What is a Stablecoin?
- Stablecoins are cryptocurrencies pegged to a stable asset, meaning they avoid the volatility often associated with cryptocurrencies such as BTC
- There are different types of stablecoins, such as collateralised and algorithmic
- Many people believe they undermin the future digital economy
The term stablecoin has become more and more commonplace in the crypto world, but you might not know what it actually is. We’ve given a quick overview of the main pieces of info you need to know about stablecoins, what they are, how’re they’re used and what the different types are.
What is a stablecoin?
Stablecoins are cryptocurrencies pegged to a stable asset (often a traditional currency). These are considered the holy grail of crypto by some enthusiasts; however, the most common use case for stablecoins is as a liquidity tool for crypto exchanges. They’re also a great on and off-ramp for the crypto ecosystem.
Many exchanges are denied access to traditional banking because banks are often wary of dealing with anything crypto-related for compliance reasons. Stablecoins are designed to combine crypto's ease of circulation, fast transactions speeds and low costs with the stability of traditional currencies. They have been popular with investors who trade on exchanges that don't support traditional currencies, as they provide an option to store crypto without the associated price volatility.
What are the different types of stablecoins?
Collateralised stablecoins function similar to how paper money used to when it was linked to the gold standard. Just as cash used to be backed by gold reserves in a central bank, collateralised stablecoins are backed one-for-one by reserves of the currencies that they are pegged to. In the case of many cryptos, who’s price is highly volatile, collateralisation ensures that the price of stablecoins remain relatively stable despite factors such as a confidence crisis.
Issuers of a token like DAI, one of the most popular fully collateralised algorithmic stablecoins, "tokenize" dollars by exchanging them for a stablecoin and depositing USD 1:1 in a bank. Those dollars are then left untouched until somebody redeems the stablecoin.
Another type of stablecoin is algorithmic stablecoins, which have become a core part of the DeFi 2.0 era. Algorithmic stablecoins rely on an algorithm (or smart contract) to determine the relationship between the stablecoin and the asset they’re soft or pegged to. These endeavour to use a set of mechanisms to absorb the stablecoin’s price volatility.
Some algorithmic stablecoins can be undercollateralised. In fact, you may have seen Terra stablecoins hit the news in 2022, as their demise was caused by the tokens not being backed fully by collateral, showing the importance of collateralisation!
Bullish for Stablecoins
A few years ago, Forbes claimed that stablecoins would be the catalyst to the new decentralised internet becoming mainstream. The hype was understandable as a major obstacle to the mainstream adoption of digital currencies is their volatility, an issue that stablecoins mitigate.
However, in reality this system doesn't always run as smoothly expected. There is a widespread misconception that stablecoins offer a similar level of stability to cash. This isn't the case and the two aren't comparable. Whereas cash is a liquid asset and will always represent the exact value of the currency it’s backed by, stablecoins can and do fluctuate.
Investopedia assets that "a currency should act as a medium of monetary value"; its value should remain relatively stable over time. Stablecoins don't fit this definition because the value of major stablecoins has fluctuated wildly in the short time they've been available - and the debate about whether fully collateralised deposits equal the value of the stablecoins in circulation rages on.
Like traditional banking, stablecoins rely heavily on the confidence of their potential users. This is key to attracting investment and maintaining value, and developers are aware of this. They often undertake measures to help boost viability, such as undergoing regular security audits to prove that tokens are destroyed when funds are redeemed.
Why not buy a stablecoin in Wirex’s app today, including DAI, USDT and NXUSD?