Updated: Jul 12, 2022
One of the main reasons behind the creation of stablecoins is to address a concern potential investors have on cryptocurrency -- high price volatility.
Stablecoins are cryptocurrencies. Unlike traditional cryptocurrencies, their value is pegged on real-world assets such as the U.S. dollar or gold.
Because stablecoins depend on the said assets, their value doesn't fluctuate as much as other cryptocurrencies. This characteristic somehow bridges the gap between fiat money and cryptocurrency.
Usually, one stablecoin is equivalent to one U.S. dollar. There are, however, other assets to which stablecoins are tied, which we will learn as we go along.
Types of stablecoins
Tether (USDT) is the first stablecoin launched in the crypto world. Each Tether created is backed by one U.S. dollar in reserve. Gemini Dollar (GUSD) and True USD (TUSD) are also stablecoins pegged on the U.S. dollar.
The financial institutions that manage these stablecoins have fiat currency reserves proportional to the stablecoins released.
These companies are audited to ensure the 1:1 proportion. If 10,000 Tether coins are circulating, there must also be 10,000 U.S. dollars kept safe in the company's bank account.
Aside from the U.S. dollar, other stablecoins are backed up by other fiat currencies such as Euro or GBP.
Commodity-backed stablecoins maintain interchangeable assets such as precious metals as collateral. These assets include precious metals, real estate, and oil.
These are real-world assets whose value does not dramatically change overnight.
A popular example of a commodity-backed stablecoin is Digix Gold or DGX. Each DGX issued is backed by one gram of gold. A reserve in Singapore keeps the gold safe and is audited every three months.
DGX holders may even visit the reserve and redeem gold bars.
The supply of algorithmic stablecoins is controlled by an algorithm. When the demand increases, new stablecoins are created to pull the price down. The opposite happens when the demand is low.
It may be confusing how a stablecoin avoids price volatility when backed by another cryptocurrency. The word you're looking for is over-collateralization.
Crypyto-backed stablecoins require cryptocurrency collateral of around 200%. Before a $10 million crypto-backed stablecoin is issued, $20million-worth of cryptocurrency must be held in reserve. Even if the price of the cryptocurrency backing the stablecoin drops by 50%, the value of the stablecoin wouldn't take the fall.
A popular example of crypto-collateralized stablecoin is MakerDao's Dai (DAI), which is pegged to the U.S. dollar but backed by Ethereum (ETH) cryptocurrency.
Benefits of using stablecoins
There are many reasons why stablecoin is gaining popularity in the cryptocurrency world. Its advantages entice users into exploring its use cases.
Stablecoins offer much less volatility than traditional cryptocurrencies. The real-world asset stablecoins have in reserve make it a safer option for those who are still starting to explore investment options.
Because of their resistance to sudden market changes, stablecoins are considered accessible as a form of digital money. Transactions such as buying other cryptocurrencies are proven much faster and much more secure through the use of stablecoins as a digital currency. It assures, for example, that the buyer and the seller receive their money's worth when executing peer-to-peer trades.
Traders are also able to circumvent high transaction fees through stablecoins. Because its value is the same as the U.S. dollar, for example, traders do not have to transfer fiat money to their crypto wallets every time the market is favorable for executing a trade. They can safely hold their funds in their exchange wallet in the form of a stablecoin without fear of the value dropping within a few minutes.
The creation of stablecoins may entice newbies in the cryptocurrency world to start exploring their options. With the increasing awareness and adoption, even experts in crypto trading can take advantage of its use cases to maximize profit.