What is a stablecoin? Stablecoins refer to cryptocurrencies that are pegged to another asset in an effort to ensure price stability. Stablecoins are revolutionary because they offer the instant settlement and security benefits of cryptocurrency without the price volatility often associated with cryptocurrency. For most people, it is also the easiest way to convert fiat […]
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Published on November 19, 2019
Stablecoins refer to cryptocurrencies that are pegged to another asset in an effort to ensure price stability. Stablecoins are revolutionary because they offer the instant settlement and security benefits of cryptocurrency without the price volatility often associated with cryptocurrency. For most people, it is also the easiest way to convert fiat currency into crypto, and vice versa.
There are three common types of stablecoins: 1) fiat-backed, 2) crypto-backed, and 3) algorithmic.
The most common, and easiest to understand, stablecoin is “fiat-backed”. As the name implies, these stablecoins are pegged to a fiat currency, almost exclusively the US Dollar, and are fully backed by fiat reserves held in traditional bank accounts. For a fiat-backed stablecoin to be issued, the corresponding one-for-one reserve must be securely stored by the issuer.
These reserves are then maintained by an independent custodian and regularly audited to ensure compliance and full collateralization. You can think of a fiat-backed stablecoin as a “digital dollar” since its value will always equal that of the fiat currency it is pegged to. The most common fiat-backed stablecoins include USD Coin (USDC), Tether (USDT), TrueUSD (TUSD), and Paxos Dollar (PAX).
Like their fiat-backed cousins, “crypto-backed” stablecoins are fully collateralized, but rather than being backed by fiat-currencies like dollars, “crypto-backed” stablecoins are backed by cryptocurrencies like Ether. It may seem counterintuitive that a stablecoin would rely on a volatile cryptocurrency for price stability, but providers try to tackle this issue by “overcollateralization,” meaning that typically $1.5-2 worth of crypto is collateralized for every $1 of a stablecoin. MakerDAO’s DAI and Synethix’s sUSD are two types of crypto-backed stablecoins.
The final type of stablecoin is often referred to as “algorithmic” or “non-collateralized”. These stablecoins are blockchain based and built to maintain a stable price. These are by far the most technically complex stablecoins, and the stability mechanism differs from one coin to another. To date, there have not been any algorithmic stablecoins that have achieved any notable success.
Other cryptocurrencies, including bitcoin, have free-floating value, so their prices can be extremely volatile. It’s common to see massive price swings in the span of 24 hours. This can be intimidating, even to the very risk-seeking.
Stablecoins were created to combat that volatility. They capitalize on crypto innovation while avoiding the associated price volatility. Simply put, stablecoins offer the best of both worlds – the security and efficiency of a global cryptocurrency, with the stability of the US Dollar.
Stablecoins are popular for a number of reasons. For starters, they tend to be the easiest way for newcomers to dip their toes into the cryptocurrency waters. Stablecoins offer a way for individuals to get started with crypto without the risk of price volatility, ultimately eliminating market uncertainty.
For crypto traders and investors, stablecoins offer a way to safely store funds without having to convert to and from fiat. Converting fiat currencies to cryptocurrencies, and vice-versa, can be complicated, expensive, and burdensome. By using stablecoins as the intermediary between fiat and crypto, investors are able to significantly reduce fees and execute transactions almost instantaneously.
Additionally, stablecoins have become widely used as a way to save in dollars from places that don’t historically support US Dollar banking services. Services like Dharma enable users to store their stablecoins and earn an attractive rate of return. Create a Dharma account in just a few minutes and start earning interest on your stablecoins today!