Stable coins are called “stable” because their value remains stable most of the time. They were created because people needed a cryptocurrency that could act as a form of payment without having to worry about its price constantly going up and down.A stable coin is simply a cryptocurrency with its value pegged to the value of a real-world asset. i.e., a fiat currency, a precious asset, or even another cryptocurrency.
Now you’re probably thinking; Bitcoin is used as a form of payment. Does that make Bitcoin a stable coin? No. You see, Bitcoin’s value is not tied to any real-world asset. Bitcoin’s value fluctuates a lot depending on market sentiments and other factors. Bitcoin’s price was $56 thousand at the beginning of December 2021. Now in May 2022, it is at $31,700. Talk about volatility.
Stable coins have their prices remain level most of the time. For example, Tether is a stable coin that has its value tied to the U.S dollar, so one tether is always equal to $1.
So how do stable coins keep their prices stable when other cryptocurrencies are always rising and falling? Well, the answer is “it depends on the stable coin.” As you will see, there are different types of stable coins, and they are grouped by how they keep their price level.
How do stable coins work?
Fiat-backed stable coins
The first type of stable coin we will be looking at is the fiat-backed stable coin. Fiat-backed stable coins like Tether have their value tied to a fiat currency. Tether has its value tied to the U.S dollar. So 1 Tether is equal to 1 dollar. Fiat-backed stable coins work by holding large fiat currency reserves in a bank. This reserve is the base value backing every token issued by the fiat-backed stable coin. So basically, Tether holds a large reserve of dollars in a bank. So whenever they issue 1 Tether, it’s backed by $1 in their reserve.
Crypto-backed stable coins
Next up is crypto-backed stable coins. Yes, folks, crypto backing another crypto. Crypto-backed stable coins are mainly used to track the price of the crypto backing them. For example, Wrapped Bitcoin (WBTC) is a bitcoin-backed stable coin on the Ethereum network. People can also use crypto-backed stable coins to keep track of the value of a fiat currency. It does this through a balancing mechanism that relies on the over-collateralization of assets. This simply means that the assets in reserve would be worth more than the stable coins in circulation. This way, if the value of the backing asset changes, there is a cushion that allows the stable coin’s value to remain level.
For example, you would need to tie about $4 worth of crypto assets to $2 worth of crypto-backed stable coins. If the value of the underlying crypto drops below $4, there is still a cushion that allows the crypto-backed stable coin to remain at $2. Another difference between crypto-backed stable coins and fiat-backed stable coins is decentralization. Crypto-backed stable coins are maintained by smart contracts, while a central organization maintains fiat-backed stable coins. Some examples of crypto-backed stable coins include: Wrapped Bitcoin (WBTC)
Precious metal-backed stable coins
Next up on our list is precious metal-backed stable coins. These are stable coins that have their assets tied to precious metals like gold, silver, platinum, palladium, etc. This type of stable coin is less volatile than crypto-backed stable coins, but there are more centralized. Usually, gold is an excellent option for hedging against inflation, so it’s no surprise that gold is the most collateralized precious metal.
The benefit of precious metal-backed stable coins is that they allow people to invest in assets that would have been out of reach for regular people like you and me. For example, a regular joe like me wanted to invest in gold. Finding a secure site to keep the gold would be expensive and difficult. Same thing with oil or silver. But with a gold-backed stable coin, I can just invest in gold without worrying about storage and other issues. They are also a quick way to trade tokens for cash. Some common examples of precious metal-backed stable coins include: Tether Gold (XAUT), DigixGlobal (DGX), etc.
Algorithmic stable coins
Last up on our list is the Algorithmic stable coin. Algorithmic stable coins are more complex than the other stable coins we’ve looked at. Algorithmic stable coins are not backed by any underlying asset. Rather, they use computer algorithms to keep their prices stable.
The algorithm uses a method of demand and supply to keep the price level. Say, for example, an algorithmic stable coin has its price at $1. If the price rises above $1, the algorithm increases the supply of tokens, so the price will go down. If the price goes below $1, the algorithm reduces the supply of the tokens, thereby driving its price back up. The algorithm doesn’t do the buying and selling. Rather, it incentivizes users of the stable coin to buy and sell the coin whenever it wants to keep the price level. Examples of Algorithmic stable coins include: Frax, FEI USD, TerraUSD (UST)
Why are stable coins important?
The price of stable coins rarely changes, so why do people fuss about them? First of all, I’ll have you know that stable coins are very important. They wouldn’t have a combined market cap of almost 200 billion dollars if they weren’t. Okay. But that doesn’t explain why they are so important. For that, we have to go back to why they were created in the first place.
