All You Need To Know About Stablecoins

Contents

Last updated on November 17th, 2022 at 12:35 pm

There are various types of cryptocurrencies, each with its own set of characteristics.

Some cryptocurrencies are designed to be utility tokens, which means they can only be used within the issuing ecosystem.

A cryptocurrency may be a DeFi token, which means it was issued by a Decentralized Finance protocol and is intended to be utilized within the platform.

Some may be NFT tokens used for various purposes depending on the platform’s use cases.

Some cryptocurrencies are “governance tokens,” which implies they can used during the voting process. Decentralized Autonomous Organizations (DAOs) typically issue this type of token. Security tokens are another type of cryptocurrency issued by a company that grants the bearers ownership of the company. The bearers can exercise their ownership rights in the company. Typically, they receive dividends from the issuing corporation. Because they are considered securities, this type of cryptocurrency is usually subject to the jurisdiction of the financial authorities in the region where the company is based. Before issuing a security token in the United States, the company or platform must obtain approval from the US Securities and Exchange Commission (SEC).

Stablecoins are a type of cryptocurrency also based on the blockchain but differ from regular cryptocurrencies in several ways. In contrast to other cryptocurrencies, the value of a stablecoin is pegged to fiat currency. This article comprehensively examines stablecoins: the many types of stablecoins, examples of stablecoins, and why people use them.

What Is A Stablecoin?

A stablecoin is a type of cryptocurrency designed to mimic the characteristics of fiat currency. This type of coin is pegged to the value of a fiat currency, such as the US dollar. With the volatility of the crypto space, stablecoins, as the name implies, are designed to remain stable or hold value over time. Holders of this type of token do not have to worry about volatility, regardless of the state of the crypto market.

The stablecoin remains constant whether or not the general status of the market is favourable to cryptocurrency prices. In a bear market, when the values of cryptocurrencies such as Bitcoin, Ether, AVAX, and so on plummet, holders of stablecoins can rest assured that the value of their stablecoin holdings will remain the same. In a bull market, the same thing happens.

Why Do People Use Stablecoins?

Stablecoins are used for a variety of purposes. Some people use it as a hedge against risks; others may use it as a means of payment. The following are some reasons why individuals hold this type of cryptocurrency.

Market Volatility

The cryptocurrency market is highly volatile, facing wide swings that may be positive or negative. The value of a cryptocurrency may skyrocket one minute and plummet drastically the next. This level of volatility is frightening for both investors and traders. Stablecoins are an option for those who want to use cryptocurrencies and reap the benefits of blockchain technology without worrying about volatility.

Investments

On crypto exchanges, cryptocurrencies are usually denominated in stablecoins.

If a trader or investor wants to purchase a regular cryptocurrency, they may be required to pay using stablecoins. Typically, they transfer the stablecoin to the exchange, then convert it to the cryptocurrency of their choice.

Some NFT marketplaces may also accept payment in stablecoins from those wishing to purchase NFTs.

Means of Payment

Stablecoins are used as a means of payment and accepted by some merchants because of their apparent lack of volatility.

Merchants who have always wanted to accept cryptocurrencies but do not want to deal with volatility but want to provide their customers with a wide range of options can accept stablecoins.

Risk Hedging

Holding regular cryptocurrencies comes with risks, especially volatility. Unlike other markets, the crypto market is always open. A trader may decide to sell their holdings for stablecoins when they are unavailable to monitor the market and make decisions. Converting their holdings to stablecoins allows them to remain comfortable until they are available to make decisions.

Store of Value

Devaluation and inflation have reduced legal tender value and purchasing power in some countries. Residents in inflation-hit economies may decide to convert their local currency into stablecoins to act as a store of value.

What Are The Types Of Stablecoins?

Commodity Backed Stablecoins

This type of stablecoin is backed by valuable commodities such as real estate and precious metals. The typical precious metals used are gold and silver. Examples are Tether Gold and Pax Gold.

