Cryptocurrencies such as Bitcoin and Ethereum offer numerous benefits. The main one is the lack of trust in the intermediary financial institutions, which opens their use to everyone worldwide.
As exchange media, from a technological standpoint, cryptocurrencies are ‘excellent.’ However, fluctuations in their value ultimately made them very risky investments rather than ideal for payment. Moreover, the main problem arises due to the small market capitalization. In other words, the smaller the market cap, the greater the price volatility.
However, stablecoins do not have these issues. Below, we will explain in detail what these coins are and how they work.
What Are Stablecoins?
Stablecoins are essentially an attempt to create a stable cryptocurrency. In other words, they are not subject to significant price fluctuations.
The value of a stablecoin is linked to the actual asset or fiat currency. Some famous stablecoins are USD Tether (USDT), Terra USD (UST), and USD Coin (USDC). All of these coins are traded 1:1 with the US Dollar. Thus, they should keep that value regardless of any influence in the market. Such coins are great for everyday value sharing, but only a few accept them as a means of payment.
Today, stablecoins are mainly used as a means of payment when exchanging other cryptocurrencies. Moreover, they are often used to getting out of the market when the market is uncertain. By using these coins, traders use stable cryptocurrencies to trade volatile cryptocurrencies to reduce the risk of changes in value.
How Do Stablecoins Work?
As mentioned earlier, stablecoins are backed by multiple sources, including fiat currency, collateralized, and algorithmic functions.
Fiat-backed stablecoins – are referred to as IOUs since you spend your dollars (or other fiat money) to purchase them, which then you can subsequently redeem for your original currency. Unlike other cryptos, which can have rapidly fluctuating values, fiat-backed stablecoins strive for relatively modest price volatility. But that is not to imply that such coins are completely risk-free – they are still new, and their risks are unknown. Therefore, you should use them with caution.
Crypto-backed stablecoins – are backed by other cryptos. Stablecoins that are backed by other cryptos are overcollateralized to protect their stability, because the asset backing the stablecoin might be volatile. These assets are less reliable than fiat-backed stablecoins. Thus, it is crucial to monitor the performance of the underlying crypto asset behind your stablecoin. DAI is an example of this stablecoin that is linked to the US dollar and runs on the Ethereum network.
Algorithmic stablecoins – make the most difficult stablecoins to comprehend because no asset backs them. Thus, they employ a computer algorithm to protect the coin’s value from changing too much. Moreover, suppose the price of the stablecoin rises, but the cost of an algorithmic stablecoin is $1. In that case, the algorithm will automatically release additional tokens into the supply to decline the price. If it goes below $1, the supply will be reduced, causing the price to rise again. The number of tokens you hold will significantly increase, but they will still show the total percentage you own. Interesting, right?
Stablecoin Risks
Although such coins are less volatile than other types of cryptocurrency, they still rely on emerging technologies that may have unknown bugs or vulnerabilities.
Whether due to a hack or human error, the risk of losing the private keys that give you access to your cryptocurrency always exists. On the other hand, stablecoins have been plagued by regulatory uncertainty. A study published by the Biden administration in November 2021 urged for increased government monitoring of such coins. While such adjustments may result in enhanced consumer safeguards, they may also affect various coins of this kind.
Limitations
Stablecoins have their limitations, though. Some time ago, the company behind USD Tether was involved in a scandal where they supposedly manipulated the price of Bitcoin. The Tether scandal illustrates how a stablecoin might be used for wrongdoings. Fiat-backed stablecoins are centralized. Thus, they are managed by a single entity. This requires trust in the entity backing up its stablecoins with ‘real’ money.
Fiat-backed stablecoins are also subject to all of the regulations with fiat money, risking the conversion process’s efficiency and the digital asset’s potential efficacy. For instance, Facebook’s Libra currency offered a stablecoin backed by a portfolio of global fiat currencies, extending the coin’s appeal and value.
However, the project’s administration ditched its multi-currency goal, separated itself from Facebook, and rebranded due to the regulatory backlash. The network is still working will regulators to have its stablecoin approved.
How To Buy Stablecoins?
Just like any other cryptocurrency, to buy stablecoins, you have to:
- Open an exchange account or a digital wallet.
- Deposit money or use a debit/credit card
- Purchase a stablecoin (USDT, USDC, UST, DAI, BUSD, etc…)
You can purchase stablecoins on exchanges such as Coinbase, Gate.io, and Binance.
Takeaways
- Stablecoin is essentially an attempt to create a cryptocurrency that is stable.
- The value of a stablecoin is the same as the value of the actual asset or fiat currency that it pegs itself to.
- Fiat currency, crypto-backed, and algorithmic functions usually serve as backers of stablecoins.
- Stablecoins have their limitations, depending on the currency they are pegged to.
- You can purchase stablecoins on various exchanges.
- Most exchanges support such coins. Some of them are Gate.io, Binance, and Coinbase.