What Is A Stablecoin: A Complete Guide

Crypto
Stablecoins

Crypto assets have made a remarkable impact on the financial sector, driving innovation and transformation in an ever-evolving space. The potential for significant returns has propelled crypto asset trading into the spotlight for investors. While they aren’t yet widely used for payments due to their price volatility, stablecoins offer a promising solution to this challenge, bringing stability and expanding their usability.

What is a Stablecoin?

Stablecoins are a type of crypto asset designed to maintain stable prices, offering a solution to the volatility often seen with other crypto assets. Their primary goal is to make digital assets more reliable for transactions and as a store of value.

For instance, if you’re sending Bitcoin for a transaction, and its value is $100 today, there’s a possibility that tomorrow its value could decrease to $95 or $90. This unpredictability can be a concern for businesses. Stablecoins address this by ensuring that each token maintains a consistent value, providing stability and making them a more practical choice for everyday use.

Types of Stablecoins

Fiat-Backed Stablecoins

  • These stablecoins maintain reserves of a fiat currency like the US Dollar or assets like gold and silver. They are used as collateral to guarantee that each token holds a 1:1 price with the underlying asset. Some examples of this type include Binance USD (BUSD) and USD Coin (USDC). 

Crypto-Backed Stablecoins

  • These tokens are collateralized using other large crypto tokens. Typically, these tokens are overcollateralized to ensure that volatile crypto prices do not affect the token’s price. Examples include DAI, which is collateralized by Ethereum. This insures the stablecoin against a decline in the collateral. 

Algorithmic Stablecoins

  • Algorithmic stablecoins may not hold any assets in reserve. Instead, the value of the token is maintained by controlling the supply according to a set formula. This removed its peg from the US Dollar and made the token unreliable. 

How Do Stablecoins Work?

Maintaining Price Stability

The most essential task for stablecoins is to keep their price pegged at the required level. Any major deviation from this level makes the token seem unreliable for transactions or other financial use cases. 

How they do this changes from project to project. Fiat-backed stablecoins maintain reserves of the asset they are backed by.

Read more: USDT VS USDC

Crypto-backed stablecoins are different, in that you must deposit crypto tokens as collateral into the platform’s smart contracts. The smart contract then grants you stablecoins in return. Finally, algorithmic stablecoins do not have any reserves, so they manage supply and demand to maintain steady prices. 

Reserve Management

Issuers of stablecoins must prove to users that the reserves are sufficient to exchange tokens for USD or collateral. Reserves are thus held in publicly viewable smart contracts or with trusted third parties like financial institutions. The reserves are also audited by independent sources. 

Advantages of Using Stablecoins

Reduced Volatility

The primary benefit of stablecoins is that they eliminate or greatly reduce the volatility of crypto tokens. While this removes them from consideration as investments, it is a huge boon to their use in payments or financial applications. 

Improved Liquidity

Another advantage is that since stablecoins are not held as investments, they flow more freely in the market. Additionally, minting new tokens is a quick and easy process that sends them straight to your crypto wallet. Many can also be converted back into fiat currency or crypto collateral easily. 

Use Cases for Stablecoins

Stablecoins Use Cases

Payments and Transactions

Stablecoins finally make it easier for crypto tokens to be used in payments. Since the price does not fluctuate, businesses do not need to worry about their reserves falling in value. Higher usability and acceptance make stablecoins a compelling alternative to traditional modes of payment. 

Trading and Hedging

Trying to use fiat currencies when trading crypto is an expensive and slow process. There is a huge fee associated with turning fiat into crypto and back again. Stablecoins greatly reduce the fees required, making the process much more streamlined. 

Decentralized Finance (DeFi)

Stablecoins are essential to the DeFi ecosystem. One of the most popular DeFi services is lending and borrowing, which are usually conducted using stablecoins. They can also be used as a means of payment on the platform, to ensure its earnings remain stable. 

Risks and Challenges

Regulatory Concerns

Stablecoins are currently not regulated by any central authorities. Thus, you cannot fall back on government support if a stablecoin project fails, like TerraUSD or Luna. Additionally, one platform’s reports may be very different from another, as there is no standardized reporting mandated by an authority. 

Counterparty Risk

This is the risk that the stablecoin platform does not have sufficient reserves to return your collateral or convert tokens into USD. This can lead to an immediate collapse in prices and eliminate the main advantage of stablecoins. This risk is usually managed through the audits a platform undergoes to ensure that reserves match the coins in circulation. 

Liquidity Risk

Liquidity risk can arise when platforms cannot issue stablecoins fast enough to match the demand. This can be a hurdle in many transactions where you may need new coins and can cause delays in several processes. However, this risk is usually short-lived, as when the project catches up to demand all stablecoins are minted. 

Conclusion

Potential Impact of Stablecoins

Stablecoins represent a significant innovation in the crypto world, enabling numerous use cases that were previously impractical. They play a vital role in the DeFi space, unlocking new opportunities for trading and investment. Moreover, by eliminating the risk of volatility, stablecoins make it easier to incorporate crypto into our daily lives, offering a more stable and reliable way to use digital assets.

Future Developments and Advancements in Stablecoin Technology

The crypto industry is expanding rapidly, with continuous advancements every day. Innovations in stablecoin technology, coupled with enhanced price stability measures, will further improve their usability and mitigate risks. Additionally, improved uptime on supporting systems will enable the seamless minting of new tokens around the clock, contributing to a more efficient and reliable ecosystem.

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FAQs on What Are Stablecoins

What is Meant by a Stablecoin?

A stablecoin is a type of crypto token that eliminates price volatility. This makes it easier to use in financial applications and payments. It is pegged to a fiat currency or commodity. Few stablecoins are also algorithmically driven.

Which Stablecoin is the Best?

While it is difficult to declare one best stablecoin, some of the most used coins include Tether (USDT), USD Coin (USDC), and DAI.

Disclaimer: Crypto products and NFTs are unregulated and can be highly risky. There may be no regulatory recourse for any loss from such transactions. Each investor must do his/her own research or seek independent advice if necessary before initiating any transactions in crypto products and NFTs. The views, thoughts, and opinions expressed in the article belong solely to the author, and not to ZebPay or the author’s employer or other groups or individuals. ZebPay shall not be held liable for any acts or omissions, or losses incurred by the investors. ZebPay has not received any compensation in cash or kind for the above article and the article is provided “as is”, with no guarantee of completeness, accuracy, timeliness or of the results obtained from the use of this information.

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