Stablesoins are crypto assets that are tied to another asset, such as fiat currency or precious metal. Staboins are designed to maintain a relatively stable price so that users avoid the volatility risks common in the crypto market.
Stablecoins are divided into three types: fiat support, encryption support and algorithm support. Stablecoins backed by fiat money, such as BUSD, are linked to traditional fiat money. They maintain the peg by keeping legal reserves of convertible stablecoins. Cryptographically supported staboins (such as DAI) overpledge their tokens to account for crypto price fluctuations, and algorithmic staboins control supply without reserve.
Regulators have taken a closer look at stablecoins because of their practical uses and large market capitalization. Some governments are even creating their own currencies to keep control.
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Cryptocurrencies are not just about volatility. In fact, some of them are specifically designed to maintain a fixed price: stablecoins. In an industry where coins and tokens could collapse overnight, there is huge demand for currencies that combine the advantages of blockchain with the ability to track more stable goods. If you haven't started using stablecoins when trading or investing, it's worth learning more about them and their benefits and drawbacks.
What are stablecoins in cryptocurrencies?
Stablecoins are digital assets that track the value of fiat money or other assets. For example, you can buy tokens tied to dollars, euros, yen or even gold and oil. Stablesoins allow holders to lock in profits and losses and transfer value at stable prices across peer-to-peer blockchain networks.
Bitcoin (BTC), Ether (ETH) and other copycats have historically been volatile. While this offers many opportunities for speculation, it does have drawbacks. Volatility makes it challenging to use cryptocurrencies for everyday payments. For example, a business may take $5 BTC one day to buy a cup of coffee, only to find their BTC value reduced by 50% the next day. This makes planning and running a business challenging.
Previously, cryptocurrency investors and traders were unable to lock in profits or avoid volatility without converting cryptocurrencies back into fiat currency. The creation of stablecoins provides a simple solution to both problems. Today, you can easily move in and out of cryptocurrency fluctuations using staboins like BUSD or USDC.
How does the stablecoin work?
Creating a coin that tracks the price or value of another good requires a hook mechanism. There are several ways to do this, and most rely on another asset as collateral. Some methods have proved more successful than others, but there is still no such thing as guaranteed hooks.
A stable currency backed by fiat money
Fiat backed stablecurrencies retain fiat currency, such as the dollar or pound sterling, as reserves. For example, each BUSD is backed by real dollars as collateral. Users can then convert from fiat to stablecurrency at a fixed exchange rate, and vice versa. If the price of the token deviates from the underlying fiat, the arbitrageman will quickly bring the price back to the fixed rate.
Suppose BUSD trades at a price above $1. Arbitrageurs convert dollars into BUSD and sell them at a higher price in the market. That increased the supply of BUSD for sale and brought the price down to $1 again. If BUSD trades below $1, the trader buys BUSD and converts it into DOLLARS. This increased demand for BUSD, bringing its price back up to 1.
Cryptographically supported stablecoins
Cryptographically supported stablecoins work in a similar way to legally supported stablecoins. But instead of using dollars or other currencies as reserves, we use cryptocurrencies as collateral. Because the cryptocurrency market is highly volatile, cryptocurrency-backed staboins often overpledge their reserves to deal with price fluctuations.
Cryptographically supported staboins use smart contracts to manage minting and burning. This makes the process more reliable because the user can audit the contract independently. However, some cryptocurrency-backed staboins are operated by decentralized autonomous organizations (DAOs), and the community can vote for changes to the project. In that case, you'll either have to get involved or just trust the DAO to make the best decision.
Let's look at an example. To mint a $100 DOLLAR-pegged DAI, you need to provide $150 in cryptocurrency to work with 1.5x collateral. Once you have your DAI, you can use it however you like. You can move it, invest it, or keep it. If you want to reclaim the collateral, you need to repay 100 DAI. However, if your collateral falls below a certain collateral ratio or loan value, it will be liquidated.
When the stablecoin falls below $1, incentives are created for the holder to return their stablecoin as collateral. This reduced the supply of tokens, causing the price to climb back to $1. When it is above $1, users are incentivized to create tokens, increasing their supply and lowering their price. DAI is one example, but all cryptographically supported staboins rely on a combination of game theory and on-chain algorithms to encourage price stability.
Algorithm stablecoin
Algorithmatic stablecoins take a different approach by eliminating the need for reserves. Instead, algorithms and smart contracts manage the supply of issued tokens. This model is much less common than cryptocurrencies or legally-backed stablecoins, and more challenging to run successfully.
