Stablecoins are digital assets designed to mimic the value of fiat currencies.
Cryptocurrencies carry features and abilities unlike other systems of exchange. But to make them more understandable, they borrow names from age-old financial systems: currency or coin. For instance “stablecoins.”
This article will explain some of the basic workings of cryptocurrencies and, in particular, stablecoins to help you decide if they’re for you.
- 1 Table of Contents
- 2 Cryptocurrency Fundamentals
- 3 How Stablecoins Are Different
- 4 How Do Stablecoins Work?
- 5 Stablecoins Use Cases
- 6 Stablecoins Pros and Cons
- 7 The Essential Nature of Stablecoins
- 8 How to Buy Stablecoins
Table of Contents
To understand stablecoins we must first look at the world of cryptocurrency.
Cryptocurrencies are based on cryptographic software to preserve their integrity, making them difficult to duplicate. This allows them to serve as a digital medium of exchange. Because they are based on software code, they can do things paper money cannot.
Paper money and coins can be recorded as entries in a digital system, but they also exist in the physical world. Known as fiat currency, such systems rely on government backing to give the paper and metal coins recognized and accepted value.
Fiat currencies aren’t backed by gold or some other universal commodity. The policies of the government in issuing the currency and maintaining it keeps its value relatively stable. This allows us to use it as a medium of exchange, not worrying that the amount that would buy a new car one day would only be good for a loaf of bread the next day.
Cryptocurrencies, unlike fiat currencies, aren’t government-controlled. Nor do their makers have the kind of overarching power a government does to control economic policy and therefore pull strings to keep a currency’s value steady.
Instead, cryptocurrencies exist on a technology called the blockchain, a distributed ledger that records transaction data in a manner that cannot be easily altered. It also supports validation and consensus protocols so users can agree on and trust transactions taking place on the blockchain.
So what gives a cryptocurrency its value? Herein lies the answer to the existence of stablecoins. A cryptocurrency gains or loses value based on demand for it and its supply.
Supply will depend on how much of a crypto is in circulation, how much is being produced by the blockchain as payment for block validators (called “mining crypto”), and if there is an ultimate cap on the number of coins that can be produced.
Demand will depend on how useful a particular crypto is. Can you spend it widely to purchase goods and services? Or is it limited to use on a particular blockchain for a limited set of interactions? This could depend on how well the crypto functions.
If a cryptocurrency’s blockchain is very efficient (fast transaction times), incurs low fees, and is widely available, it may have a distinct advantage over other cryptos and be in higher demand. But then there’s another thing that can affect crypto value: trading.
Given the nature of how they derive value, most cryptocurrencies do not behave like fiat currencies. Enter stablecoins: a category of cryptocurrency designed to change that.
What Are Stablecoins?
Stablecoins are digital assets designed to mimic the value of fiat currencies, like the dollar or the euro. They allow users to cheaply and rapidly transfer value around the globe while maintaining price stability.
Cryptocurrencies like Bitcoin and Ethereum are notorious for their volatility when priced against fiat currency. This is to be expected, as blockchain technology is still very new, and the cryptocurrency markets are relatively small.
The fact that the value of a cryptocurrency isn’t tethered to any asset is interesting from a free-market perspective, but it can be cumbersome when it comes to usability.
Why Crypto Can Be Volatile
Why is crypto sometimes volatile? Partially because a crypto may not be accepted or easily used everywhere. But there’s another reason.
Consider this real-life example:
In 2010, a person bought two pizzas. Except this person used a cryptocurrency — Bitcoin — instead of fiat currency to buy the pizza. And the 10,000 Bitcoins used were worth roughly $40.
Today those same 10,000 Bitcoins are worth in the neighborhood of $200,000,000! If you’d spent $40 paper dollars in 2010, then calculated how much they’d be worth if you had saved them instead of splurging on pizza, there’d be no such regret.
The difference is volatility. Governments work very hard to keep their currencies stable. They may be affected by inflation, but governments will take steps to stamp out inflation if it becomes significant.
Cryptocurrencies have no such protection. For some, that’s part of the attraction. Ups and downs in value can present opportunities to make money by buying low and selling high, or selling high on margin and repaying the borrowed asset when its price falls.
The wider the swings, the greater the opportunities to profit.
As mediums of exchange, cryptocurrencies are excellent from a technological standpoint. However, the fluctuations in their value have ultimately rendered them highly risky investments and not ideal for making payments. By the time a transaction settles, coins can be worth significantly more or less than they were at the time they were sent.
Although originally designed as a medium of exchange, that’s not all cryptocurrency is good for.
