Meta Description: Stablecoins are integral to digital currencies. They shield investors from high crypto volatility, hedge against falling markets, and offer attractive yields.
While digital currencies have existed since 2009, it wasn’t until 2014 that stablecoins were introduced. Nowadays, these unique stable tokens command 8% of the entire crypto market cap (worth around $133 billion), according to data from CryptoSlate. Despite their shortcomings, stablecoins have become a necessary part of crypto. Let’s discover how they benefit the crypto revolution.
A stablecoin is a cryptocurrency with a stable price achieved by being pegged to another asset, typically a fiat currency, e.g., the US dollar and the Euro. This pegging happens on a 1:1 ratio. So, $1 equals one of whatever the stablecoin is.
Fiat-backed stablecoins are universal for those who trade crypto and include popular names like Tether (UDST), USD Coin (USDC), and TrueUSD (TUSD). These stable tokens require a trusted custodian to keep the pegged asset in reserves. So, if the stablecoin is USD-pegged, the custodian must have real US dollars to back it.
There are three other stablecoins:
These digital currencies get their backing from a commodity, most often gold. These are less popular stablecoins than fiat-backed options. Nonetheless, the most popular choice is Tether Gold (XAU₮).
These stablecoins use another cryptocurrency managed through smart contracts as collateral. Unlike fiat and commodity-backed counterparts, these tokens are over-collateralized to buffer against the volatility expected of standard digital currencies. The most well-known example is Wrapped Bitcoin (WBTC).
These tokens use algorithms and smart contracts to self-stabilize the stablecoin by managing the supply and demand of a related one. Popular examples include Dai (DAI), USDD, USDX, etc.
Let’s cover the main reasons why stablecoins are beneficial.
The primary purpose of stablecoins is to enjoy the benefits of associated digital currencies without price fluctuations. Bitcoin and Ethereum may be faster and cheaper than traditional fiat money.
Yet, the rate of their daily fluctuations makes them inappropriate for regular business and personal use. For context, the average daily volatility rate for Bitcoin is currently around 14%, according to Statista. This isn’t sustainable for exchanging one asset with another to retain the same value.
A stablecoin is like using a regular fiat currency that barely fluctuates in value but is fast and cheap.
Lending or saving your funds in stablecoins offers considerably higher interest rates than regular money, sometimes up to 20% yearly. It boils down to the demand for these tokens.
Stablecoins form a considerable part of the liquidity for exchanges and other crypto payment-based platforms. Such entities often lend out the stablecoins to other traders and institutions. They will then provide above-average rates to attract users. Also, the excellent yields are a way to compensate investors for the potential risks of stablecoins.
Many investors ‘park’ their funds in a digital currency for long periods while deciding their next move within the market. Using a stablecoin solves the volatility issue. Additionally, it can give them some returns when their money is idle.
As mentioned, investors typically leave their funds indefinitely within an exchange. This wouldn’t be advisable for regular fluctuating digital currencies. So, stablecoins offer a way to hedge against declining standard digital assets by liquidating them into said stable token. They can re-enter later to trade crypto when the prices are more reliable.
Sadly, stablecoins aren’t always stable and offer unique, notable risks.
Whether the stablecoin is fiat or algorithmically backed, there is no guarantee that it will hold its peg against whatever asset. This is due to there being no collateral, along with other unforeseen technical and market risks.
Hence, your funds can become worthless in a flash. The worst example of this event was the Terra-Luna crash.
Stablecoin issuers are supposed to provide audits of their reserves to maintain the peg. Yet, sadly, many companies have been found not to provide such evidence. Thus, some stablecoins aren’t backed by tangible assets, as the issuer may claim.
The companies that issue stablecoins are like other businesses. There is always a real chance of failures like bankruptcy, liquidations, etc., which can negatively affect your stablecoin holdings.
Despite their drawbacks, stablecoins remain integral to the vast digital currency ecosystem. They offer the speed and low costs we expect when we trade crypto without worrying about unexpected price drops. It’s worth noting that stablecoins aren’t technically investments that naturally rise in value. Yet, as discussed, they provide yield appreciation when users save or lend them. Generally, investors can use savings accounts with centralized exchanges like Binance and Coinbase. The other option is to participate in several decentralized finance (DeFi) projects like crypto lending and borrowing platforms, which tend to offer better yields. All investors should understand that stablecoins carry considerable risks with potential financial loss.