What Are Stablecoins and How Do They Work?

Get the full lowdown on stablecoins, what they are, how they work, where to buy them, and the most popular tokens.

Feb 25, 2022
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What Are Stablecoins Otp

Key Takeaways:

  • Stablecoins are designed to maintain price stability and bridge the gap between fiat money and cryptocurrencies.
  • They are pegged to traditional assets like fiat money or gold, making them a relatively less volatile alternative than typical cryptocurrencies.
  • Promising faster transactions and lower costs, stablecoins are an alternative to traditional banking solutions.
  • They allow traders to keep their money in the crypto ecosystem while storing them in a stable asset between trades or during volatile periods.
  • Stablecoins are not risk-free. Some algorithmic stablecoins have depegged in the past.

What Are Stablecoins?

Stablecoins are cryptocurrencies that have their price pegged to a specific asset — which is most often, but not always, the United States dollar. 

It’s common knowledge that cryptocurrency prices can drastically rise and fall within a short period of time. Recalling the historical price of Bitcoin (BTC) in February 2021, it nearly doubled, rising from around US$32,000 to US$58,800. However, its price then dramatically dropped three months later in May 2021 to approximately US$34,000.

Such fluctuations, or so-called ‘short-term volatility’, make cryptocurrencies unfavourable for everyday use by the general public. 

Serving the purpose of maintaining value and purchasing power, pegging against an asset can make stablecoins more resilient to market fluctuations in the cryptocurrency space. For instance, one of the most popular stablecoins — Tether (USDT) — is commonly equal to US$1. Other popular stablecoins include USD Coin (USDC) and Dai (DAI).

Unlike typical cryptocurrencies, stablecoins not only have significantly lower volatility due to their asset-backed nature, they also play a bridging role in the world of cryptocurrencies and fiat money to facilitate daily commercial transactions and exchange.

Benefits of stablecoins include:

  • Lower volatility
  • Lower transaction costs
  • Safer options to store funds in the crypto ecosystem
  • Real-time payments

These benefits make stablecoins more competitive than other cryptocurrencies, as they relieve a number of consumer and business pain points. BTC and other cryptocurrencies are currently not able to offer the same level of stability and scalability for real-time transactions as compared to stablecoins.

The total market capitalisation of all the stablecoins in the world has reached more than half of the global crypto trading volume, making them an important asset for the DeFi ecosystem.

What Are Stablecoins Used For?

There Are Four Types of Stablecoins:

  • Fiat-collateralised stablecoins (the most popular)
  • Crypto-backed stablecoins
  • Commodity-backed stablecoins
  • Non-collateralised stablecoins

The primary use for a stablecoin is to facilitate trades on crypto exchanges. Instead of buying BTC directly with fiat, like the US dollar, traders often exchange their fiat for a stablecoin. Following that, they’ll use the stablecoin to execute a trade for another cryptocurrency, say BTC or CRO.

Stablecoins also have the potential to act as payment alternatives to fiat currencies. By utilising stablecoins, businesses can accept payments at a very low cost, and governments can run conditional cash transfer programmes more seamlessly. Stablecoins can also be used to quickly distribute monetary aid to beneficiaries worldwide, thanks to their high transaction speeds.

Another use for stablecoins is to send funds across international borders. Digital sol, a stablecoin that’s pegged to the sol, Peru’s national currency, launched on the Stellar blockchain in September 2021. It can be exchanged between individuals in different countries for cross-border money transfers without third-party fees.

How Do Stablecoins Work?

The pegging of stablecoins is near-perfectly one-to-one through various methods, including:

Reserving of pegged assets

Reserving of pegged assets refers to a fully collateralised system backed by pegged assets, where arbitrageurs are incentivised by helping to stabilise their price. When the price of a stablecoin is lower than its pegged asset, arbitrageurs can buy the stablecoin at a lower price before redeeming it at the price of its pegged asset. Conversely, when a stablecoin’s price is higher than its pegged asset, arbitrageurs can sell their holdings to turn a profit. Examples of asset-pegged stablecoins are USDC and USDT.

