What are Stablecoins, and how are they different from other cryptocurrencies?
One of the significant criticisms of Bitcoin and other cryptocurrencies is that their price is highly volatile.
Most cryptocurrencies could see price fluctuations from 1% to 1000% daily.
This makes them highly unsuitable for everyday use to purchase goods and services. When you receive a cryptocurrency payment, the value could be far above or below what was sent.
This makes cryptocurrencies considered hazardous investments and practically unusable in making payments for goods and services.
Stablecoins were developed to tackle this problem with bitcoin and other cryptocurrencies as they are relatively stable with minute price fluctuations.
What Are Stablecoins?
Stablecoins are cryptocurrencies with a fixed value pegged to a fiat currency such as the dollar or any other underlying asset (gold, real estate, etc.) and backed by fiat or other reserve assets.
This class of cryptocurrencies provides investors with the best worlds of cryptocurrencies and traditional fiat –instant, secure, and private (anonymous) processing of payments and stability, respectively.
Categories of Stablecoins
There are three different types of Stablecoins, based on how they work to maintain their stable price:
- Fiat-backed Stablecoins
- Crypto-backed Stablecoins
- Code-backed Stablecoins
- Commodity-backed Stablecoins
Let’s examine them one after another below.
1. Fiat-backed Stablecoins
Fiat-backed Stablecoins such as Tether and TrueUSD maintain a fiat currency reserve held in custody by a regulated financial institution such as a bank, and their value is pegged to the value of the base fiat currency.
These forms of Stablecoins were the first to emerge in the market, and their values are pegged to one or more fiat currencies, such as the US dollar and euro, in a fixed ratio.
The number of the Stablecoin in circulation must reflect precisely what it has in its fiat currency reserve.
2. Crypto-backed Stablecoins
As the name suggests, crypto-backed Stablecoins such as MakerDAO’s DAI are backed by other cryptocurrencies like fiat reserves; unlike fiat-backed Stablecoins, their monetary policy is determined by “voters” in a decentralized governance system, and new coins are minted or created based on a smart contract rather than the decision of individuals as it is with fiat-backed Stablecoins.
Therefore, rather than trusting a single institution to act in the good interest of the users, you are trusting all the network participants.
Trust is minimized with smart contract-regulated and decentralized Stablecoin compared to its fiat-backed counterpart.
However, it is more technically complex to implement and more prone to bugs that malicious hackers may capitalize on to wreak havoc on the system and steal users’ funds.
3. Code-backed Stablecoins
Code-backed Stablecoins uses algorithms to control the supply and regulate the value of the Stablecoin.
These forms of Stablecoins are less popular, as evidenced by the fact that I cannot find any single Stablecoin of this category in the market.
The value of the Stablecoins is adjusted by pieces of code (considering demand and supply) on the blockchain, and no reserve is required for printing and minting more coins.
4. Commodity-backed Stablecoins
Commodity-backed Stablecoins such as Digix Gold Tokens (DGX) have their value pegged to real-world assets such as gold, silver, stocks, real estate, etc. and are harder to inflate compared to fiat-backed Stablecoins, which can be created out of thin air as Tether is mainly accused of doing.
Commodity-backed Stablecoins can be redeemed for the physical asset they represent on-demand based on a promise to pay by unregulated individuals, agorist firms, or regulated financial institutions.
What are Stablecoins used for?
Stablecoins are usually used to preserve, transfer, and store value.
By maintaining and operating with a stable value, stablecoins are mainly used to pay or transfer value within the network.
Secondly, Stablecoins can be used as a bridge between the traditional financial system and cryptocurrencies, as evidenced by many people (especially institutional investors) purchasing cryptocurrencies (bitcoin) with Stablecoins.
More so, cryptocurrency traders use Stablecoin as a hedge against their positions. Traders can effectively reduce their risk by keeping a portion of their trade account in Stablecoins. They can take advantage of downward price movements or buy other cryptocurrencies.
What are the best Stablecoins?
Some of the best and most popular Stablecoins in the market are Tether (USDT), TrueUSD (TUSD), USD Coin (USDC), DAI, SAI, Binance USD (BUSD), etc.
The “best” Stablecoin is the one that does what it says it does.
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Which is your favorite Stablecoin (s)? Share with us in the comments section below.