What are stablecoins and how do they work?

Why are stablecoins used in crypto trading?

The problem with using cryptos such as Bitcoin as a form of payment is that they experience changes in market value. Using stablecoins can help eliminate this since they are often backed by stable assets, meaning their values do not fluctuate. Stablecoins form a crucial part of the overall crypto market.

Due to their stable nature, they can be used for things such as financing, borrowing, or lending. They are a great alternative to regular banking since they promise lower costs and faster transactions. Stablecoins are used to lend since they offer better rates compared to those offered by regular savings accounts. Some people also use them to gain crypto-backed loans in the Defi space.

Traders prefer using stablecoins because they allow one to keep their funds in the crypto ecosystem while storing them in a stable asset when the market is volatile. In the world of cryptocurrency, dealing with fiat money is not always easy due to regulations and restrictions.

Investing in cryptocurrency with hard cash is difficult since most crypto exchanges deal with USD. Stablecoins are a great substitute for dollars since they can help one invest in other cryptocurrencies.

They can mimic the nature of the U.S dollar to help investors sell bitcoins and, in turn, get cash. They are also used in crypto trading since they offer the liquidity that the crypto marketplace requires. Many traders also utilize stablecoins to invest in other assets such as off-chain assets within a decentralized finance protocol.

Some forms of stablecoins are also used in crypto staking. If, for instance, you are a crypto owner, you can lend out your holdings to help execute different transactions and, in turn, earn rewards.

As crypto staking has certain risks, it is important to understand everything regarding the stablecoin you wish to utilize. Some people also use stablecoins to pay salaries in cryptocurrency to save on costs when doing cross-border transactions.

Types of Stablecoins 

Though stablecoin cryptocurrencies may have similar algorithms, they are not created equally. Each stable coin uses specific mechanisms. They are often categorized into the following types:

Fiat-backed stablecoin

Fiat money often backs this type of stablecoin. As fiat-backed stablecoin is the digital form of the currency that nations use, the value of this type of stablecoin is the same as that of regular currency. This implies that if your currency is $1, the value of each stable coin crypto will therefore be $1. The currency ratio, therefore, remains at 1:1.

Many traders choose fiat-based stablecoin since it is not only fairly stable but also simple. Just because the government backs up fiat currency, they are quite stable. The problem with dealing with fiat money is that you have to abide by certain regulations and rules. For example, for one to purchase stablecoins from issuers, they must go through Anti-Money Laundering and Know Your Customer checks.

Commodity backed stablecoin

This refers to blockchain-based representations of commodities like gold or other valuable metals or gas. Precious metals such as gold have great value and are tradable. Commodity-backed stablecoins are often backed by reserves that are held by a central entity. A stablecoin backed by a commodity such as gold will have a precise value assigned to it. For example, a single gold stablecoin can represent 1 gram of gold.

Due to the value of the gold, it is usually kept in a secure vault. Apart from metals, real estate is sometimes utilized to back such stablecoins. Commodity-backed stablecoin gives investors a chance to invest in a real asset. Holding real assets in a digital form is an alternative to using fiat-backed stablecoins.

Since the assets are tangible, one can redeem them. Commodity-backed stablecoin also offers liquidity. Despite this, one must understand that the price of commodities can sometimes fluctuate. It also needs audit sessions which can take a lot of time.

Cryptocurrency backed stablecoin

Other crypto assets back up such stablecoins. Famous cryptocurrencies that have high market value, such as Bitcoin or Ethereum, are often used. Rather than backing these stablecoins with one crypto, a mix of crypto assets is used to prevent the risk of volatility.

Crypto-backed stablecoins are usually overcollateralized to maintain the value fluctuations. Compared to other types of stablecoins, this has a more decentralized system. It is also quite transparent since a ledger system is used to record transactions. This means that you can easily see what is happening.

Compared to fiat-backed stablecoins, these are less stable. If you choose this type, you should therefore be keen on how the crypto asset behind the stablecoin is performing.

Algorithmic stablecoins

Unlike stablecoins that are backed by assets, these utilize a computer algorithm to prevent the value of the coin from fluctuating so much. The use of complex algorithms helps to balance the funds on the blockchain to maintain stability.

Algorithmic stablecoins often function like actual central banks since they utilize a more governed approach to ensure the limiting or expanding of coins on the network. For example, if the demand goes up, new coins are minted to stabilize the hike in price. The objective of this is to maintain a value close to $1.

What are the risks of stablecoins?

Stablecoins may not be as volatile as other types of cryptocurrencies but they still use new technology which may have certain vulnerabilities. It is possible to lose the private keys that can help one access their cryptocurrency. You may lose the private keys through a user error or hack.

Apart from that, they are also associated with counterparty risk. There is the risk of another party that is involved in an agreement defaulting. Unauthorized third parties can also block or embezzle accounts.

There is also the risk of algorithm manipulation. Since decentralized stablecoins are within smart contracts, the algorithm designed to maintain the stability of the currency might fail. A third party can also manipulate an algorithm.

Stablecoins have also been facing regulatory uncertainty from the time of their introduction. For instance, in 2021, a certain report called for more government oversight on these cryptocurrencies. This led to more restrictions that have been affecting some coin holders in different ways. Stablecoins that depend on central entities are also subject to human errors since sometimes audits can fail to notice potential problems.

Conclusion

Though cryptocurrencies have their advantages, they often experience price volatility. If you wish to invest in cryptocurrencies, you can consider stablecoins since they are less volatile. This type of cryptocurrency offers investors price stability since certain assets back them. Take your time to compare the different types of stablecoins before choosing one, and approach them with an open mind.

FAQ section

Are stablecoins worth investing in?

Yes. These are safe sources of investments that you can consider. Dai and Gemini Dollar are some of the safest stablecoins you can pay more attention to.

Is Bitcoin a stablecoin?

No. Though these two are types of cryptocurrencies, they are not the same. They differ in that Bitcoin is volatile in nature while stablecoin is less volatile.

*This article is not to be taken as a financial advise, it is for educational purposes only.