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What are stablecoins.png

What are stablecoins?

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PDAX

July 18, 2022

6 min read

BeginnerTokensCrypto Basics

TL;DR

Stablecoins are cryptocurrencies that are designed to minimize volatility. Stablecoins are often tied to the value of existing assets like the US dollar or with commodities like oil or gold. Because they are stable, they are commonly used in trading cryptocurrencies since they can stand in for the fiat currencies they represent. They are also used as a store of value and as a hedge during times of extreme market fluctuations. 

What are stablecoins?

As its name implies, stablecoins are designed to offer the stability and trust that comes with traditional fiat money. In the same way that we can generally count on the US dollar or the Philippine peso to be worth the same tomorrow as it is today, stablecoins can also be counted on to maintain their value unlike other cryptocurrencies which are generally regarded as more volatile. 

Coins like Bitcoin (BTC) and Ethereum (ETH) can be used as currencies, but they are not in widespread use for purchases and payments since their values can deviate from day to day–making it difficult and impractical for merchants and buyers to use them for exchanging goods and services.

Most popular stablecoins today like Tether (USDT) or USD Coin (USDC) are pegged to the US dollar. Since one USD stablecoin is always equal to one US dollar, they are also more convenient to use for everyday purchases among other uses:

Stablecoins make trading more convenient - Traders commonly use stablecoins as the “base” token in a cryptocurrency trading pair. This is because it is much easier to quote the different cryptocurrencies with different fluctuating values against the US dollar than it would be to quote them against another token with a fluctuating value. Using stablecoins as your base currency also makes it much simpler to record and keep track of your trading history and account your profit and loss margins. 

Stablecoins can hedge against volatility - During times of extreme volatility, traders can simply choose to convert their assets into stablecoins, rather than cashing them out for fiat money–which also means saving a lot on withdrawal fees. This also conveniently allows traders to keep their crypto on the exchanges, making it easier for them to resume trading whenever they choose to. 

Stablecoins are used in DeFi and CeFi - Aside from minimizing volatility, investors can also earn interest through stablecoins on various decentralized finance (DeFi) and centralized finance (CeFi) platforms. Similar to how banks can offer interest with your fiat money, DeFi and CeFi savings and loans applications can also do the same with your stablecoins–often with significantly higher interest rates. For long-term crypto investments, parking assets in stablecoins is a less risky approach and allow assets to grow through those interest rates.

Remittances are easier through stablecoins - Sending large amounts of US dollars to another bank account can often accrue expensive fees. But transferring stablecoins from one crypto wallet to another is a lot easier and cheaper. Since they run on blockchain networks, these transactions are also processed without hardly any waiting time. 

Technically, stablecoins are also utility tokens that are built on a blockchain network. Stablecoins still offer all of the benefits of standard cryptocurrencies such as privacy, anonymity, and convenience, but with an added bonus of dependability.

How are stablecoins “stable”?

Most stablecoins are able to maintain their price pegs by being backed by real world assets. There are generally four types of stablecoins depending on the asset that they’re directly tied or pegged to as collateral:

Fiat-backed stablecoins

Fiat-backed stablecoins such as USDT or USDC are kept stable by actual dollar reserves which are kept in banks. Generally, the process works this way: everytime US dollars are sent through the coin issuer’s bank account, a smart contract is drawn up which then automatically issues the corresponding amount of stablecoins onto the blockchain.

Conversely, everytime US dollars are withdrawn from the coin issuer’s bank account, the same amount of stablecoins are “burned” or removed from circulation. This simple system ensures that there is always a liquid supply of cash for any amount of stablecoins that are already in circulation. 

Ordinary users though won’t have to deal directly with the coin issuer to mint new stablecoins, as it is more convenient to acquire already existing stablecoins via cryptocurrency exchanges. 

Commodity-backed stablecoins

Commodity-backed stablecoins are those that are tied to the value of precious metals such as gold or silver, or to other commodities such as oil. But because the prices of commodities tend to fluctuate more, commodity-backed stablecoins are not as stable as their fiat-backed counterparts. 

Commodity-backed stablecoins have values that depend on the real-time values of the commodities that they represent. Stablecoins are able to accurately reflect the real-time values of these commodities through “oracles”.

If mining and staking nodes supply computational power to a network, oracle nodes on the other hand supply critical real world information to the blockchain so that smart contracts can execute their functions required by their algorithms. They fetch the real-time prices of various commodities like oil and gold and deliver these details to the blockchain so that commodity-backed stablecoins can maintain their price pegs. 

Currently, gold is the most popular commodity for backing stablecoins such as Tether Gold (XAUT) and Paxos Gold (PAXG).

Cryptocurrency-backed stablecoins

A cryptocurrency-backed stablecoin is a cryptocurrency which is backed by another cryptocurrency instead of cash reserves. A stablecoin like Dai (DAI) for example, is pegged to the value of the US dollar but is backed instead by ETH. But because the value of a crypto asset such as ETH can be volatile, the cryptocurrency-backed stablecoin might require double the amount of collateral for every token issued. 

Algorithmic stablecoins

An algorithmic stablecoin is the most unique among the group as it isn’t directly pegged to a tangible asset like fiat money or gold. Instead, the value of an algorithmic stablecoin is maintained by a computer code that is programmed into the blockchain network. 

These computer codes are programmed in a way that induces a healthy trading market in accordance with the laws of supply and demand. By analyzing market behavior on the blockchain, the supply of these algorithmic stablecoins also rise and fall to maintain its algorithmic peg. For example, USD Digital (USDD), a stablecoin on the Tron (TRX) blockchain, is able to keep its one-dollar peg through a mechanism that burns or mints USDD to balance its supply in response to current demand. 

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DISCLAIMER: The statements in this article do not constitute financial advice. PDAX does not guarantee the technical and financial integrity of the digital asset and its ecosystem. Any and all trading involving the digital asset is subject to the user’s risk and discretion and must be done after adequate and in-depth research and analysis.

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