The article discusses stablecoins in the crypto space, explaining their role, their various types, operational mechanics, use cases, and potential risks.
When you think of cryptocurrencies, “stable” probably is not the first thing that comes to mind. In the volatile world of digital assets, prices can go up, or they can go down, often dramatically. However, stablecoins aim to achieve the opposite effect, maintaining a constant value to offer investors a haven from the intense price fluctuations of bitcoin and other tokens.
The collapse of one so-called stablecoin, TerraUSD, has shaken investors’ faith in crypto. It also set off alarm bells for global regulators who worry that this phenomenon may hold much broader risks to the financial system.
In this article, we will delve into the world of stablecoin assets, exploring their types, uses, and potential pitfalls.
What are Stablecoins?
Stablecoins are digital currencies precisely anchored to stable reserve assets, such as prominent fiat currencies like the US dollar or even commodities like gold. Unlike unbacked cryptocurrencies such as Bitcoin, stablecoins maintain unwavering values, primarily due to their secure foundation in stable assets. This inherent stability renders them notably less susceptible to price fluctuations, creating a dependable and predictable currency environment (or at least, that is how it should work).
Types of Stablecoins
Stablecoins are categorized into four distinct groups based on their operational mechanics:
1. Fiat-Collateralized Stablecoins (⚠️Risk: 1/5)
Examples: Tether (USDT), TrueUSD (TUSD), Gemini Dollar (GUSD), PayPal USD (PYUSD)
This group of stablecoins leverages a fiat currency reserve, typically the US dollar, to generate an appropriate volume of cryptocurrency coins. The issuance is backed by collateral held and safeguarded by a central issuer or a financial institution; and the amount of collateral is maintained in proportion to the quantity of stablecoin tokens in circulation. A team of independent trustees oversees these reserves, ensuring their sound management–regular audits are conducted to guarantee compliance with essential standards.
2. Crypto-Collateralized Stablecoins (⚠️Risk: 1.5/5)
Examples: Dai (DAI), Wrapped Bitcoin (WBTC), Wrapped Ethereum (WETH)
This category of stablecoins aptly earns its name by being secured through the backing of other cryptocurrencies. Your cryptocurrency holdings are locked into a smart contract, and in return, you receive tokens that hold an equivalent value. Instead of relying on a central issuer, this method operates through smart contracts.
Stablecoins in the crypto collateralized group are intentionally over collateralized, a practice that safeguards against price fluctuations of the underlying cryptocurrency collateral. Due to the inherent volatility of the reserve cryptocurrencies, a greater quantity of crypto tokens is held in reserve. This buffer ensures the release of a comparatively smaller number of stablecoins, preserving the stability of the coin’s value.
3. Non-Collateralized or Algorithmic Stablecoins (⚠️Risk: 5/5)
Example: Frax (FRAX)
In this particular category of stablecoins, reserves are absent, but a functional mechanism is in place to maintain price stability. Analogous to the actions of a central bank, the base coin in this context, like the dollar-pegged one, employs a decision-making approach to adjust token production according to demand.
These operations mirror the actions of a central bank that prints banknotes to uphold the value of fiat currencies. This is achieved through the creation of a smart contract on a decentralized platform, capable of autonomous execution, thus ensuring a stable price for the stablecoin.
4. Commodity-backed Stablecoins (⚠️Risk: 2/5)
Examples: Paxos Gold (PAXG), Tether Gold (XAUT)
This specific cluster of stablecoins derives its stability from tangible assets like precious metals such as gold and silver. It is important to recognize that the prices of these commodities are subject to fluctuations, thus entailing a potential risk of value loss. Nonetheless, stablecoins secured by commodities offer an accessible avenue to invest in assets that might otherwise be intricate and laborious to engage with.
To provide context, acquiring and managing assets such as real estate can be complex and costly in various regions. Similarly, the practicality of owning tangible commodities is not always feasible. For those seeking the flexibility to convert tokens into cash or obtain ownership of the underlying tokenized asset, commodity-backed stablecoins serve as a valuable solution.
For any financial market to operate efficiently, it must exhibit liquidity, involving substantial trading activity and seamless functioning. However, the challenge arises when transitioning from fiat currencies to cryptocurrencies, as this process can be cumbersome, costly, and time-consuming.
Stablecoins effectively address this issue by enabling the conversion of fiat currency into a corresponding quantity of tokens. Traders purchase stablecoins using actual dollars and these tokens then serve as a means to trade various cryptocurrencies and altcoins. Whenever an individual wishes to convert back, they can exchange their stablecoins for the equivalent dollar amount.
Furthermore, traders and investors holding onto stablecoins offer them some sense of security against potential downside risks, while waiting for an entry position in the crypto markets.
For the adept and experienced crypto traders, stablecoins serve diverse purposes, such as staking and lending. However, newcomers often utilize them primarily to curtail trading expenses.
Are Stablecoins Good Investments?
Stablecoins are meticulously crafted to maintain stability, resulting in minimal price fluctuations. As such, they are not typically considered investments, as they do not generate substantial profits.
Within the broader context of the crypto industry, regulatory frameworks are still in the process of development (although progress is being made). Users who engage with stablecoins must be cognizant of the associated risks they are assuming and should prudently manage their investment expectations.
In essence, until comprehensive regulations are firmly established, stablecoins are most suitable for short-term applications like facilitating swift entry and exit into the crypto realm, or as a medium of exchange.
How To Buy?
The bulk of stablecoin transactions occur on centralized crypto exchanges, following a similar purchasing process as any other cryptocurrency. Make sure that the exchange you opt for supports the specific stablecoin you intend to acquire.
Many exchanges have incorporated their own stablecoins into their operational strategy, aiming to provide traders with an enhanced and steady trading environment, boosting liquidity and generating revenue, ultimately contributing to the expansion of their market presence.
While stablecoins provide a measure of stability in the turbulent cryptocurrency landscape, it’s essential to remain vigilant and conduct your own research (DYOR). The industry is continuously evolving, and even seemingly stable assets can carry risks. Until robust regulations are established, consider using stablecoins for their intended purposes: efficient transfers, short-term holdings, and facilitating trading activities.