Stablecoins for Beginners
What are stablecoins?
Stablecoins are cryptocurrencies that are pegged to the value of another currency.
- Fiat-backed stablecoins
Tether (USDT) and USD Coin (USDC) both have a significantly large reserve of US Dollars that is regulated audited by independent institutions. This is also known a s a fiat-backed stablecoin. Essentially, the fiat-backed stablecoin keeps the prices stable by backing each coin to a 1:1 ratio. This allows users to always exchange 1 USDT or USDC for $1 USD.
2. Crypto-backed stablecoins
This is similar to the fiat-backed stablecoins except, the major difference is that the large reserve in this instance consists of cryptocurrency as opposed to fiat currency like the USD.
The most popular crypto-collateralized stablecoin is DAI. Dai is a stablecoin also pegged to the value of the USD, but is backed by cryptocurrencies like Ethereum. The basket of cryptocurrency backing can be of one or more, and because cryptocurrencies are by nature very volatile, DAI will overcollateralize by 150% of the circulating supply. This helps with alleviating the major concern, which is when a certain cryptocurrency undergoes major selling pressure, DAI has to be able to sustain the volatility of the market.
3. Algorithmic stablecoins
Algorithmic stablecoins rely on algorithmic formulas to protect price stability by increasing or decreasing supply, using market forces to maintain a peg. Due to the fact that these stablecoins are not backed by any hard assets or collateral, there is a chance that the currency has nothing to fall back on when the market has a crisis. The most recent example of this happened with TerraUSD (UST). You can read more about one of the largest events in crypto history here.
Why do we need stablecoins?
Stablecoins are very useful because they aim to provide stability in a market where there is high volatility. The volatility is what makes cryptocurrencies unusable as an actual medium of exchange. Therefore, it will be interesting to keep an eye on which stablecoins are able to survive the ups and downs of the market and eventually subside.
It is of strong belief that a successful stablecoin requires enough reserve of cash or other highly-liquid collateral to be able to support the stablecoin in the event of a crisis. Users of stablecoins should also always be conscious of what assets are used to back the coin.
