Spend just a week observing crypto prices and you will see how volatile they can be. Some people are good at creating strategies to take advantage of this volatility but for others, it can pose quite a challenge. That’s where stablecoins come into the picture! Keep reading to learn more about how you can find some stability in crypto.
What are Stablecoins?
Stablecoins are a type of cryptocurrency that brings all the benefits of blockchain technology without the volatile experience. It is programmed to track the value of another asset such as gold or the US Dollar. Essentially, 1 BUSD (type of stablecoin) = 1 USD.
Many crypto users rely on its efficiency, transparency, and stability to provide relief during extreme times. They are a valuable alternative to holding US dollars or physical assets in the bank. On top of that, users are still able to purchase stablecoins with crypto funds that they hold and perform transactions as they would with any other cryptocurrency.
Types of Stablecoins
It is important to understand that not all stablecoins are created equal. There are a few types of assets that stablecoins rely on which we will briefly discuss below.
This type of stablecoin is backed by an equivalent amount of cash in a bank and is the most common type on the market. The US dollar is the most popular currency but companies are also exploring other fiat currencies. Fiat-backed stablecoins are largely considered the safest type of stablecoin and are more resilient in turbulent conditions.
Cryptocurrency backed Stablecoins
How can a stablecoin remain stable if it’s backed by a cryptocurrency that is susceptible to volatility? The process behind this is a bit more complicated and involves the use of software to enable borrowers to lock crypto assets and generate new stablecoins. By over-collateralizing (meaning the deposit amount is higher than the value of the stablecoin), the volatility of the underlying cryptocurrency is accounted for.
Algorithmic stablecoins are not fully backed by any asset, rather it relies on smart contracts to regulate their stability. The smart contract adjusts the supply of the cryptocurrency as the demand for it fluctuates. Each stablecoin might slightly differ in mechanism but most, if not all, will involve a burn/mint mechanism. Unfortunately, these stablecoins are risky because they are largely supported by collective faith in the system. Make sure to read more about the downfall of UST in the additional resources below.
Commodity backed Stablecoins
These stablecoins are backed by physical assets such as real estate, gold, and oil. Among these, gold is the most popular commodity to be collateralized. Commodity-backed stablecoins give users access to assets that may otherwise be unavailable to them. However, these commodities are also susceptible to price fluctuations just like they would if you had a physical gold bar in the bank.
The Stability of Stablecoins
Stablecoins are able to provide users with relief when the markets get too red and unpredictable. Unfortunately, there are still some risks involved which vary from token to token. Fiat-backed stablecoins are considered to be more stable while algorithmic stablecoins involve more risk.
The biggest concern with stablecoins is their ability to maintain their peg (their tie to the FIAT), and if the protocol can allow redemptions. If the reserves are stored in a bank or third party, there is added vulnerability. Some might question if the entity is actually in control of the reserves needed.
Users can rely on stablecoins for certainty that the value of their asset is safe from unpredictability. Additionally, they can easily trade or save assets that might not be within their reach with traditional financial services. There are also many protocols and services that enable stablecoin holders to earn interest. As with all cryptocurrencies, there is still some risk involved.
Read through this Stablecoin 101 guide
You should be able to answer all the questions below. If you are having trouble answering any of them, go back and review the lesson & the external content.
- Are stablecoins considered cryptocurrencies?
- Why do users invest in stablecoins?
- What are the four types of stablecoins and how are they different from each other?
- Which is considered the safest type of stablecoin?
- What kind of risk do stablecoins hold?