What are stablecoins?

One of the main factors that discourage people from joining web3 and using cryptocurrencies is the high volatility of their prices.

Stablecoins were created to address these concerns while retaining the most important benefits of digital assets. In this article, you’ll discover different types of these unique tokens and learn more about their use cases.

 

Why do stablecoins matter?

Stablecoins serve as a “safe haven” in the volatile crypto world. They’re basically web3 equivalents of popular fiat currencies (such as US Dollars) that can be transferred and used the same way as other cryptocurrencies.

Thanks to that, people are provided with assets that don’t serve investment purposes at all. Even though it’s possible to earn interest rates on stablecoins, their destiny is different. USDC, USDT, or BUSD enable typical crypto transactions, payments, and other activities without worrying about the current market conditions. They resemble real-world money while remaining in the web3 space.

 

How do stablecoins work?

However, to understand how stablecoins work and effectively reflect the value of fiat currencies, we must take a quick blast to the past. Do you know what happened on the 15^th of August 1971?

Well, many people consider this date as the moment when the modern financial system started to collapse. This was when US President Richard Nixon decided that US Dollar would no longer be backed by physical gold supply. In other words, from this point in history, USD doesn’t have coverage in anything “real.” In consequence, money printing became much easier and more popular.

We won’t get into explaining or evaluating the rightness of this decision. However, the idea of backing the currency with physical assets is still vital – albeit for digital assets, such as stablecoins, and not fiats, such as US Dollar.

The majority of stablecoins, especially the most popular ones (USDC, BUSD, etc.), work exactly this way – they maintain a stable price thanks to being backed by other assets. Whenever one USDC is minted, there is one US Dollar (or a commodity worth 1 USD) in the issuer’s reserve that can cover the digital asset. It means that if the USDC holders decide to convert the stablecoin to fiat currency (and withdraw it to their bank account), they’ll always be able to do so.

However, these are not the only ways stablecoins can maintain a stable price. We’ll explain other solutions in the latter parts of the article.

 

What are stablecoin examples?

As finding a bridge between cryptocurrencies and usual fiat currencies was always the case for the blockchain industry, multiple stablecoins emerged over the years. However, while looking at the market capitalization, there are four clear leaders (as of January 2023) in this category:

• USDT – also known as Tether. USDT, pegged 1:1 to US Dollar, was launched in 2014 (originally as Realcoin) and is most commonly used on Ethereum and Tron blockchains. It serves as a part of trading pairs on most renowned centralized exchanges (however, Binance decided to remove it from their service in 2022) and – thanks to that – remains the most popular and widely traded stablecoin on the market. However, due to the lack of external public audits and a hazy balance sheet, USDT raises doubts among both regulators and web3 enthusiasts.
• USDC – also known as USD Coin. It’s the second largest stablecoin and, same as USDT, remain pegged 1:1 to US Dollar. USDC is often referred to as a “safer alternative to Tether” – thanks to its transparent balance sheet and generally positive public image.
• BUSD – also known as Binance USD. It’s a stablecoin issued by Paxos, a US infrastructure blockchain platform, in collaboration with Binance. BUSD gained massive adoption in 2021 and 2022, and thanks to regular audits and a strict regulatory environment, it is also treated as a safer alternative to Tether. However, its further growth is currently limited by the Binance ecosystem.
• DAI – a crypto-collateralized (we explain this term below) stablecoin based on the Ethereum blockchain. In contrast to the three aforementioned coins, DAI is not backed by off-chain assets (like fiat currencies, commodities, or bonds). The collateralization that enables DAI to maintain a 1:1 peg to US Dollar is held on-chain (in the form of cryptocurrencies) and regulated by complex algorithmic mechanisms. Thanks to that, DAI is very close to the web3 ethos of decentralization and lack of intermediaries. However, it’s also a much riskier asset that could be more vulnerable to massive market turmoil.

 

Types of stablecoins

The category of a stablecoin very much defines its characteristics and the level of security. The main differences refer to how a stablecoin maintains its peg to a fiat currency.

1. Off-chain collateralized stablecoins

The most popular and essential type of stablecoins. Such coins are backed by real-world assets – US Dollars (mostly cash), commodities, or US Treasury bonds. These resources should serve as collateral or overcollateralize the number of coins in circulation.

Examples: USDC, BUSD, USDT (presumably).

 

2. Crypto-collateralized stablecoins

Other cryptocurrencies, such as Bitcoin and Ethereum, can also back stablecoins. In this case, the assets that serve as a reserve for stablecoins remain on-chain. It’s obviously a riskier type of stablecoin, but, at the same time, more aligned with crypto world primitives.

Examples: DAI

 

3. Decentralized stablecoins

The most complex algorithms stand behind the so-called decentralized stablecoins. In the case of such tokens, the 1:1 peg to US Dollar (or other fiat currency) is not a result of off-chain or on-chain reserves. It’s the smart contracts and various incentive mechanisms (such as seigniorage and arbitrage) that determine the price of the token.

Decentralized stablecoins remain the riskiest category of such assets and, as the collapse of Terra in 2022 shown, are currently not mature enough to thrive in challenging market conditions. However, they remain closest to web3 ethos and should be significantly improved in the future.

Examples: UST (TerraUSD), Frax

 

What are stablecoins used for?

Why does the crypto world, very unfavorable of fiat currencies, needs coins that actually reflect traditional money? Besides enabling users to store their USD or Euro in a digital, cryptographic form, stablecoins also serve other important roles:

• Stablecoins minimize volatility. Thanks to their design and maintaining a 1:1 peg to fiat currencies, they’re relatively free from the price volatility usually associated with crypto space.
• Stablecoins serve as a primary medium of exchange. As people are used to trading using US Dollars or euros in the “real world,” digital assets that reflect their price become natural equivalents in virtual environments.
• Stablecoins lay the foundation for crypto trading. It’s much easier to buy and sell crypto while referring their price to fiat currencies rather than other cryptocurrencies (whose prices are also volatile).
• Stablecoins enable you to earn interest. Like fiat currencies, USDT, USDC, or DAI can also be used in the form of a bank deposit and bring frequent earnings.
• Stablecoins drive the crypto adoption. Thanks to the reduced risk and high utility, stablecoins can become more critical catalysts of web3 growth than typical cryptocurrencies like Bitcoin or Ethereum.

 

What are the most secure stablecoins?

As you can figure out from the paragraphs above, there are no perfectly safe stablecoins. Even though they intend to prevent users from market turmoil and price volatility, their mechanisms and the current state of blockchain technology don’t guarantee a peaceful sleep.

Therefore, we encourage you to take massive caution when interacting with stablecoins – whether centralized or decentralized. However, if you want or need to hold them in your portfolio, look for the ones with transparent balance sheets, regular audits, and the renowned company behind them. Even though it won’t make you 100% confident about the security of your money, it can significantly reduce risks related to investing in cryptocurrencies.