Different Uses of Crypto
A medium of exchange, like a fiat currency, works best when its price doesn’t fluctuate wildly. If you’re selling a product, you want assurance that the amount you collect will be worth what you intended by the time you deposit it in your bank.
Crypto as a store of value benefits from appreciation over time, much the way a homeowner hopes that the house they bought 30 years ago will sell for far more than they paid for it. In this scenario, a change in value for the crypto is good — as long as it’s on the upside.
But we’ve also seen that traders may seek to benefit from a crypto’s volatility. Iron out all the ups and downs, and it loses its allure. But there’s still another reason some cryptos have for living: They facilitate an ecosystem of digital interaction.
The Ethereum blockchain, for example, has an associated cryptocurrency, Ether. But the blockchain exists in support of a huge community of application developers, artists, innovators, and others looking to interact digitally. It sees itself as a frontier for development and its own digital economy.
But what about cryptocurrencies that want to act primarily as a medium of exchange? How can they if they are cumbersome and volatile? This is where stablecoins come into play.
How Stablecoins Are Different
Most stablecoins don’t have the same issues as other types of cryptocurrencies. These assets often see negligible price movement and closely track the value of the underlying asset or fiat currency that they emulate. As such, they can potentially serve as safe haven assets amid volatile markets.
There are a number of ways in which a stablecoin can maintain its stability.
How Do Stablecoins Work?
There are a few categories of stablecoins, each of which goes about pegging their units in different ways. Below are some of the most common types of stablecoin.
The most popular kind of stablecoin is that which is directly backed by fiat currency with a 1:1 ratio. We also call these fiat-collateralized stablecoins. A central issuer (or bank) holds an amount of fiat currency in reserve and issues a proportionate amount of tokens.
For instance, the issuer may hold one million dollars and distribute one million tokens worth a dollar each. Users can freely trade these as they would do with tokens or cryptocurrencies, and at any time, the holders can redeem them for their equivalent in USD.
With fiat-backed stablecoins, there is still some degree of counter-party risk in that the user may not be able to determine with confidence whether the issuer is actually holding the required funds in reserve. However, some teams behind stablecoins, including the team behind USD Coin (USDC), commit to transparency and require exchanges and partners to report their U.S. dollar holdings regularly.
Binance.US offers stablecoins that are fiat-backed, including USD Coin (USD), Tether (USDT), and Binance USD (BUSD), which all maintain a peg with the U.S. dollar.
Commodity-backed stablecoins use a commodity instead of a fiat currency to provide a stable foundation and steady their price. Think of this as similar to government currencies backed by the gold standard from years ago.
There may be one or a portfolio of commodities used as backing and the crypto can be redeemed for a fixed amount of the commodity when demanded. The supply of the commodity must be maintained to correspond with the amount of the cryptocurrency in circulation.
Crypto-backed stablecoins mirror their fiat-backed counterparts, with the main difference being that cryptocurrency is used as collateral. But since cryptocurrency is digital, smart contracts handle the issuance of units. Due to crypto’s inherent volatility, assets are often overcollateralized with ratios routinely reaching 200%.
Crypto-backed stablecoins are trust-minimized, but it should be noted that monetary policy is determined by voters as part of their governance systems. This means that you’re not trusting a single issuer, but you’re trusting that all the network participants will always act in the users’ best interests.
To acquire this kind of stablecoin, users lock their cryptocurrency into a contract, which issues the token. Later, to get their collateral back, they pay stablecoins back into the same contract (along with any interest).
The specific mechanisms that enforce the peg vary based on the designs of each system. Suffice it to say, a mix of game theory and on-chain algorithms incentivize participants to keep the price stable.
Algorithmic stablecoins aren’t fully backed by fiat or cryptocurrency. Instead, their peg is achieved entirely by algorithms and smart contracts that manage the supply of the tokens issued. In the past, algorithmic stablecoin pegs have been attacked and broken, which resulted in the loss of most if not all of that algorithmic stablecoin’s value.
Essentially, most algorithmic stablecoin systems will reduce the token supply if the price falls below the price of the fiat currency it tracks. If the price surpasses the value of the fiat currency, new tokens enter into circulation to reduce the value of the stablecoin.
You might hear this category of tokens referred to as non-collateralized stablecoins. This is technically incorrect, as they are collateralized — albeit they may be undercollateralized compared to the other types of stablecoins. Algorithmic stablecoins may have some kind of pool of collateral to handle exceptionally volatile market moves.
Stablecoins Use Cases
However, there are also instances of the other two aforementioned categories that are currently available on the market. Bitshares USD and DAI are crypto-collateralized coins, while Carbon and (the now-defunct) Basis are examples of algorithmic variants.
