What are Stablecoins?

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One of the biggest cons of crypto assets is their volatility. A cryptocurrency like SOL can lose or gain up to 20% of its value in a single day. It is still difficult to use cryptocurrencies for day-to-day transactions because of their volatility. SOL may be worth 200 dollars today and skyrockets to 250 dollars tomorrow only to plunge to 180 dollars the next day.

What if there’s a way you can get into cryptocurrency without being exposed to its volatility? Is it possible to enjoy the benefits of cryptocurrency like decentralization, convenience, safety, anonymity, and freedom without risking volatility? Today you will learn all you need to know about stablecoins. We will talk about what they are, how they work, and some risks involved in holding them.

Simply put, stablecoins are cryptocurrencies without volatility. A stablecoin is a utility token pegged to an underlying asset whose price depends on the price of the underlying asset or collateral. Stablecoins let you enjoy both the advantages of blockchain technology and that of the  world of traditional finance. You can enjoy the trust and stability of fiat currencies while also benefiting from blockchain technology’s decentralization, anonymity, safety, and freedom.

What are stablecoins used for?

Stablecoins are mostly used on cryptocurrency exchanges. You can trade your cryptocurrencies for stablecoins when you want to reduce your risk. Say you invested in SOL when it was about 5 dollars, then the price goes up to 200 dollars. To reduce your risk, you may decide to trade your SOL for a stablecoin like USDT. Let’s say the price of SOL falls to 100 dollars. Naturally, you’d decide to exchange your USDT for more SOL. In that way, you enjoy the profits of trading crypto assets while reducing your exposure to their volatility.

Another use of stablecoins is that you can easily transfer funds between crypto exchanges conveniently and quickly without worrying about government regulations or fees. Also, you can invest your stablecoins in liquidity pools and earn interest on your assets. You wouldn’t have to worry about things like impermanent loss or price fluctuations. With stablecoins, you get to enjoy the interest and not worry about the volatility. 

How stablecoins work.

So how do stablecoins work? How is it possible for them to be both cryptocurrencies and not be volatile?. Let’s get into some technicalities. Remember our definition of stablecoins? They are utility tokens pegged to an underlying asset whose prices depend on the price of the underlying asset or collateral.

The different assets stablecoins can be pegged to are:

• Fiat currencies like the dollar.
• Real-world assets like gold.
• Cryptocurrencies like Ethereum.
• Algorithms or smart contracts. 

Let’s carefully explain these concepts.

Fiat currencies

A stablecoin may be pegged to a fiat currency, usually the US dollar. In most cases, one unit of a stable coin is the same as one US dollar. Examples of stablecoins pegged to the US dollar are:

USDT

USDC

BUSD

An advantage of fiat-backed stablecoins is:

1. They are safe against volatility.

However, there are cons too, they include:

1. A company issues them; hence they are centralized.
2. It’s difficult to prove that the company owns enough collateral to back the amount of the coins in circulation. Hence, frequent auditing is needed to ensure the company has sufficient collateral.
3. There’s the risk of embezzlement of the collateral or the company going bankrupt.

Real-world assets

In this case, instead of being backed by fiat, the stablecoins are backed by assets like gold. An example is Digix. The advantage of gold-backed stable coins is there’s no risk of volatility associated with crypto assets.

But, the cons are similar to fiat-backed stablecoins:

1. They are centralized
2. There’s no way to prove that the company has enough assets in reserve, so you have to trust them.

Crypto-backed stablecoins

These stablecoins are backed by other cryptocurrencies like ETH. They are quite volatile compared to other types of stablecoins. Their value depends on the value of the underlying crypto asset, which is volatile. To ensure their stability, they are overcollateralized. This means that a $1 stablecoin has underlying assets worth above $2. This ensures that if the price of the crypto asset drops, more of it must be available to back the stablecoin, else the stablecoins will lose their value.

An example of a crypto-backed stablecoin is Dai.

Advantages of crypto-backed stablecoins include:

1. Decentralization and transparency.
2. With crypto-backed stablecoins, everything is stored on the blockchain.
3. You can easily exchange it for the underlying crypto asset.

Some cons of crypto-backed stablecoins are:

1. Volatility.

They are quite volatile compared to other stablecoins, so you must continually keep an eye on the value of the underlying crypto asset.

       2. They are heavily dependent on the value of a particular crypto asset. They can be auto-liquidated during a price crash.

Algorithmic or smart contract backed stablecoins

These stablecoins are not backed by any underlying asset.  Instead, they are controlled by smart contracts. The smart contracts use oracles to monitor the price of a stablecoin on different exchanges. When the price goes up above desired value, an algorithm will supply more tokens, and when the price goes down, an algorithm will sell tokens. This ensures that the value of the stablecoin remains the same. Because the number of tokens in circulation is continually changing, the number of tokens in your wallet will change. Still, the value will always remain the same.

An example of smart contract-backed stablecoins is Ampleforth.

Pros of smart contract-backed stablecoins

1. No underlying collateral is required.
2. It is controlled by a public and easily accessible algorithm.
3. It’s not tied to any fiat or cryptocurrency.

Some cons of smart contract-backed stable coin

1. The balance of coins in your wallet will change based on the total circulating supply.
2. You need to read the algorithm or at least trust it.

Where you can buy stablecoins?

You can easily buy stablecoins on both centralized and decentralized exchanges. You can also buy a cryptocurrency like SOL on a centralized exchange, transfer it to your wallet and then swap it for a stablecoin on a decentralized exchange.

In conclusion, stablecoins enable you to invest in crypto technology without exposing yourself to the risks of volatility.