What are stablecoins? A Beginner’s Guide

• Cryptocurrencies provide many advantages, but their legendary volatility and unpredictability discourage some investors and the general public from engaging with the industry.
• Stablecoins play a role in this context by providing stability and a safety net for such actors. Tether (USDT), one of the most prominent stablecoins, has established itself as a dominant means of exchange within the cryptocurrency market.
• What are stablecoins, how do they function, and what role do they play in the cryptocurrency market? This page provides answers to all of these questions as well as others.

What are stablecoins?

• Pegged to a “stable” asset, often fiat money like the US Dollar, a stablecoin is a kind of cryptocurrency. As a result, stablecoins mitigate the risks associated with investing in the volatile cryptocurrency market by keeping their value constant over time.
• In contrast to the standard structure of crypto assets like Bitcoin and Ethereum, where you risk losing all of your money or making massive gains in a short time frame, these tokens are built to minimize the former and maximize the latter. As a result, stablecoins, which exist on the blockchain yet have a constant value, have been called the “fiat money” of the cryptocurrency world.

Understanding stablecoins: How do they work, and what are their types?

Stablecoins typically either keep collateral reserves or use an algorithmic calculation to set the peg. However, with the catastrophic failure of TerraUSD, an algorithmic stablecoin, the reputation of collateralized stablecoins has grown compared to that of algorithmic stablecoins.

Here’s how each variety works:

Collateralized stablecoins

• These stablecoins can maintain their value since a reserve backs them. However, whenever a holder of a stablecoin redeems some of his tokens for fiat currency, an equivalent quantity of the underlying collateralized asset is removed from the reserve. For example, when a user withdraws USD-backed stablecoin, 1 USD (or assets equivalent to 1 USD) is deducted from the reserve.
• You should be aware that the architecture of certain collateralized stablecoins is more complicated than others since they employ other cryptocurrencies as collateral while still pegging their value to a stable asset like the US dollar. DAI (DAI) is the most well-known stablecoin based on this design; any fiat asset does not back it but instead uses the Target Rate Feedback Mechanism to keep its value at $1 (TRFM). DAI’s collateralized reserve is made up of a wide variety of cryptocurrencies, including the centralized stablecoins USD Coin (USDC) and Pax Dollar (USDP), as well as Ethereum (ETH) and Wrapped Bitcoin (WBTC).

What can be used as collateral?

• Collateralized stablecoins may back their value with a variety of assets, including
• Most stablecoins keep their reserves in fiat money, such as the US dollar or the Euro.
• Investments such as Treasury Bills, Commercial Paper, and More Cash and cash equivalents such as corporate bonds, US Treasury Bills, and commercial paper are sometimes used to support stablecoins pegged to fiat currencies. In contrast to short-term, government-backed Treasury Bills, commercial paper issued by businesses is unsecured and has a maturity of one year or less. Two of the most popular stablecoins, USDT and USDC, use a “mixed” reserve of fiat money (cash) and other assets to keep their value stable relative to the dollar. The main component of the USDT reserve is US Treasury Bills, followed by cash and other equivalents, secured loans, corporate bonds, and digital currencies.
• Some stablecoins act as collateral for other cryptocurrencies using a platform called “Vault.” Stablecoins backed by cryptocurrencies are designed to be used in turbulent markets without fluctuating value and are also designed to be decentralized.
• Commodities like gold and silver back some stablecoins. Gold-backed stablecoins are Tether gold (XAUT) and Paxos Gold (PAXG), to name only two.

Algorithmic stablecoins 

• depend on an algorithm rather than a physical reserve to maintain a 1:1 price peg. Instead, they use supply and demand to keep the price of each currency stable at a predetermined level, achieved via protocol-driven supply management. For example, when the price of a dollar-pegged algorithmic stablecoin goes over a specific range, the protocol generates new coins to bring it back down to $1. In contrast, stablecoins are destroyed (burned) when the price drops below $1.
• The biggest algorithmic stablecoin, TerraUSD (UST), saw a catastrophic collapse in May 2022 as it failed to hold its peg. By minting and burning a secondary currency, the value of TerraUSD was frozen at $1. (LUNA). According to the system’s algorithmic architecture, Luna tokens were generated and destroyed automatically with each purchase and sale of UST stablecoins. However, the coin lost 99.9 percent of its value in a week owing to its poor design and other manipulations. The loss from the UST catastrophe is anticipated to exceed $60 billion.

What are the primary use cases of stablecoins?

Stablecoins have made a name for themselves as an intermediary currency between digital currency and fiat currency. When the value of a cryptocurrency is expected to stay constant, traders may purchase stablecoins with fiat currency and use those coins to acquire other cryptocurrencies at favorable exchange rates. Stablecoin coins act as a go-between for crypto-to-crypto transactions. To purchase AVAX using ETH, for instance, you may first convert your ETH to USDT and then trade the USDT for AVAX, avoiding the effects of AVAX’s extreme volatility.

Stablecoins are used for quick, low-cost, third-party-free international money transfers. Additionally, stablecoins provide unique possibilities to produce passive income with much higher interest rates than are typical of conventional bank accounts. Moreover, as was previously said, stablecoins are widely used because of their inexpensive money transfer capabilities. Stablecoins have the potential to make the transfer of large sums of money easy with low transaction costs.

List of the most prominent stablecoins

• When it comes to stablecoins that track the value of the US dollar, the most widely used one to date is Tether (USDT), released in 2014. Users may benefit from a constant value in the turbulent cryptocurrency industry and take advantage of decentralized transactions with a $1 fee. With a market worth of over $68 billion, Tether is now the third most valuable cryptocurrency.
• Another popular stablecoin that is 1:1 tied to the US dollar is USDC, which ranks #5 in the cryptocurrency market. Of its entire $44 billion market capitalization, USD Coin reverses comprise a combination of short-duration US Treasury bonds ($35.7 billion) and cash ($8.5 billion).
• DAI (Decentralized Autonomous Institutions) is a stablecoin that is crypto-collateralized and built on Ethereum, with a soft peg to the US dollar. The Maker Protocol and the MakerDAO oversee the coin’s issuance and operations, and the coin’s market valuation is close to $6.2 billion.