What Are Stablecoins And How Do They Work In Crypto?
Summary
- A stablecoin refers to a range of cryptocurrencies that are linked to another asset whose value stays stable over time compared to the currency it is connected to since it represents the underlying asset
- Stablecoins can be categorized on the basis of their working mechanisms — crypto-collateralized, algorithmic, and fiat-collateralized stablecoins
- As of June 29, 2022, Tether (USDT): $66.7 billion, USD Coin (USDC): $55.8 billion, and Binance USD (BUSD): $17.5 billion are among the most well-known stablecoins
- According to CoinGecko, the entire market capitalization is $904.37 billion, of which the value of all stablecoins is less than $150 billion
What is a Stablecoin?
A stablecoin is a cryptocurrency whose value is linked to another asset class, such as a fiat currency or gold, to stabilize its price. The value of a stablecoin is frequently correlated to a real currency, most frequently the U.S. dollar. In this situation, one cryptocurrency unit is equivalent to one fiat currency unit. In contrast to highly volatile cryptocurrencies like Bitcoin, the prices of stablecoins are not meant to fluctuate.
According to experts from JPMorgan, the sudden increase in the market share of stablecoins like Tether (USDT) might portend future gains for cryptocurrencies.
Government regulators are, however, closely watching this market due to recent incidents, such as the collapse of TerraUSD. The Secretary of US Treasury, Janet Yellen, has recognized dangers to overall financial stability due to stablecoins in the market, even though the Federal Reserve has published a report describing the ambiguity of what is backing stablecoins and the lack of monitoring in that area.
Here’s how Stablecoins Work
A stablecoin is linked to another asset whose value stays stable over time compared to the currency it is connected to since it represents the underlying asset. In actuality, it appears as though the underlying asset, such as a dollar, has gone digital. Because their primary function is to track an asset, stablecoins are typically backed by the specific assets to which they are connected. For instance, the business issuing the stablecoin frequently establishes a reserve with a financial institution that holds the underlying asset.
So a stablecoin might produce 100 million coins with a set value of $1 each while still maintaining a reserve of $100 million. The fiat money can eventually be removed from the reserve if the owner of a stablecoin wishes to cash out the coin.
Most cryptocurrencies, like Bitcoin and Ethereum, have no backing whatsoever, in contrast to this arrangement. As a result, the prices of these cryptocurrencies vary a lot as traders try to benefit from price fluctuations.
Not all stablecoins are backed by tangible assets. Individuals control the price of a crypto coin using technical means (such as eliminating a portion of the coin supply to increase scarcity). Stablecoins backed by assets is known as algorithmic stablecoins and carry higher risk.
Types of Stablecoins
Based on the mechanism used to stabilize their value, there are primarily three types of stablecoins.
1- Fiat-Collateralized: Fiat-collateralized stablecoins are backed by a government-issued currency, as the name implies. This means that in order to issue a certain quantity of a given cryptocurrency’s tokens, the issuer must provide collateral in the form of dollar reserves equal to that quantity.
A reserve of the money is retained as security for stablecoins backed by fiat currency. Other forms of fiat include precious metals like platinum or silver, as well as goods like grain or oil.
TrueUSD and Tether are examples of cryptocurrencies that are backed by dollar deposits (USDT).
2- Crypto-Collateralized: Crypto can also be used to support another crypto. Stablecoins that are backed by crypto retain an overcollateralized position to offset the increased relative volatility of backing stablecoins with cryptocurrencies.
In contrast to fiat-backed currencies, the stablecoin will circulate in a far smaller quantity than the reserve. For instance, a cryptocurrency-backed stablecoin might not maintain a 1-to-1 ratio but issue just $500 worth of coins for every $2,000 worth of cryptocurrency in reserves.
3- Algorithmic Stablecoins: Although asset-backed stablecoins are thought to be stable because of their underlying assets, they necessitate keeping enormous sums of cash on hand. Algorithmic stablecoins are a possible substitute for this. These employ mathematical techniques written in smart contracts on the blockchain to tether the price of coins to the reserve currency.
This is frequently accomplished by releasing a governance token along with the stablecoin. The governance token may be purchased, burnt, or arbitrated to counteract the price volatility of the primary stablecoin.
Why are Stablecoins Used in Crypto Trading?
One of the biggest issues with many popular cryptocurrencies is that they are difficult, if not impossible, to use for actual transactions. Stablecoins address this issue.
Thanks to their stability, many stablecoins can also be utilized as a functional currency within a cryptocurrency brokerage. For instance, rather than converting Bitcoin to dollars, traders may instead convert it into a stablecoin like Tether. Stablecoins are more readily available than currency earned through the banking system, which is shut down during the weekend and overnight.
Additionally, stablecoins may be utilized with smart contracts, an electronic contract that automatically executes when all of its conditions are met. The digital currency’s steadiness also aids in avoiding disputes that could develop when dealing with more volatile cryptocurrencies.
Which Stablecoins are the Most Widely Used?
Stablecoins often don’t receive as much coverage as other cryptocurrencies because they don’t provide the same kind of “get rich quick” possibility as other cryptocurrencies.
As of June 29, 2022, the following handful are among the most well-known cryptocurrencies by market capitalization:
- Tether (USDT): $66.7 billion
- USD Coin (USDC): $55.8 billion
- Binance USD (BUSD): $17.5 billion
Source: https://coinmarketcap.com/
The magnitude of these coins is dwarfed by the most prominent cryptocurrencies, including Bitcoin, with a market cap of close to $384 billion, and Ethereum, with $134.7 billion.
Another popular choice was TerraUSD, an algorithmic stablecoin, but it lost its tie to the dollar in May 2022. To keep its value at 1:1, this stablecoin used other cryptocurrencies and a clever arbitrage scheme. However, the downturn in the cryptocurrency market and the subsequent reduction in trust in the stablecoin have caused its price to decline drastically.
Conclusion
The percentage of stablecoins in the overall crypto market dropped from 10% to 7% in late April 2022, prompting analysts to predict a brief decline in price. According to cryptocurrency analytics company CoinGecko, the entire market capitalization is $904.37 billion, while the value of all stablecoins is less than $150 billion.
The share of stablecoins has been rising over the past several weeks, even though the total supply of all stablecoins had one of the sharpest reductions ever during the second quarter of 2022. The failure of algorithmic stablecoins like TerraUSD has led to a lot of FUD being spread about the stablecoin industry.
However, keep mind that although stablecoins have the potential to offer several benefits, they are not immune to risks. One of the most significant risks associated with stablecoins is depegging, leading to a loss in value relative to the underlying asset.