Fiat Backed Stablecoins

Fiat-backed stablecoins are typically backed by fiat currencies such as the US Dollar, the Chinese Yuan, Pounds Sterling, etc.

Most stablecoins in this category are backed by dollar reserves, such as the US Dollar and money market instruments. Renowned third-party organizations usually audit them to determine if the designated value ascribed to their holdings is genuine. Examples include USDT, TUSD, BUSD, and USDC.

Crypto-Backed Stablecoins

This type of stablecoin is backed by another cryptocurrency, usually a major cryptocurrency such as Bitcoin or Ether. An over-collateralized position is held to ensure that volatility does not affect the value of the stablecoin and that the peg is maintained. An example is wrapped Bitcoin (wBTC), which is backed by Bitcoin and based on the Ethereum blockchain.

Instead of keeping the reserves in a ratio of 1:1 like in fiat-backed stablecoins, the reserve of a crypto-backed stablecoin may have a reserve of 10:1 or similar ratios. This means that for every $1 stablecoin issued, the issuing organization should have $10 of the cryptocurrency used to back the stablecoin.

Seigniorage Style Stablecoins

This type of stablecoin is backed by a complex algorithm instead of a commodity, fiat currency, or another cryptocurrency. An example of this stablecoin is the TerraUSD, or UST, which is an algorithmic stablecoin. It was designed to keep its peg via an advanced algorithm while linked with another Terra network token, Terra (LUNA).

What Are The Risks Associated With Stablecoins?

Although stablecoins are intended to be volatile and stable, this is not always the case. A stablecoin’s value may occasionally deviate from its 1:1 peg to a fiat currency, increasing or decreasing slightly in value.

Mismanagement from the team

In some cases, it may do more than that; an example is TerraUSD or UST. TerraUSD is an algorithmic stablecoin released by Terraforms Lab and based on the Terra network.

The Terra protocol designed the TerraUSD architecture to be linked to the Anchor Protocol.

Anchor Protocol began by offering crypto enthusiasts a 20% interest rate on TerraUSD deposits. This was one of the factors that drove up demand for UST.

During that period, more people began to hold UST to benefit from the high-interest rate, which was higher than the regular rates available in the crypto market.

In March 2022, Anchor Protocol decided to significantly modify the rate it offered its users, converting the 20% standard rate to a variable rate. With the new variable rate, it was apparent that the new return on investment (ROI) would be less than 20%. This rate modification irritated numerous holders, prompting them to leave Anchor and sell their UST and LUNA.

The crypto market was flooded with users attempting to sell their tokens at the same time.

Because the cryptocurrency market follows the laissez-faire system, the invisible hands of demand and supply are at work. According to basic economic theory, a high supply level reduces a commodity’s value.

This was what played out in the case of UST and LUNA. As more people withdrew their UST from Anchor Protocol, the value of the stablecoin reduced, prompting other stablecoins in the ecosystem to follow suit.

Fraudulent practices

Many stablecoin issuers claim that their coins are pegged against a fiat currency. They back their tokens with either bank-stored fiat currency, primary market instruments, or both.

This sometimes is not the case, especially if the issuer refuses to open up their records and treasury for audit. This is a risk that could lead to the stablecoin losing its peg.

In Conclusion,

A stablecoin is a type of cryptocurrency designed to mimic fiat currency’s characteristics on the blockchain.
Stablecoins are used as a means of payment, a risk hedge, a means of purchasing other cryptocurrencies, and so on.
There are risks attached to stablecoins, and the case of TerraUSD is an example.
Commodity-backed stablecoins are backed by valuable commodities such as real estate and precious metals.
Fiat-backed stablecoins are typically backed by fiat currencies like the US Dollar.
Crypto-backed stablecoins are backed by another cryptocurrency, usually a major cryptocurrency like Bitcoin or Ether.
Seigniorage Style Stablecoin is being backed by a complex algorithm instead of a commodity, fiat currency, or another cryptocurrency
It is recommended that you conduct adequate due diligence before investing in a stablecoin or any other type of cryptocurrency.