What is a Stablecoin? Most Popular Stablecoins
Cryptocurrencies have long been known for their high volatility, which has hindered their widespread use for everyday transactions. People typically desire a stable currency to ensure financial security and stability. This is where stablecoins come into play. In this article, we will dive deep into the world of stablecoins, their technology, their types, and the risks associated with them
What is a stablecoin?
A stablecoin is a type of cryptocurrency that is designed to have a stable value in comparison to a fiat currency or a commodity. In simpler terms, stablecoins are digital tokens that are pegged to a specific value, usually to a fiat currency like the US dollar or the Euro. The idea behind stablecoins is to provide a more stable and less volatile form of cryptocurrency that can be used for everyday transactions.
Stablecoins were created to solve the volatility problem that is often associated with cryptocurrencies like Bitcoin and Ethereum. Unlike traditional cryptocurrencies, stablecoins are backed by tangible assets, such as fiat currency, gold, or other commodities. The assets are held in reserve to ensure that the stablecoin’s value remains stable, regardless of market fluctuations. Stablecoins are used for various purposes, including trading, payments, remittances, and store of value.
History of stablecoins
The concept of stablecoins was first introduced in 2014 by a cryptocurrency exchange called Bitshares. Bitshares launched a stablecoin called BitUSD, which was pegged to the US dollar. However, BitUSD did not gain much traction, and it was not until 2018 when stablecoins gained widespread adoption.
In 2018, Tether (USDT) became the first stablecoin to gain significant popularity in the cryptocurrency market. Tether was designed to be pegged to the US dollar and was used primarily for trading on cryptocurrency exchanges. However, Tether faced criticism for its lack of transparency and its failure to prove that it had the necessary reserves to back its stablecoin.
How do they work?
There are various economic mechanisms that stablecoins utilize to maintain relative stability by holding their peg. The technology behind stablecoins can vary depending on the type of stablecoin. Stablecoins can be classified into different types based on the asset they are pegged to. Here are the most common types of stablecoins:
Fiat-сollateralized сtablecoins: аiat-collateralized stablecoins are backed by a reserve of fiat currencies, such as the U.S. dollar or the euro. Examples of popular fiat-collateralized stablecoins include Tether (USDT), USD Coin (USDC), and TrueUSD (TUSD).
However, even such trusted and established stablecoins are not bulletproof considering the latest events. Circle's USDC stablecoin has deviated from its $1 peg due to Circle's exposure to the now-collapsed Silicon Valley Bank, one of the most renowned lenders to Silicon Valley startups. Circle revealed that it holds $3.3 billion of its $40 billion USDC reserves at the fallen lender. The news sparked redemptions, causing USDC to burn $2.34 billion and slide to an all-time low of $0.8774 on Saturday, March 13, 2023. After that, it quickly began to return to its normal price.
Сommodity-collateralized stablecoins: сommodity-collateralized stablecoins are backed by a reserve of commodities such as gold or silver. Examples of commodity-collateralized stablecoins include Digix Gold (DGX) and Paxos Gold (PAXG).
Crypto-collateralized stablecoins:crypto-collateralized stablecoins derive their value from cryptocurrency used as collateral. Through the use of smart contracts on the blockchain, users can exchange their cryptocurrency for stablecoins of equal value, and then retrieve their original cryptocurrency by returning the stablecoins to the same smart contract. The popular stablecoin DAI employs this mechanism by utilizing a collateralized debt position (CDP) through MakerDAO to secure assets as collateral on the blockchain.
Algorithmic stablecoins: such stablecoins maintain their price stability through the use of specialized algorithms and smart contracts to manage token supply. They do not have any tangible assets backing them. When the market price of the algorithmic stablecoin falls below the price of its corresponding fiat currency, the system reduces the number of tokens in circulation. Conversely, if the token price surpasses the price of the fiat currency, the system releases new tokens into circulation to lower the stablecoin's value. However, this type of stablecoin is considered risky and has been facing harsh criticism due to the notorious collapse of TerraUSD.
On May 11, 2022, the TerraUSD (UST) algorithmic stablecoin experienced a drastic decline of over 60%, leading to the loss of its peg to the U.S. dollar. This drop occurred as the price of the Luna token, which is used to peg Terra, plummeted by more than 80% overnight.
Although stablecoins offer a more stable and less volatile form of cryptocurrency, they are not without risks. One of the biggest risks is that their value can be depegged from the underlying asset, which can lead to significant losses for investors, stablecoins continue to come under scrutiny by regulators, particularly with regards to their lack of transparency and potential for use in money laundering and illicit activities. It is important to thoroughly research any stablecoin before investing and to monitor its performance and any regulatory developments closely.