a stablecoin in cryptocurrency?
Before, crypto investors and traders had no way to lock in a profit or avoid volatility without converting crypto back into fiat. The creation of stablecoins provided a simple solution to these two issues. Today, you can easily get in and out of crypto volatility using stablecoins like BUSD or USDC.
How do stablecoins work?
Fiat-backed stablecoins
Crypto-backed stablecoins
Crypto-backed stablecoins work in a similar way as fiat-backed stablecoins. But instead of using dollars or another currency as reserves, we have cryptocurrencies acting as collateral. As the crypto market is highly volatile, crypto-backed stablecoins usually over-collateralize the reserves as a measure against price swings.
Let’s look at an example. To mint $100 of a DAI pegged to USD, you will need to provide $150 of crypto working at 1.5x collateral. Once you have your DAI, you can use it how you want. You could transfer it, invest with it, or simply keep it. If you want your collateral back, you’ll need to pay back the 100 DAI. However, if your collateral drops below a certain collateral ratio or the loan’s value, it will be liquidated.
Algorithmic stablecoins
Essentially, an algorithmic stablecoin system will reduce the token supply if the price falls below the fiat currency it tracks. This could be done via locked staking, burning, or buy-backs. If the price surpasses the value of the fiat currency, new tokens enter into circulation to reduce the stablecoin’s value.
What are the advantages of stablecoins?
Stablecoins are versatile and powerful tools for investors, traders, and cryptocurrency users. Their main strengths include the fact that:
What are the disadvantages of stablecoins?
Despite their potential to support widespread cryptocurrency adoption, stablecoins still have limitations:
Stablecoin use cases
Let’s take a deeper dive into two popular stablecoins available on the market: BUSD and DAI.
Fiat-backed stablecoin: Binance USD (BUSD)
BUSD is a USD-backed stablecoin created by Paxos and Binance. The New York State Department of Financial Services regulates BUSD, and regular attestations confirm that fiat reserves are equal to the supply of BUSD. Through Paxos’ website, you can directly mint new BUSD or burn BUSD for the underlying collateral. This mechanism allows for arbitrage that keeps BUSD successfully pegged.
Crypto-backed stablecoin: MakerDAO (DAI)
Are stablecoins regulated?
Stablecoins have caught regulators’ interest worldwide due to their unique mix of fiat and crypto. As they maintain a stable price, they are useful for reasons other than speculation. They also can be transferred internationally cheaply and quickly. For this reason, some argue that stablecoins could act as a competitor to fiat, although they cannot be controlled directly by a country’s central bank. Some countries are even experimenting with creating their own stablecoins in reaction to this.
As a stablecoin is a type of cryptocurrency, it will likely fall under the same regulations as crypto in your local jurisdiction. Issuing stablecoins with fiat reserves may also need regulatory approval.
Closing thoughts
It’s hard to find an investor or trader nowadays who hasn’t held a stablecoin at some point. Stablecoins are often held in crypto exchanges so that traders can quickly capitalize on new market opportunities. As we’ve discussed, they are also very useful to enter and exit positions without having to cash out into fiat. Apart from trading and investing, stablecoins are also very useful for making payments, worldwide transfers, or earning passive income with staking in the DeFi ecosystem.
Even though they are an integral part of crypto and enabled the creation of a new financial system, you shouldn’t underestimate the risks. We’ve seen stablecoin projects with failing pegs, missing reserves, and lawsuit problems. So while stablecoins are incredibly versatile tools, don’t forget they are still a cryptocurrency and hold similar risks. You can mitigate risks by diversifying your portfolio, but make sure to do your own research before investing or trading.