What Are Stablecoins and How Do They Work? Types of Stablecoins

The technology behind Bitcoin and Ethereum is groundbreaking and has opened up many potential uses. However, some characteristics make them difficult to use as a replacement for fiat currencies on a day-to-day basis: their notorious volatility.

Stablecoins are referred to as the “holy grail” of cryptocurrencies. They satisfy a need that cryptocurrencies have not been able to meet so far, the desire for price stability. But why is this so important, and why is it so difficult to implement?

What Are Stablecoins?

For a trader, volatile cryptos are good as they can allow larger profit margins. For an investor looking for a currency to store value, this is a significant disadvantage. In addition to the high transaction fees, this is also one of the main reasons why many companies do not accept currencies such as Bitcoin as a means of payment. When a currency fluctuates within a few hours, it is difficult to use it as a means of payment.

Stablecoins aim to offer a solution to this problem. These are cryptocurrencies that are less susceptible to price fluctuations. The idea of ​​a price-stable cryptocurrency was already discussed in 2014. However, the first projects of this kind only started in 2017 with Basecoin, Carbon, or MakerDAO. From these ideas, a stablecoin was born.

So, what is a stablecoin? A stablecoin is a digital currency connected to a “stable” reserve asset such as the US dollar or gold. Stablecoins come in various forms: fiat-backed, crypto-backed, commodity-backed, and algorithmic.

Stablecoin definition can be easily explained in practice. Let’s take an example. Imagine you have a clothing store. You accept cryptocurrencies as a form of payment, and a customer has made a purchase from you and paid you $50 in cryptocurrency.

The next day, this cryptocurrency loses value on the market, so instead of $50, you have $40. Of course, the losses from a small sale are not very big, but can you imagine that value is multiplied by 10 or 100?

Let’s imagine a reverse scenario. You are a customer who paid in cryptocurrencies, and at the time of confirming your transaction with the merchant, the price of the digital currency has increased by 20%. A few hours apart — and you could have more cryptocurrencies in your wallet.

Indeed, stablecoins were born out of the need to reduce cryptocurrency volatility. Be careful: we are not talking about Bitcoin or Ethereum not being suitable for exchange. What we are talking about is that stablecoins offer you a worry-free experience when spending or receiving digital currencies.

And that’s the most positive side of stablecoins, but they also have their gray areas, which we’ll discuss later after telling you about the types of stablecoins that exist.

How Do Stablecoins Work?

The stablecoins segment has developed significantly over the past year. Decentralized stablecoins, for example, are more transparent and also more stable than conventional stablecoins because their value is automatically stabilized. As decentralized stablecoins become larger, they can provide more stability and transparency within the traditional financial system. 

To put it simply, a stablecoin is an asset-based on the blockchain. This asset is tied to a specific price, usually one US dollar. 

Here are the advantages of stablecoin that attract many investors:

• Due to this price-fixing, holders of stablecoins are independent of the fluctuations of the crypto market.

• Stablecoins offer a secure and stable investment solution.

• Assets invested in stablecoins remain in the crypto space and can be invested more quickly in the growing DeFi sector.

To ensure their legitimacy as a means of payment, stablecoins must be backed by fiat currency, other cryptocurrencies, or on-chain tokens.

Types of Stablecoins

Each stablecoin project has developed its own mechanism, but they generally boil down to four basic models. Find more information in this article below.

Fiat-Collateralized Stablecoins

This model is used by Tether, for example. Fiat currency like the US dollar can back the crypto’s value. With this mechanism, a centralized company or financial institution holds assets and issues tokens in return. This gives the digital token value because it represents a claim on another asset with a certain value.

However, the problem with this approach is that it is controlled by a centralized company. As this model involves fiat currency, the issuing party must have a particular basic trust that they actually have the appropriate assets to pay out the tokens. Fiat currencies introduce serious counterparty risk for token holders. The example of Tether shows this difficulty because the solvency and legitimacy of the company were publicly questioned several times in the past.

Commodity-Collateralized Stablecoins

Commodity-backed stablecoins are backed by the value of commodities, such as gold, oil, diamonds, silver, and other precious metals. The most popular commodity to be collateralized as a backing asset is gold; Tether Gold (XAUT) and Paxos Gold (PAXG) are the most common examples here. 

