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Stablecoins are cryptocurrencies that peg their values to other assets to avoid massive market volatility.
When Bitcoin appeared, many investors envisioned it as a means of payment for everyday products like pizza. For instance, Laszlo Hanyecz paid 10,000 BTC for two pizzas in 2010. At that time, BTC’s value was dismal and below one dollar. However, the same order would cost someone over $600 million today.
In the past decade, Bitcoin has increased in value exponentially. However, it was also the subject of intense volatility throughout this period. Like fiat currencies, BTC and most other cryptocurrencies cannot escape extreme market volatility. However, a handful of crypto assets maintain a stable value by pegging to fiat currencies and becoming stablecoins.
In this short guide to stablecoins for beginners, we look at some of the most interesting crypto assets. If you are new to crypto, you should find this information helpful to your initiation.
What Are Stablecoins?
As its name implies, stablecoins are a new breed of cryptocurrencies with stable prices. They rely on the backing of underlying assets to maintain a little value. These assets can be on-chain tokens or real-world assets like gold and fiat currencies. And this mechanism aims to create cryptocurrencies almost immune to the crypto market volatility.
Over the past year, stablecoins have increased in popularity. For instance, transaction volumes hit an all-time high of $54.9 billion in June 2021. Meanwhile, the global market cap of stablecoins has recently quadrupled to $140 billion. It represents over 14% of the total crypto market cap of approximately $1 trillion.
How Do Stablecoins Work?
Similar to the dollar in your bank account, the value of stablecoins does not change much. This is because the stablecoin creators realized the importance of stability when using a currency. In turn, a stable asset has to anchor cryptocurrencies to achieve this much-needed stability.
Generally, these tokens have a backing ratio of 1:1. Simply put, if 1 million stablecoins are in circulation, the issuer must have a minimum of $1 in its reserve.
Stablecoin can also have the backing of real-world assets. For example, each token can be backed by one barrel of oil or one ounce of gold. Recently, a new category of stablecoins backed by smart contracts that control the token’s price has surfaced in the market. These digital contracts eliminate the need for reserve asset backing.
Types of Stablecoins
Let’s delve deeper into stablecoins by analyzing them depending on the assets that back their stability.
These coins use fiat currencies as collateral. Additionally, they may use commodity reserves like silver, gold, or oil. However, most fiat-backed stablecoins use the U.S. Dollar. Generally, independent custodians maintain these reserves, and auditors check them regularly to ensure strict compliance with the measures.
These stablecoins use other cryptocurrencies as collateral. Market volatility can affect the reserve currency. So, the industry considers these types of stablecoins over-collateralized. This means that by issuing a lower number of stablecoins, a more significant number of crypto-assets enter the reserves.
For instance, a total of $100 crypto-collateralized stablecoins has a $200 price of crypto in reserves. This translates into more than 50% if the market drops in the reserve currency.
These non-collateralized stablecoins do not utilize any reserves. Instead, they use a working technology similar to central banks to maintain a steady price. In addition, these coins depend on a mechanically-generated algorithm that changes the supply if necessary.
These stablecoins employ smart contracts to sell the coins if the price falls below the set price. Also, the mechanism aids in increasing the value to supply more coins to the crypto market.
List of the most popular stablecoins
Below are four of the most popular stablecoins available in the market today.
Tether (USDT) is the first virtual currency that uses the U.S. Dollar as collateral. The token launched in and uses a U.S. dollar bank reserve under the management of Tether Limited. This coin has a market capitalization of about 73 billion, making it the fourth-largest cryptocurrency in the world.
Tether is available on all major cryptocurrency exchanges, including Coinbase, Binance, Bitfinex, and Kraken. Also, you can invest in it by directly exchanging it with another cryptocurrency, like ETH, on the same platforms.
USD Coin (USDC)
USD Coin (USDC) was launched in 2018. Today, it is one of the fastest-growing dollar-backed stablecoins in crypto. It is a joint project between Coinbase and Circle. Also, it features monthly reserve evidence from an industry-leading auditing firm. This way, investors can be sure of its transparency and reliability.
USDC functions as a blockchain-based network available on many blockchain networks. These networks include Solana, Tron, Algorand, Ethereum, and Stellar. In turn, you can use USDC as a medium of cross-border payments. Furthermore, you can use it to trade against other cryptocurrencies and as a store of value in DeFi markets.
Binance USD (BUSD)
In 2019, Binance teamed up with Paxos to launch Binance USD (BUSD), a virtual dollar-backed. It has a ratio of 1:1 USD, and the New York State Department of Financial Services regulates it. Also, its U.S. dollar reserve remains in FDIC-insured banks.
A reputable audit firm checks the authenticity and compliance of the reserves every month. This way, the platform ensures investors of its stability and reliability.
You can hold BUSD as a hedge against crypto market volatility and fiat money devaluations. Also, you can trade it in the DeFi markets for lending and borrowing.
Maker Dao (DAI)
Maker Protocol and MakerDAO launched this popular ERC 20 coin on the Ethereum blockchain. However, unlike other stablecoins, DAO employs a smart contract to manage its supply. For instance, the platform deposits cryptocurrencies in its smart contract vaults for every DAI token it issues.
DAO maintains a stable reserve of 1:1 to the U.S. Dollar. Thus, the platform will burn DAO if a certain amount of crypto exits the smart contract vault.
One of DAO’s significant advantages is its public records on the Ethereum blockchain. Therefore, the burning and issuance of these tokens are open for all to see.
Due to the increasing adoption of virtual currencies, the importance of stablecoins within the traditional financial industry will increase drastically. And so will their regulations, which will develop parallel to their mainstream adoption.