If the crypto market could be defined in one word, it would be ‘volatile’. In a market where price fluctuations and swings are rampant, there is ample room for speculation. Traders and investors often jump in to gain exposure to the price actions of these assets, anticipating potential gains.
Source: biztechafrica
Amidst this cycle of plummets and pumps, stablecoins—true to their name—emerge as stable, less volatile tokens. They rarely fluctuate and are typically pegged to real-life fiat currencies, commodities, etc.
Stablecoins are designed to maintain the value of the currency (e.g. U.S. dollar) or commodity to which they are pegged, providing crypto users with a way to avoid certain market conditions, store value, purchase goods, pay for services, move liquidity, etc.
In this article, we will comprehensively break down stablecoins: what they are, their uses, types, and the risks associated with this category of cryptocurrency.
What are Stable coins?
Stablecoins are cryptocurrencies whose value is pegged to that of a fiat currency or commodity. They are designed to track the value of the underlying asset, typically maintaining a 1:1 ratio with the fiat currency or commodity they are tied to.
For example, one unit of a stablecoin is generally worth exactly one dollar, pound, euro, etc., in the case of fiat currencies, or an equivalent metric standard in the case of commodity-backed stablecoins, such as those tied to gold.
Stablecoin maintains this peg through cash reserves or other commodities held by the issuing company, ensuring their value remains stable. If the price peg is threatened, the issuing organisation take action to restore it to parity.
Why Stablecoins?
Although the volatile nature of the crypto market creates opportunities for speculation, it also hinders most cryptocurrencies from being effective mediums of exchange.
Even in the short term, the prices of these assets can fluctuate significantly, and this uncertainty makes many cryptocurrencies unsuitable for everyday purchases.
Why would I use BTC for purchases when the price might rise tomorrow, next week, or next month?
Conversely, why would I accept BTC for payments when the price could plunge tomorrow?
For a currency to serve as an effective medium of exchange, it must remain relatively stable, giving those who accept it confidence that it will retain its purchasing power and store value, at least in the short term.
Stablecoins addresses this issue by bridging the gap between volatile crypto-assets and highly stable real-world assets.
See: Introduction to Real World Assets: Importance and Uses
Types of Stablecoins
Fiat-backed Stablecoins
These are stablecoins backed by fiat currencies like USD or EUR. In this case, for every unit of the stablecoin issued, an equivalent value in fiat currency is held in reserve by the issuer. Some of the most popular stablecoins in the market, such as USDC and USDT, are tokenised U.S. dollars collateralised by USD reserves.
Commodity-backed Stablecoins
Commodity-backed stablecoins are a type of cryptocurrency whose value is tied to the market price of physical commodities like gold, silver, or oil. A well-known example of this kind of stablecoin is Tether Gold (XAUT), which is backed by gold reserves.
Crypto-backed Stablecoin
In this case, stablecoins are pegged to more established cryptocurrencies or a mix of different cryptocurrencies. To offset the volatility of the reserve cryptocurrency, this class of stablecoins are over-collateralized, meaning the value of the cryptocurrency held in reserve exceeds the value of the stablecoin issued. DAI is an example of this type of stablecoin; it is collateralised by a mix of cryptocurrencies deposited into a smart contract each time a new DAI is minted.
Algorithmic Stablecoins
These stablecoins are not pegged to any tangible assets such as commodities, currencies, or other cryptocurrencies. They maintain their stability without relying on collateral. Instead, they employ algorithms that adjust the supply according to market demand. These algorithms can either permanently reduce the number of coins in circulation or create new ones in response to changes in the demand for the stablecoin.
Some Use Cases of Stablecoins
- As a medium of exchange stablecoins facilitate routine transactions and everyday purchases without exposure to volatility for the buyer and seller.
- Investors and traders convert or swap their assets to stablecoins to avoid exposure to unfavourable market conditions.
- Commodity-backed stablecoins appeal to investors because they offer a hassle-free way to invest in gold without the need for sourcing and storage.
- They help move liquidity across different blockchains as users don’t have to sell their asset for cash before buying another coin instead they can simply swap to stablecoins and then use them to buy other crypto.
Risks and Drawbacks Associated with Stablecoins
Stablecoins come with several risks and drawbacks. Centralisation is a major concern, as many stablecoins are issued by centralised entities, necessitating trust in these issuers to manage reserves and operations properly. Additionally, for fiat-collateralised stablecoins, the management and auditing of reserve assets are critical. Any deficiencies in reserve management, transparency, or the potential for fraudulent behaviour can threaten the stability of the asset.
Closing Thoughts
Since their advent in 2014, stablecoins have become a mainstay in the crypto world. Currently, data from CoinMarketCap shows that two stablecoins, USDC and USDT (Tether), are among the top 10 most valuable cryptocurrencies by market cap.
Tether (USDT), a fiat-backed stablecoin, has seen its market cap grow from $152,225 in March 2015 to $118.20 billion in September 2024. This makes it not only the largest stablecoin by market cap but also the third largest cryptocurrency overall, following Ethereum and Bitcoin. This growth underscores the usefulness and importance of stablecoins in the crypto space.
[Author’s Note: This article does not represent financial advice, everything written here is strictly for educational and informational purposes. Please do your own research before investing.]
Author: Godwin Okhaifo
Also read: What is Maximal Extractable Value (MEV) In Crypto?