Commodity-backed stablecoins are backed by rare gems, gold, oil, and real estate. Of these types, stablecoins backed by precious metals are the most commonly seen. While commodity-backed stablecoins are less prone to inflation than fiat-backed ones, they are also less liquid and harder to redeem.

Crypto-Collateralized Stablecoins

This approach aims to create stablecoins backed by other trusted assets on the blockchain. This model was initially developed by BitShares but is also used by other stablecoins. Here security is backed by another decentralized cryptocurrency. This approach has the advantage of being decentralized. The collateral is stored confidentially in a smart contract, so users do not rely on third parties.

However, the problem with this approach is that the collateral intended to back the stablecoins is itself a volatile cryptocurrency. If the value of this cryptocurrency falls too quickly, the issued stablecoins may no longer be adequately secured. The solution would be overinsurance. However, this would result in inefficient use of capital, and larger amounts of money would have to be frozen as collateral compared to the first model.

Non-Collateralized Stablecoins

Uncollateralized stablecoins are price-stable cryptocurrencies that are not backed by collateral. Most implementations currently use an algorithm. Depending on the current price of the coin, more algorithmic stablecoins will be issued or bought from the open market. This is intended to be a counter-regulation to keep the course as stable as possible. 

However, the most severe disadvantage is that there is no pledged security in the event of a crash since the value of the stablecoin is not tied to any other asset in that case.

How Are Stablecoins Different from Traditional Cryptocurrencies?

Stablecoins are expected to become the solution to the high volatility of cryptocurrency prices and make crypto tokens more accessible and friendly for daily financial transactions in the future. Stablecoins can also be used to progressively merge cryptocurrencies with traditional financial markets, bridging the gap between these two separate ecosystems. Additionally, traders and investors use stablecoins as valuable hedge in their crypto trading portfolio. This trading strategy helps reduce the risk of buying cryptocurrencies and protects the value of the investments. The existence of stablecoins is a forward-looking statement that crypto assets are as valid as centralized currencies.

The credit and lending markets are likely to see a surge in the use of stablecoins and no longer be dominated by government-issued fiat currencies. Algorithmic stablecoins pave the way for the use of automatic smart contracts on the blockchain network, enabling transparent, fast, and traceable transactions in loan payments and subscriptions.

What Are the Risks of Stablecoins?

Even though stablecoins are viewed as a low-cost means of trading crypto assets and transferring funds across borders, the transparency issue remains. Because there are many different issuers of stablecoins, each offering their own policies and varying degrees of transparency, do your own thorough research.

However, like everything else, stablecoins have some disadvantages. 

Because, in most cases, their fixed value is pegged to another asset, fiat-backed stablecoins enjoy less decentralization than other cryptocurrencies. So, they are subject to fiat currency regulations, and since fiat-backed stablecoins are very tightly coupled to their underlying assets, they risk crashing if the macroeconomy enters recession. Traders must trust central issuers or banks that the issued tokens are fully and securely backed by fiat. If these issuers do not have sufficient assets, traders could face the risk of not being able to convert their stablecoins back into fiat when needed.

With crypto-backed stablecoins, token holders must trust the unanimous consent of all users of the system as well as the source code. The lack of a central issuer or regulator can make crypto-backed stablecoins vulnerable to the risk of plutocracy, meaning the power of governance rests in the hands of those who hold a large number of tokens. Additionally, the value of crypto-backed currencies is also less stable than that of fiat-backed stablecoins. If there is an increase or decrease in the supply of collateralized stablecoins, the stablecoin will also experience drastic impacts, resulting in less stability in the deposit system. 

What Can You Do with a Stablecoin?

Now that we’ve explained what stablecoins are let’s move on to what we can do with them. Lend them to generate profits. Lending stablecoins has a significant benefit as it takes market volatility out of the equation. 

Through the lending CeFi and DeFi platforms, investors can earn above-average interest rates, which are higher than the usual interest rates in traditional finance. Most banks offer annual interest rates that do not exceed 1%, while interest rates for stablecoins range from 4% to 12% per year. Many lending platforms even offer daily interest payouts, allowing investors to earn on compound interest. How to buy stablecoin? Read below!

How Do Stablecoin Companies Make Money?

Stablecoins are great when you want to establish yourself some passive income. Stablecoin companies make money through short-term lending and investing. This is a common enterprise. These companies lend a portion of their reserve assets from a bank account to earn interest. This way, they preserve their stablecoin stock. 