Dual stablecoins

Two coins exist in this system, where one is a pegged coin and the other is a coin used to absorb the volatility of the pegged coin.

Algorithmic stablecoins

Instead of using reserve systems or backed assets, algorithmic stablecoins use a fully algorithmic approach to adjust their supply in response to price fluctuations. However, due to their uncollateralised nature and reliance on algorithms to maintain the peg of an asset, they are broadly considered inherently more vulnerable to the risk of depegging. 

Algorithmic stablecoins largely depend on independent traders who are interested in profiting from an algorithm’s arbitrage opportunities to maintain the peg. In periods of uncertainty or crisis, the lack of demand for a digital asset can cause it to lose tremendous value in a short amount of time. This phenomenon is known as a death spiral, as seen in May 2022’s Terra (LUNA) crash.

Hence, when an uncollateralised stablecoin is compared against an asset-backed stablecoin, the latter is commonly viewed as the safer option.

Leveraged loans

Leveraged loan stablecoins are backed by an over-collateralised system. The most successful example is DAI, which is collateralised by multiple stablecoins and cryptocurrencies. The biggest share of its backing consists of USD Coin (USDC) and Pax Dollar (USDP), followed by Ethereum (ETH) and Wrapped Bitcoin (WBTC). If the collateral price falls sharply, the debt position will be liquidated, and the remaining collateral will be returned to the user.

Are Stablecoins Safe?

A common concern over stablecoins is whether they are secure and can be relied on as an alternative to fiat. Market participants should consider two things. First, perform the classic crypto advice of DYOR before committing funds. Check the issuing entity, its history, and past projects in detail before purchasing its stablecoins. Second, if in doubt, users can move their funds into other stablecoins or even other cryptocurrencies. 

What’s Next for Stablecoins?

Currently, stablecoin regulations are still up for discussion in most jurisdictions. For example, the President’s Working Group on Financial Markets in the US — composed of the heads of the US Treasury Department, Federal Reserve, US Securities and Exchange Commission (SEC), and Commodity Futures Trading Commission (CFTC) — released a report in November 2021 raising risks related to the lack of transparency, market integrity, and investor protection. Legislation to regulate stablecoin issuers is proposed but yet to be enacted.

With the growing acceptance of cryptocurrencies and the steadiness that stablecoins bring to DeFi, their integral role in the ecosystem is cemented. They make cryptocurrency trading and lending much easier. While legislation in some countries may place additional restrictions and requirements on stablecoin issuers, it is also anticipated that financial regulatory agencies and relevant stakeholders will continue to work closely on ways to foster financial innovation while minimising the associated risks.

Learn More About Stablecoins

Crypto.com offers the most popular stablecoins in the market for trading, including USD Coin (USDC), Tether (USDT), and Dai (DAI). Users can purchase them on the Crypto.com App or Exchange. For those new to crypto, take a look at Crypto.com University and the Help Centre to learn more about buying stablecoins and other cryptocurrencies.

Due Diligence and Do Your Own Research

All examples listed in this article are for informational purposes only. You should not construe any such information or other material as legal, tax, investment, financial, or other advice. Nothing contained herein shall constitute a solicitation, recommendation, endorsement, or offer by Crypto.com to invest, buy, or sell any coins, tokens, or other crypto assets. Returns on the buying and selling of crypto assets may be subject to tax, including capital gains tax, in your jurisdiction. Any descriptions of Crypto.com products or features are merely for illustrative purposes and do not constitute an endorsement, invitation, or solicitation.

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Past performance is not a guarantee or predictor of future performance. The value of crypto assets can increase or decrease, and you could lose all or a substantial amount of your purchase price. When assessing a crypto asset, it’s essential for you to do your research and due diligence to make the best possible judgement, as any purchases shall be your sole responsibility.

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