Stable coins were created as a way to bridge crypto and everyday use. People trust stable coins because they know their value rarely changes. This makes stable coins perfect for many financial services, usually called Defi, or Decentralized finance.
What can you do with stable coins?
Let’s get into more detail about what you can do with stable coins.
Remember, we said that stable coins minimize their volatility by using different mechanisms to keep their price stable. So, what is the benefit of this minimized volatility? Say you wanted to take a crypto loan, maybe from one of the defi protocols on the Cardano blockchain. Would you rather take $1000 in bitcoin or a stable coin? If you said bitcoin, then you better think again. If you take the loan in bitcoin, next month, you could see that the amount you now have to pay has grown by 20%. But if you take the loan in a stable coin, you can rest easy knowing that the amount you owe will still be the same in a few months.
- Trading and saving assets
Stable coins are perfect for trading on an exchange. Usually, if you want to trade on an exchange, you would give them a fiat currency for the asset you want to buy. But cash is not always so accessible, especially on days that the traditional finance and banking system is shut down, i.e., on weekends and major holidays. Stable coins are a great option for trading on exchanges. They maintain little volatility, plus they are always accessible, making it easier to facilitate trades on an exchange. E.g., If you want to buy bitcoin on an exchange, e.g., Coinbase, you can trade dollars for bitcoin. Or you can trade Tether for Bitcoin.
Another use of stable coins is saving. It’s no news that interest earned on savings in the bank is much lower than the interest earned on crypto savings. Unfortunately, crypto prices fluctuate constantly, making it a very risky option to save in crypto. However, stable coins do not suffer from the same issues.With stable coins, you can get a high-interest rate on saving with crypto plus low volatility, which keeps your holdings safe.
The next benefit of stable coins we will discuss is making international payments. You see, the system of making global payments has come a long way. Today, sending money from one developed country to another is easy and cost-effective. Say the USA to France. Or Germany to Canada. The problem comes when trying to make international payments to and from developing countries. People living in these emerging countries have to suffer issues like expensive transfer fees, huge exchange fees, and delayed settlement time.
Stable coins are a great solution to this problem of making international payments. Their low volatility makes them a perfect bridge between crypto and fiat in day-to-day financial transactions.
Another way that stable coins will ease the making of international payments is by reducing the number of intermediaries involved in a typical international transaction.
Many don’t know this, but it typically takes four intermediaries to complete an international transaction. Stable coins will cut down the number of intermediaries, thus reducing the settlement time and cost.
Remember when we said that stable coins are used for trading on exchanges? Well, that’s called “providing liquidity.” And it adds another huge benefit to stable coins; earning interest.
Thanks to the huge demand for stable coins on exchanges, many defi protocols offer incredible interest rates on stable coins that users provide as liquidity. Another reason stable coins offer such lucrative interest rates is the demand for defi services.
Lending and staking are some of the most popular defi services out there. And the main collateral used in these services is dollar-pegged stable coins. Staking simply means holding your coins in a pool, which a blockchain will then use to verify transactions. The blockchain then rewards you with extra tokens for your contribution. Many defi protocols offer huge percentage returns on your investment.
Are there any other risks?
So all this while, we’ve been talking about the benefits of stable coins. And so you’re wondering, are there any risks? Well, there are a few. Stable coins are still a very new asset class, and they don’t have any history that we can use to judge them. Yes, they have performed well in the short time they’ve been around. But it’s like they say in the financial world. Past performance is no guarantee of future performance – especially for such a new asset.
Another issue that you might want to take seriously is that most stable coins have little to no regulations guiding their activities. This means that there is little protection from the government if the issuers should put their investors at risk. So you should be careful when investing in stable coins.
Where can I buy stable coins?
If you want to buy stable coins, you should check out an exchange. When it comes to exchanges, there are generally two types. Centralized exchanges and decentralized exchanges. A single entity runs centralized exchanges, and they are usually KYC compliant. KYC-compliant means that the exchange uses a policy of know-your-customer. You have to give them your personal information. On the other hand, decentralized exchanges are run by the users of the exchange, who have voting rights on how the exchange should work. Smart contracts are what make trading possible.
Decentralized exchanges are not KYC compliant, so you can remain anonymous while using a decentralized exchange. Examples of centralized exchanges include Coinbase, Binance, Kraken, KuCoin, etc. While examples of decentralized exchanges include AirSwap, io, Barterdex, Blocknet, etc. Please note that with decentralized exchanges, there is no need to transfer assets to a third party. Trade is done directly from peer to peer. A big disadvantage of using decentralized exchanges is that liquidity might be hard to come by because most crypto trades are made on centralized exchanges.