One of the most used terms that you might have come across if you are a crypto trader is Stablecoin. In this article we will try to cover all the concepts around stablecoins and provide answers to the below questions :
- What is a Stablecoin?
- How are they different from Cryptocurrencies?
- How are Stablecoins created?
- Why do we need Stablecoins?
- Are Stablecoins a safer bet?
Cryptocurrencies like Bitcoin are very volatile when considering their price stability, after touching an all-time high of $69,045 on 10th Nov 2021 its price dropped to $17,622 on 18th June 2022.
Bitcoin lost close to 80% of its value in just a span of 8 months. Due to its high volatility and unstable exchange rates, a more stable option is sought that not only provides the stability of a fiat currency but also inherits the decentralized nature of a cryptocurrency.
So, may I have to honor to introduce you to the work of Stablecoins?
So, What is a Stablecoin?
Stablecoin is a cryptocurrency that provides the price stability that other cryptocurrencies fail to achieve. Its price is pegged to another currency (USD) or commodities like Gold, which drastically reduces the volatility and the investors can be at peace that their stablecoin asset is not going to reduce its value over time.
It provides an alternative to fiat currencies, as it can be shared across borders for payments over the Blockchain network with a minimum transaction fee.
This unique combination of a fiat digital currency and the freedom over the decentralized network has made this concept very popular.
Billions of dollars in value have flown into stablecoins like USDT, USDC, and others. They are the most popular ways to store and trade in the cryptocurrency ecosystem.
Types of Stablecoins
Fiat-Collateralized Stablecoins
Fiat-Collateralized stablecoins hold a reserve of fiat currencies (like the US dollar) making sure that the value of stablecoin remains stable.
There are other forms of collateral that can include but are not limited to, Gold, Silver, or crude oils. Most of the stablecoins use fiat currencies as their collateral.
The reserve of collaterals is maintained and audited by independent curators at regular intervals. Tether (USDT) and TrueUSD (TUSD) are the most popular stablecoins which use US dollars as their collateral.
Crypto-Collateralized Stablecoins
Crypto-Collateralized Stablecoins are backed by other cryptocurrencies, which means the value of stablecoin is pegged by keeping other cryptocurrencies as collateral. Because of the highly volatile nature of other cryptocurrencies, these kinds of stablecoins are highly collateralized.
This means that the value of the cryptocurrency held as collateral is significantly higher than the value of the stablecoin issued, which reduces the risk associated with this kind of concept.
The value of the collateralized cryptocurrency might be $2 million but the worth of the stablecoin issued might still be $1 million, even a 50% drop in the value of cryptocurrency will not impact the price of the stablecoin.
MakerDAO’s DAI stablecoin is pegged to US Dollar but collateralized by Ethereum (ETH) and other cryptocurrencies
Algorithmic Stablecoins
Algorithmic Stablecoins may not hold collaterals, they keep the value of their stablecoin stable via algorithms. Algorithms are computer programs that increase or decrease the stablecoin’s circulation to keep its value stable.
It’s similar to how central banks issue fiat currencies and hike interest rates to control inflation and keep the value of their currency stable.
Some examples of algorithmic stablecoins are:
Conclusion
There are a host of stablecoins to choose from when it comes to trading in cryptocurrencies. So the question that might come to one’s mind is which out of the list is the best stablecoin.
To answer that you must know that Tether (USDT) ranks in the top 5 of the most traded cryptocurrencies and ranks third in terms of market cap. It is also the most traded stablecoin in the crypto ecosystem.
Your strategy should be to divide your liquidity between 2 or 3 top stablecoins, just to avoid any risk associated with any of the stablecoin projects.
On 11th May 2022, TerraUSD (UST) an algorithmic stablecoin, lost its peg with the US dollar and plunged more than 60% as the price of its related Luna collateral dropped by 80% overnight.
It’s always safe to keep a backup and distribute your liquidity across different currencies be it a stablecoin or a cryptocurrency, this minimizes the loss and prevents complete liquidation in case of any foreseen event.
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