For example, Tether loaned $1 billion to Celsius Network in October 2021. The CEO of this network confirmed that they would pay Tether an interest rate between 5% and 6% each year. That’s $50 to $60 million dollars of interest per year.

What Happened with UST? 

Stablecoins like TerraUSD (UST), as the name suggests, are intended to offer stability against the price fluctuations of the crypto market. In the case of TerraUSD, this is done by counteracting fluctuations using algorithms. 

However, it doesn’t always work out: the third-largest stablecoin, TerraUSD, lost its peg to the dollar and even briefly traded under $0.65 instead of the $1 market price. “Stability,” the very meaning of the stablecoins, was ruffled by this case. The viable opinion of the market is that Terra won’t be recovering soon from this drop.

UST is an algorithmic stablecoin. It differs from other stablecoins because it has no reserves, like other crypto assets. Its value is based on an algorithm that is coded for a balance between the stablecoin and a partner coin.

In May 2022, a tragic series of events followed. According to CoinMarketCap, as UST has “depegged,” the price of LUNA, its sister token, has dropped 45% to $33 and continues to fall. 

The Luna Foundation Guard (LFG) deployed 28,205 BTC (Bitcoin) in a bid to defend the peg by buying up UST and providing liquidity on exchanges. That action coincided with a modest recovery in UST’s price; it surged from lows in the $0.65 range to $0.78 as of press time.

FAQ

Stablecoins explained: let’s dive deep into the most frequently asked questions about stablecoins!

What makes a coin a stablecoin?

Stablecoins are cryptocurrencies intended to maintain value parity with an underlying asset value such as the US dollar through unique mechanisms. Therefore, they are less volatile than cryptocurrencies, such as Bitcoin.

Is stablecoin the same as Bitcoin?

In contrast to a typical specimen like Bitcoin, the stablecoins linked to currencies are remarkably stable in their value retention. Stablecoins lack the critical advantages of Bitcoin and Ethereum: large profit margins and independence. Nevertheless, they are interesting as they offer advantages over other investment options, as reported by BTC-Echo. They are based on crypto technology and can be traded digitally. This eliminates the need for depots or the storage of real money. Stablecoins can also be combined with smart contracts. Their protection is also digitized.

What is stablecoin used for?

You can invest in stablecoins or use them in your business like other cryptocurrencies. One of the most significant advantages of stablecoins lies in the transfer: while bank transfers made according to the outdated SEPA or SWIFT standards are associated with high costs and long time frames, funds can be sent via stablecoin within (fractions of) seconds — worldwide.

Is stablecoin a cryptocurrency?

Yes, stablecoin is a cryptocurrency. A stablecoin is not a single crypto but a term for a group of cryptocurrencies.

Are stablecoins a good investment?

The stability means that large profit jumps are not possible. Stablecoins will not see an increase in value like Bitcoin has achieved this year. That is the nature of these digital currencies. They are based on other values ​​that are not as volatile as the original cryptocurrencies and promise systematic passive crypto income. How to invest in stablecoin? They can be easily bought through platforms like Changelly and will be a good addition to an investment portfolio.

What is an example of a stablecoin?

The most popular stablecoins are as follows:

• USDT, aka Tether
• EURL (LUGH), a stablecoin pegged to Euro and designed to be in full legal compliance with relevant EU regulations 
• USD Coin (USDC), a USD-backed stablecoin
• DAI, a mixed breed of stablecoin pegged to USD but backed by Ether
• BUSD, a coin by Binance that has its full value backed by USD

Is Tether backed by USD?

In March 2019, Tether Limited announced that Tether’s backing is not just fiat money (US dollars). Other digital assets and outstanding amounts from loans granted to third parties also cover the tokens.

Where to buy stablecoin?

Changelly is here to help! Buy stablecoins like Tether directly from our platform. Crypto exchanges are also an option. You can first buy BTC and then exchange it for a stablecoin. This works for cases when you can’t buy stablecoins with fiat currency directly.

Disclaimer: Please note that the contents of this article are not financial or investing advice. The information provided in this article is the author’s opinion only and should not be considered as offering trading or investing recommendations. We do not make any warranties about the completeness, reliability and accuracy of this information. The cryptocurrency market suffers from high volatility and occasional arbitrary movements. Any investor, trader, or regular crypto users should research multiple viewpoints and be familiar with all local regulations before committing to an investment.