Home » What is Stablecoin? The Advantages and Types of Stablecoins

What is Stablecoin? The Advantages and Types of Stablecoins

by Gözde Karakaya

Stablecoin is a type of cryptocurrency created to provide more stability than other cryptos. That is, the value is pegged in price, and that can maintain pretty much the same value from the day a user buys them to the day they spend or trade them. The only main difference of Stablecoin, which offers many advantages that other cryptocurrencies have, is that it is not volatile. 

There are four stablecoins that are among the top 50 cryptocurrencies by market capitalization as of October 2022. These are Tether, USD Coin, Binance USD and Dai.

This article is going to dive into the advantages, and types of stablecoins while elaborating on the risks.

Advantages of Stablecoins

  • Stablecoins offer an alternative to the high volatility of the most popular cryptocurrencies, including Bitcoin (BTC). Stablecoins are safe-haven in the sense that they do not have any risk of loss, unlike fluctuating cryptocurrencies. Traditional cryptocurrencies do not have centralized control. Stablecoin, on the other hand, is different in that it is managed by a central authority. The asset reserve that gives the stablecoin value also acts as collateral. As long as the asset value is stable, the stablecoin price is also stable.
  • Stablecoins provide the advantage of 24/7 money transfer to any point in the world via cryptocurrency exchanges. Moreover, the transfer time is much lower than in traditional stock markets and banking systems. Moreover, using stablecoin, you can make transfers with a low commission, especially for international money transfers.
  • Stablecoins are less or not affected by speculative calls and bear traps, unlike many cryptocurrencies. Therefore, it has the same reaction as fiat currencies for investment or transfer.
  • For staking, stablecoins are among the reliable options. In fact, many cryptocurrency exchanges offer higher interest returns.
  • Lending or borrowing with cryptocurrencies always carries more risk. However, stablecoin variants prevent this situation. The amount you will pay or will be paid to you is almost the same whether you borrow money or buy it.

Types of Stablecoins

  • Fiat-backed Stablecoins

Being the most common and reliable option, fiat-backed stablecoins are digital assets pegged to the value of an underlying fiat currency at a 1:1 ratio. They are typically collateralized by fiat at a 1:1 ratio as well and are built to reduce the volatility associated with digital assets. Stablecoins not only serve as a store of value, but they also simplify engagement in on-chain endeavours like decentralized finance (DeFi). The fiat currency which serves as collateral to a stablecoin — the most common being USD — is held off-chain, which requires users to trust that the fiat reserves are properly managed and audited.

  • Crypto-backed Stablecoins

Cryptocurrency-backed stablecoins use a cryptocurrency as a reference and collateral, unlike fiat-backed stablecoins. For this reason, it is less reliable for many investors than fiat-backed stablecoins. Hence, cryptocurrency-backed stablecoins bolster their reserves against sudden price fluctuations with over-collateralization. To obtain a crypto-backed stablecoin, a user locks their cryptocurrency in a smart contract to receive stablecoins. Paying the stablecoins back into the same smart contract allows a user to withdraw their original collateral.

  • Commodity-Backed Stablecoins

Commodity-backed stablecoins are pegged to the value of underlying commodity assets like gold, silver, or real estate. Holders of these stablecoins have a claim to their underlying assets. Gold is the most commonly collateralized commodity. For example, each PAX Gold (PAXG) token is pegged on a 1:1 ratio to one troy ounce (t oz) of a 400-ounce London Good Delivery gold bar.

  • Algorithmic Stablecoins

Algorithmic stablecoins use algorithms and smart contracts that control the token supply instead of the reserve asset. These mechanisms, whose functions are similar to central banks, try to maintain price stability by reducing the supply if the price of the stablecoin falls below the price of the currency in which it is fixed.

The Risks of Stablecoins

By trusting a third party to print money and maintain a stable cryptocurrency, dollars can be partially reserved rather than fully guaranteed. In this case, a bank run can lead to a significant drop in the price of the coin.

Accounts may be hijacked, blocked or accessed by unauthorized third parties. Centralization risk means the same money problems that fiat currencies face when a central authority has the power to print money without supervision. This can lead to hyperinflation.

Since most decentralized stablecoins live in smart contracts in protocols like Ethereum or Stellar, there is a risk that the algorithm that keeps the coin stable will fail. Algorithms can even be manipulated by a third party. Since “code is law”, network updates can impact previous smart contracts – a huge problem for decentralized projects.

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