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Cryptocurrency Guide | Guides

What are Stablecoins and How Do They Work?

Author

Jay Solano

Tags

Reading time

4 mins
Last update

Author

Jay Solano

Tags

Reading time

4 mins
Last update

Author

Jay Solano

Tags

Reading time

4 mins
Last update

stablecoins

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Key Takeaways

  • Stablecoins are like digital cash. Their value is tied to something steady, like a dollar, so they’re more stable and predictable.
  • This stability makes them better for everyday spending. You can use them to buy things without worrying about wild price swings.
  • Stablecoins are a new technology, so some risks remain to consider. For example, they might rely on banks that could have problems, which are not yet widely used.

Stablecoins are a type of cryptocurrency introduced to solve the problem of wild price swings in traditional cryptocurrencies. Unlike Bitcoin or Ethereum, whose value can fluctuate dramatically, stablecoins are pegged to another asset, like the US dollar or gold. This peg acts like an anchor, stabilizing the stablecoin’s value and making it more predictable.

On the other hand, stablecoins are more like a flat train ride. This stability makes them more suitable for everyday transactions.

Purpose of Stablecoins

  • Reduce volatility: They aim to make cryptocurrency a more practical option for everyday use by minimizing the price fluctuations that plague traditional cryptocurrencies.
  • Bridge the gap: Stablecoins can bridge the gap between the traditional financial system and the crypto world. You can hold value in a familiar format (like a dollar-pegged stablecoin) while still benefiting from the advantages of cryptocurrency, such as faster and potentially cheaper transactions.
  • Enable new applications: Stablecoins can unlock new financial applications within the crypto ecosystem. For instance, they can be used for lending, borrowing, and even earning interest.

While stablecoins offer some advantages, it’s important to remember that they are still a developing technology. There are ongoing discussions about regulations and potential risks associated with them.

Different Types of Stablecoins

Understanding the three main stablecoins, each using a different method to maintain a steady value, is essential for making investment decisions. This knowledge will help you to choose the type that best suits your investment strategy and risk tolerance. 

  • Fiat-backed stablecoins

These are like cash in the crypto form. They’re pegged to real money (usually US dollars) and backed by real-world dollars in a bank account. Think of them like getting a digital dollar token. Tether (USDT) is a famous example.

  • Crypto-backed Stablecoins

These stablecoins use other cryptocurrencies as deposits, but because of crypto’s volatility, they are usually “overcollateralized.” This means the value of the crypto they hold as a deposit is always more than the total value of the stablecoins they create.

  • Algorithmic Stablecoins

These are the most complex, relying on computer programs to manage their value. They’re still new and can be risky, as shown by TerraUSD (UST) which lost its peg to the dollar in 2022.

Choosing the right stablecoin depends on your investment goals and how much risk you’re comfortable with.

Stablecoins are cryptocurrencies pegged to a stable asset, to reduce volatility. This makes them more practical for everyday transactions than traditional cryptocurrencies, which can fluctuate in price. Here are some of the most popular stablecoins:

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  • Tether (USDT): Tether is the most widely used stablecoin, with a market capitalization of over $80 billion. It is pegged to the US dollar and is backed by a basket of assets, including cash and short-term debt.
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  • USD Coin (USDC): USD Coin is another popular stablecoin pegged to the US dollar. It is backed by a consortium of regulated financial institutions, including Coinbase and Circle.
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  • Binance USD (BUSD): Binance USD is a stablecoin issued by Binance, one of the world’s largest cryptocurrency exchanges. It is also pegged to the US dollar.
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  • Dai (DAI): Dai is a decentralized stablecoin that is not pegged to a single asset. Instead, it is backed by a pool of other cryptocurrencies.
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  • TrueUSD (TUSD): TrueUSD is another US dollar-pegged stablecoin regulated by a group of financial institutions.

These are just a few of the many stablecoins that are available. When choosing a stablecoin, it is important to consider the asset it is pegged to, the reputation of the issuer, and the regulatory environment.

Disadvantages of Stablecoins

This centralization can be a disadvantage, as it can make stablecoins more prone to manipulation and hacking. Stablecoins like USDC are still new, and their adoption is limited compared to traditional cryptocurrencies like Bitcoin and Ethereum.

Final Thoughts

Stablecoins has a future of crypto for everyday use. They act like digital cash, pegged to stable assets for price stability, making them ideal for buying your morning coffee without fearing price swings.

But it’s important to remember that they’re still a new technology. They might be great in the future, but some challenges remain. Their use may depend on institutions that face challenges, and everyday use is still in its early stages.

Overall, stablecoins have a lot of potential. They connect the gap between traditional finance and the crypto world, offering a more stable and more convenient version of cryptocurrency.