Stablecoins have become essential components in the crypto world, offering important functions for investors and speculators.
What are Stablecoins in Crypto?
Stablecoins are digital currencies that are pegged to a "stable" reserve asset, such as the US dollar or gold. Stablecoins are intended to lessen volatility in comparison to unpegged cryptocurrencies.
The entire cryptocurrency market capitalization can fluctuate by billions of dollars a day. Fiat currencies, such as the US dollar or the British pound, do not experience this amount of price fluctuation. Another way to think of stablecoins is as a tokenized version of fiat money. In theory, a US dollar-based stablecoin is a token that will stay on a blockchain and always trade for a dollar.
Some events have highlighted that stablecoins can differ in their ability to maintain price stability. For example, the TerraUSD crash showed that even stablecoins may not always guarantee stable prices.
Types of Stablecoins
Stablecoins are classified into three types based on the mechanism used to keep their value stable.
- Fiat-Collateralized Stablecoins - The primary and most common way is to back up each stablecoin in circulation with an equivalent value in fiat currency or cash equivalents. This is referred to as a fiat-backed stablecoin. This means that for every stablecoin, the equivalent of one USD is held on reserve in the issuer's U.S. bank accounts. These reserves are regularly audited by independent accounting firms on a monthly basis, and details of their holdings are displayed openly for public observation.
- Crypto-Collateralized Stablecoins - Stablecoins that are backed by other cryptocurrencies. Since reserve cryptocurrency can also be highly volatile, such stablecoins are overcollateralized, meaning that the value of cryptocurrency held in reserves exceeds the value of issued stablecoins.
- Algorithmic Stablecoins - Algorithmic stablecoins may or may not contain reserve assets. Their biggest distinction is the technique of maintaining the stablecoin's value by regulating its supply via an algorithm, which is effectively a computer software performing a preset formula. In some respects, this is similar to central banks, which don't rely on a reserve asset to maintain the value of the currency they issue. The difference is that a central bank, such as the US Federal Reserve, openly sets monetary policy based on well-defined parameters, and its role as a legal tender issuer adds to the legitimacy of that policy.
What Can Stablecoins Be Used For?
- Trade or Save Assets - Stablecoins do not require a bank account and can be transferred easily. Their value can be easily transferred around the world, even in regions where the US dollar is hard to obtain or where the local currency is unstable.
- Minimize Volatility - The value of cryptocurrencies fluctuates significantly, sometimes even within minutes. An asset that is pegged to a more stable currency can provide buyers and sellers with confidence that the value of their tokens will neither rise nor fall unexpectedly in the foreseeable future.
- Transferring Money at a Low Cost - Some people have sent up to a million dollars in USDC with transfer fees of less than $1.
- Send Internationally - Stablecoins are a great alternative for sending money anywhere in the world because of their fast processing and minimal transaction fees.
- Make Money by Earning Interest - There are simple ways to generate interest on a stablecoin investment which is usually higher than the interest rates offered by banks.
Most Popular Stablecoins
The best known stablecoins are those used for trading on cryptocurrency exchanges. Tether (USDT) is the most popular stablecoin, with one of the top five highest market caps for cryptocurrencies.
Another is USD coin, or USDC, an open source project managed by a consortium called Centre, and binance USD, a stablecoin created by Binance, the world's largest cryptocurrency exchange.
On the other hand, DAI is a cryptocurrency built on the Ethereum blockchain and is governed and operated by MakerDAO, a decentralized autonomous organization (DAO). As one of the first examples of decentralized finance (DeFi) to gain widespread acceptance, DAI has established itself as a popular and viable option for those seeking a stable cryptocurrency.
Stablecoins are currently under heightened scrutiny from regulators due to their rapid growth and the potential for them to impact the wider financial system. In October 2021, the International Organization of Securities Commissions (IOSCO) recommended that stablecoins, like payment networks and clearinghouses, be regulated as financial market infrastructure. The proposed regulatory measures would mainly focus on stablecoins that are deemed to be of systemic importance by regulatory authorities.
What are the Risks
Compared to cryptocurrencies that lack any underlying asset or backing, stablecoins are generally considered to be lower-risk coins. However, like other types of cryptocurrencies, stablecoins are not without risk. The reserves that back a stablecoin are a crucial component of the stablecoin ecosystem, serving as the last line of defense for the coin's value. Without adequate reserves, the issuer cannot guarantee the value of the stablecoin.
While the use of stablecoins may appear to be fully decentralized, the transactions actually involve multiple parties, including the bank that holds the reserves and the company that creates the stablecoin. In order to maintain the coin's value, these parties must take the right actions in terms of security, reserve adequacy, and other factors.
The main risk associated with stablecoins is the possibility that they are not fully backed by the reserve currencies they purport to be backed by. This can occur if the reserve is not adequately secured or if the reserve currency itself experiences significant fluctuations in value."
Each USDU coin is backed by the US dollar, positioned in custodian bank or by USDC coin (a cryptocurrency with a stable price), positioned in custodian escrow firm.
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