This list is far from exhaustive. The market for stable digital currencies is broad, something evidenced by the proliferation of hundreds of stablecoin projects.
For an in-depth exploration of stablecoins, be sure to check out Binance Research’s report: The Evolution of Stablecoins. Otherwise, take a look at the top stablecoins below.
Top 10 Stablecoins
Launched in 2014, Tether is an asset-backed stablecoin. It may be the most well-known stablecoin in the crypto world and is said to be backed by gold, U.S. dollar reserves, and cash equivalents.
USD Coin (USDC)
USD Coin is an asset-based stablecoin managed by the Centre consortium, which includes representatives from Coinbase, a cryptocurrency exchange, Bitmain, a Bitcoin mining company. Its coins are backed by U.S. dollars and other “approved assets.”
True USD (TUSD)
True USD is a highly liquid asset-based stablecoin. It is claimed to be the first independently verified digital asset redeemable 1-for-1 in U.S. dollars.
Origin Dollar (OUSD)
Origin Dollar is backed by other top stablecoins, including USDC, DAI, and USDT. It also claims to allow users to earn interest while it is still in a user's crypto wallet.
Pax Dollar/Paxos Standard (PAX)
Pax dollar is the first regulated asset-based stablecoin, with reserves held in cash or cash equivalents.
Pax Gold (PAXG)
Pax Gold is a digital commodity-based currency backed by gold. Each Pax Gold token is tied 1:1 to one toy ounce of gold stored in a London Vault. In essence, it allows investment in gold without having to physically own/store gold.
Celo Dollar (USD)
Celo Dollar is a hybrid stablecoin, relying partially on a series of smart contracts operating on Celo’s blockchain that manage a portfolio of cryptocurrencies to manage the supply of Celo to keep it stable.
DAI is an algorithmic stablecoin operating on the Ethereum blockchain. It also uses smart contracts to keep the coin’s value close to that of the US dollar.
EURS is an asset-backed stablecoin pegged to the Euro.
Frax is a “fractionally algorithmic” stablecoin, meaning it is collateral-backed and stabilized in part by algorithms.
Stablecoins Pros and Cons
The main advantage of stablecoins is their potential to provide a medium of exchange that complements cryptocurrencies.
Due to high levels of volatility, cryptocurrencies have been unable to achieve widespread use in everyday applications, such as payment processing. By providing higher levels of predictability and stability, these stabilized currencies can solve this ongoing problem.
Stablecoins are designed to act as a safeguard against volatility and may be able to play a role in integrating cryptocurrencies with traditional financial markets.
As it stands, these two markets exist as separate ecosystems with very little interaction. With a more stable form of digital currency available, it’s very likely that cryptocurrencies will see increased usage in loan and credit markets that, up to now, have been dominated exclusively by government-issued fiat currencies.
In addition to their usefulness in financial transactions, stablecoins can be used by traders and investors to hedge their portfolios. Allocating a certain percentage of a portfolio to stabilized coins is an effective way to reduce overall risk.
At the same time, maintaining a store of value that can be used to buy other cryptocurrencies when prices drop can be an effective strategy. Likewise, these coins can be used to “lock-in” gains made when prices rise, without the need to cash out.
Despite their potential to support widespread cryptocurrency adoption, stablecoins still have certain limitations. Fiat-collateralized variants are less decentralized than ordinary cryptocurrencies, as a central entity is needed to hold the supporting assets.
As for crypto-collateralized and under- or uncollateralized coins like algorithmic stablecoins, users must trust the wider community (and the source code’s ability to keep up with extreme market conditions, such as large-scale withdrawals) to ensure the longevity of the systems. These are still new technologies, so they will need some time to mature.
The Essential Nature of Stablecoins
Although they have some disadvantages, stablecoins are a critical component of the cryptocurrency markets.
Through a variety of mechanisms, these digital currencies can remain more or less steady at set prices. This allows them to be used not only as mediums of exchange but as a safe haven for traders and investors.
While initially designed to provide traders with an effective tool to manage risk, it’s clear that the applications of stablecoins extend far beyond trading. They’re a powerful tool that could strengthen the cryptocurrency space as a whole, serving in use cases where volatile alternatives are not ideal.
How to Buy Stablecoins
Looking to start your journey with stablecoins? Start by finding a crypto partner like Binance.US. Binance.US offers choice, education, trading tools, and reasonable fees. Then, open an account, fund it, and you’re ready to place your first order. No matter what your goal is, stablecoins may be a suitable part of your cryptocurrency strategy.
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