In essence, an algorithmic staboin system reduces the token supply if the price is lower than the fiat currency it tracks. This can be done by locking up pledges, destruction or repurchase. If the price exceeds the value of the fiat currency, new tokens enter circulation to reduce the stablecoin's value.
What are the advantages of stablecoins?
Staboins are a versatile and powerful tool for investors, traders, and cryptocurrency users. Their main advantages include:
1. Stable currency can be used for daily payments. Stores, businesses and individuals value stability. Cryptocurrencies are not yet widely used for payment processing due to high volatility. Large staboins have a track record of maintaining pegs, making them suitable for everyday use.
2. Stablecoin has the advantage of being based on blockchain. You can send stabecoins to anyone around the world who has a compatible cryptowallet (which can be created for free in seconds). Double spending and fraudulent transactions are also almost impossible. These qualities and more make stablecoins incredibly versatile.
3. Traders and investors can use stablesoin to hedge their portfolios. Allocating a percentage of your portfolio to staboins is an effective way to reduce your overall risk. Your overall portfolio will be more resistant to market price swings, and you'll have money on hand just in case a good opportunity comes along. You can also sell cryptocurrencies for stablecoins during market downturns and then buy them back (aka short) at a lower price. Stablecoins allow you to easily enter and exit positions without having to take money down the chain.
What are the disadvantages of stablecoins?
While they have the potential to support widespread adoption of cryptocurrencies, stablecoins still have limitations:
1. The stablecoin peg is not guaranteed. While some large projects have a good track record, many fail. When the stabocurrency keeps having problems maintaining its peg, it could depreciate sharply.
2. Lack of transparency. Not all stablecoins issue comprehensive public audits, and many stablecoins only provide periodic certification. Private accountants perform this work on behalf of stablecoin issuers.
3. Stablecoins backed by fiat currencies are generally more centralized than other cryptocurrencies. Collateral is held by a central entity and may also be subject to external financial supervision. This gives them significant control over tokens. You also need to trust the issuer to have the reserves they require.
4. Crypto and unsecured tokens rely heavily on their communities to function. It is common to have open governance mechanisms in cryptography projects, meaning that users have a say in the development and operation of each project. Therefore, you need to engage or trust the developers and community to run the project responsibly.
Stablecoin use cases
Let's take a closer look at two popular staboins in the market: BUSD and DAI.
Stable currency supported by Fiat: Binance USD (BUSD)
BUSD is a dollar-backed stablecoin created by Paxos and branded by Binance. It is approved by the New York State Department of Financial Services and periodically certifies that statutory reserves are equal to BUSD supply. Through the Paxos web site, you can directly cast new BusDs or destroy busDs as underlying collateral. This mechanism allows arbitrage to anchor BUSD successfully.
Cryptographically supported stablesoins: MakerDAO (DAI)
DAI is a cryptographically supported staboin that tracks dollars on Ethereum. The token is managed by the MakerDAO community, which holds the governance token MKR. You can use MKR to create and vote on proposals to change the project. DAI was over-mortgaged to cope with the volatility of cryptocurrencies, with users entering collateralised debt obligation positions (CDP) to manage their collateral. The whole process runs through smart contracts.
Are stablecoins regulated?
Staboins have attracted the interest of regulators around the world because of their unique combination of fiat and cryptocurrency. Because they aim to maintain stable prices, they are useful for reasons other than speculation. They can also be moved cheaply and quickly internationally. Some countries are even trying to create their own stablecoins. Since stablecoins are a cryptocurrency, it is likely to be subject to the same regulations as cryptocurrencies within your local jurisdiction. The issuance of stablesoin with statutory reserves may also require regulatory approval.
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It is now difficult to find an investor or trader who has not owned stablecoins at some point. Stablesoins are typically housed on cryptocurrency exchanges so that traders can quickly take advantage of new market opportunities. As we discussed, they are also useful for entering and exiting positions without having to be cashed into fiat currency. In addition to trading and investing, staboins can also be used for payments, global transfers, or passive income through collateral in the DeFi ecosystem.
While they are an integral part of cryptocurrencies and have led to the creation of new financial systems, you should not underestimate the risks. We have seen stablecoin projects with failed anchoring, missing reserves and litigation problems. So while stabecoins are a very versatile tool, don't forget that they are still a cryptocurrency and carry similar risks. You can reduce risk by diversifying your portfolio, but make sure you do your own research before investing or trading, and don't invest more than you can afford to lose.