What’s a Stablecoin? Main Types and Tips for Newbies
Something makes stablecoins different from ‘traditional’ crypto money. They are crafted to preserve a consistent value, not just out of some market agreement or speculations. Price volatility is a natural feature of any ‘true’ cryptocurrency like Bitcoin (BTC), Ethereum (ETH), or Solana (SOL). On the other hand, not just the most popular stablecoins but any stablecoins are developed to uphold an unchanging value. This is the difference between stablecoin and Bitcoin and other cryptocurrencies.
Stablecoins use various tools to tether their value to specific benchmarks. For example, it could be the value of fiat money, commodities, or alternative assets. Among the top stablecoins in 2024, one can find USDT, USDC, TUSD, and DAI out of many others.
How Do Stablecoins Work
Stablecoins are valuable for individuals seeking to minimize a cryptocurrency’s exposure to volatility. But traders still stay within the crypto world with all its benefits.
Stablecoins linked to fiat money like the USD or EUR act as a crucial tool. They connect the traditional and decentralized finance sectors (DeFi). Such a bond is achieved thanks to smooth, fast, dependable transactions worldwide, denying borders and distances.
Cash-collateralized stablecoins, such as USDT (Tether) and USD (USD Coin), derive their value from reserves of traditional currencies.
In this case, an equivalent amount of fiat currency, or its cash equivalent, is held in reserve as a backup for each coin. Such a reserve-backed model keeps the market confident. It assures people they can redeem their stablecoins for their stated value anytime.
In decentralized finance, people use stablecoins for lending, borrowing, and earning interest on their crypto assets. The price stability exhibited by these coins is paramount in DeFi protocols. It provides traders with a reliable unit of account for financial activities. It also helps to minimize risks like impermanent loss.
Every stablecoin endeavors to track the price of another asset. Yet, there are various methods of achieving it.
Certain stablecoins might introduce risks not encountered by others, depending on their pegged currency or commodity. Moreover, the susceptibility to price fluctuations, which stablecoins aim to mitigate, can differ among them.
Grasping the operational mechanisms of various stablecoins is a crucial stride toward selecting the most suitable coin.
Types of Stablecoins
The world of stablecoins has three types:
- Cash-collateralized stablecoins
- Crypto-collateralized stablecoins
- Algorithmic stablecoins
You may wonder: What type of stablecoin is USDT? However, first we should discover more about the nature and functionality of this digital money.
The stablecoins list is accessible through various cryptocurrency exchanges, such as Binance. Traders leverage stablecoins to mitigate the impact of price volatility, eliminating the need to convert their digital assets into traditional cash.
Presently, numerous stablecoin initiatives are in operation, with only a select few commanding the majority of stablecoin trading activity.
In 2022, the stablecoin transaction volume surpassed the annual volume of Mastercard and American Express payments. As you can see, the global interest in stablecoins as a reliable global financial tool is growing.
1. Fiat-collateralized Stablecoins
Fiat-collateralized stablecoins (or cash-collateralized stablecoins) are digital currencies backed on a 1:1 basis by a government currency, such as USD or EUR. The so-called ‘cash equivalents,’ primarily treasury bills, is another backup. These treasuries, securing stablecoins, are held in a financial institution like a bank.
Each unit of circulating stablecoin is supported by an equivalent amount of fiat currency held in reserve. This is why the stablecoin maintains a consistent value.
This type emerged in 2014 when Tether released the now-famous USDT. It is a dollar-backed cryptocurrency designed for trading on the global crypto markets. Tether is still the most popular stablecoin around the world.
Central banks or other finance authorities oversee USDT and other cash-collateralized stablecoins. Tether also released and currently manages another stablecoin, EURT, tied to the EUR.
Usually, third-party audits are conducted regularly. Auditing ensures that the tokens in circulation align with the reserves in a central bank. This boosts confidence in the stablecoin and reinforces its value in the market.
Following Tether, USD Coin, or USDC, is the #2 cash-collateralized coin by market capitalization. It was launched on the Ethereum blockchain in 2018. Now, USDC has expanded to support other top blockchains, such as Solana (SOL), Algorand (ALGO), and Tron (TRX).
2. Crypto-collateralized Stablecoins
These stablecoins are supported cryptocurrencies. They secure their value based on one or more cryptocurrencies.
Central administrative bodies operate such crypto-collateralized stablecoins. These assets leverage open-source software to empower traders to lock crypto assets as collateral. This generates new stablecoins through loans.
These stablecoins are frequently over-collateralized. This happens because their reserve cryptocurrencies could be subject to high volatility. In this case, the value of the cryptocurrency supporting such coins in circulation surpasses their value.
Because of its decentralized nature, the stablecoin supply cannot be manipulated within the blockchain. In this case, smart contracts adapt to the market price volatility of locked assets.
If you’re looking for a leading crypto-collateralized stablecoin, MarkerDAO’s DAI token is one of them.
3. Algorithmic Stablecoins
These digital assets rely on smart contracts to uphold their price pegs.
Some algorithmic stablecoins feature a secondary native token to maintain price stability. Some algorithmic stablecoins are known as rebase tokens. Their circulating supplies automatically adjust to maintain pegs. If prices exceed the pegs, the algorithm launches the new token minting. They are distributed among existing holders; this helps to ensure market price stability. On the other hand, if prices go down below the peg, the algorithm removes tokens in circulation until prices stabilize.
When the stablecoin surpasses its peg, holders can exchange one USD’s worth of the secondary token for one ‘initial’ unit of stablecoin. This enables them to sell and profit until the price returns to one USD.
If the stablecoin’s price falls below one USD value, holders can burn their tokens for a USD worth of secondary tokens. This model secures a modest profit for holders. At the same time, it reduces the supply of remaining stablecoins to restore its peg.
Are Stablecoins… Stable?
It’s crucial to understand that algorithmic stablecoin has carried more risks due to its bigger vulnerability to manipulation and attacks.
In 2022, Terra Luna, a leading algorithmic stablecoin project, collapsed within a few days. The event became known as a ‘death spiral’ in the crypto world. An investor offloaded plenty of the platform’s algorithmic stablecoin TerraUSD on the market. Such a move caused its price to detach from the US dollar. It triggered a series of troubles.
At the end of the day, the project’s market capitalization fell from around USD 60 billion to zero! Despite such dramatic fluctuations, operational examples of algorithmic stablecoins still function differently than UST. The examples are Ampleforth and Yam.
To Buy Or Not to Buy?
Just like other cryptocurrencies, stablecoins go across the borders on the global level. The transactions take place seamlessly at minimal expenses or commissions. These tangible advantages make stablecoins a valuable option to traditional banking.
Traders may still be interested in buying stablecoins. They offer the benefits of traditional cryptocurrencies, like transparency. At the same time, they protect holders from price volatility.
It is entirely up to you to try your luck in stablecoins. Yet, cash-collateralized stablecoins seem to be the most reliable solution regarding investing options.
If you decide to dive into the world of stablecoin investing, check your USDT wallet address balance often, and be sure to check our guide on how to manage risks when trading crypto. In an ever-changing world of stablecoins, your route must always be as safe as possible!
FAQ
How Do Stablecoins Maintain Stability?
Are Stablecoins Volatile Like Other Cryptocurrencies?
How Can I Buy Stablecoins?
