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Education | Guides

A Beginner’s Guide To Stablecoins: Understanding Their Types And Uses

Author

Rickie Sanchez

Tags

Tags Editor's Choice / Slider Posts

Reading time

4 mins
Last update

Author

Rickie Sanchez

Tags

Editor's Choice / Slider Posts

Reading time

4 mins
Last update

Author

Rickie Sanchez

Tags

Editor's Choice, Slider Posts

Reading time

4 mins
Last update

stablecoins

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Key Takeaways

  • Stablecoins are cryptocurrencies whose value is pegged to another asset class, such as fiat currencies like the US dollar or the Euro.
  • They aim to offer price stability, making them more suitable for everyday transactions.
  • Some stablecoins are backed by reserves of the pegged asset (fiat-backed), while others use algorithms to manage supply and demand (algorithmic).

When you think of cryptocurrencies, “stable” probably is not the first thing that comes to mind. In the volatile crypto world, prices can go up or down dramatically.

However, stablecoins aim to achieve the opposite effect, maintaining a constant value to offer investors a haven from the intense price fluctuations of Bitcoin and other tokens.

The collapse of one so-called stablecoin, TerraUSD, has shaken investors’ faith in crypto. It also set off alarm bells for global regulators who worry that this phenomenon may hold much broader risks to the financial system.

What Are Stablecoins?

Stablecoins are a type of cryptocurrency designed to address the volatility issues of digital currencies. Unlike Bitcoin or Ethereum, whose values fluctuate wildly, stablecoins are pegged to real-world assets such as the US dollar or gold. This peg aims to stabilize the stablecoin’s price, making it more suitable for everyday transactions.

Types Of Stablecoins

Fiat-Collateralized Stablecoins (⚠️Risk: 1/5)

This group of stablecoins leverages a fiat currency reserve, typically the US dollar, to generate an appropriate volume of cryptocurrency coins. 

The issuance is backed by collateral held and safeguarded by a central issuer or a financial institution, and the amount of collateral is maintained in proportion to the number of stablecoin tokens in circulation. 

A team of independent trustees also oversees these reserves, and regular audits are conducted to guarantee compliance with essential standards.

Examples: Tether (USDT), Circle (USDC), PayPal USD (PYUSD)

Crypto-Collateralized Stablecoins (⚠️Risk: 1.5/5)

This category of stablecoins aptly earns its name by being secured through the backing of other cryptocurrencies. Your crypto holdings are locked into a smart contract; in return, you receive tokens with equivalent value. Instead of relying on a central issuer, this method operates through smart contracts.

Crypto-collateralized stablecoins use a safety net called over-collateralization. This means they hold more valuable crypto assets than the stablecoins they issue, protecting the peg if the price of the collateral drops.

Due to the inherent volatility of reserve cryptocurrencies, a greater quantity of crypto tokens is held in reserve. This buffer ensures that releasing a comparatively smaller number of stablecoins preserves the stability of the coin’s value.

Examples: Dai (DAI), Wrapped Bitcoin (WBTC), Wrapped Ethereum (WETH)

Commodity-Backed Stablecoins (⚠️Risk: 2/5)

Some stablecoins are backed by real-world assets like gold or silver. While this provides stability, the price of these commodities can fluctuate, meaning the stablecoin’s value could also change. However, these commodity-backed stablecoins offer an easier way to invest in these assets than traditional methods.

To provide context, acquiring and managing assets such as real estate can be expensive and inconvenient, especially depending on where you live. Commodity-backed stablecoins could offer a solution for people who want the flexibility to easily buy and sell these assets (convert tokens to cash) or even take possession of the real thing (obtain ownership).

Examples: Paxos Gold (PAXG), Tether Gold (XAUT)

Non-Collateralized Or Algorithmic Stablecoins (⚠️Risk: 5/5)

Unlike other stablecoins, algorithmic stablecoins don’t rely on reserves of assets for stability. Instead, they use smart contracts and algorithms to manage the supply of tokens automatically.

Similar to a central bank that controls the money supply to influence fiat currency value, algorithmic stablecoins rely on smart contracts to keep the stablecoin’s price pegged to its target, like the US dollar.

Example: Frax (FRAX)

How To Buy Stablecoins?

Most people buy stablecoins on centralized exchanges, just like any other cryptocurrency. The process is similar, but make sure the exchange you choose offers the specific stablecoin you want.

Some crypto exchanges create their own stablecoins to improve their business in a few ways. They can make trading smoother for users, attract more buyers and sellers (increase liquidity), and bring in profits for the exchange.

Are They Good Investments?

Stablecoins are designed to maintain stability, leading to minimal price fluctuations. Therefore, they are not regarded as investment vehicles since they do not generate profits.

Final Thoughts

Stablecoins offer some stability in the wild world of crypto, but it’s important to do your own research (DYOR) before you buy. This is a fast-changing space, and even seemingly stable assets can still be risky. Until things are more regulated, it is best to use stablecoins for what they are good for, such as sending money quickly, holding it for short periods, and making trades easier.