WTF is a stablecoin?
Stablecoins have emerged as a pivotal component of crypto, designed as an asset to maintain a fixed value and usually pegged to a specific currency, such as the US Dollar. While stablecoins are relatively new compared to traditional currencies, widespread adoption for stablecoins have been steadily increasing over time.
In this article, we’ll dive into what stablecoins are, their role and how you can decide which stablecoins to use in your favour.
What Are Stablecoins?
Stablecoins are a type of crypto token that aims to provide price stability by being pegged to a reserve asset, such as a fiat currency like the U.S. dollar, or even other crypto tokens. Unlike Bitcoin or Ethereum, which are known for their price volatility, stablecoins are designed to maintain a steady value, making them more suitable for everyday transactions and as a store of value.
The Role of Stablecoins
Stablecoins are widely used across DeFi platforms for lending or borrowing services. For traders, stablecoins serve as a tool to move in and out of volatile assets without having to convert to fiat currency, thereby saving time and transaction fees.
In addition to their use in trading, stablecoins are increasingly being adopted for cross-border payments, offering a faster and cheaper alternative to traditional money transfer services. Moreover, in regions with unstable local currencies, stablecoins can act as a hedge against inflation, providing everyone with easy access to a more reliable store of value.
Approaching Different Stablecoins
Deciding which stablecoin to use depends on several factors, including transparency, collateral backing, use cases, and regulatory compliance.The stability of a stablecoin is achieved through various pegging mechanisms with different pros and cons:
Fiat-collateralized stablecoins
Fiat-collateralized stablecoins are backed by a reserve of fiat currency, such as the U.S. dollar, held in a bank account or similar custodian. For every stablecoin issued, there is an equivalent amount of fiat currency held in reserve, such as USD Coin (USDC) or Tether (USDT). These stablecoins are generally considered “safe” due to regular audits of reserves transparent to the industry. However, actual reserve balance sheets can’t be transparently proven sometimes.
Crypto-collateralized stablecoins
Crypto-collateralized stablecoins are backed by crypto assets like Ethereum. A great example here is Sky’s USDS (previously known as MakerDAO’s DAI), which is decentralised and over-collateralized. This decentralisation makes it resistant to regulatory shutdown, especially since users lock up Ethereum as collateral to generate USDS tokens. However, the value of the collateral such as Ethereum can fluctuate, potentially causing issues during extreme market conditions.
Algorithmic stablecoins
Algorithmic stablecoins rely on market dynamics with algorithms and smart contracts to stabilise their value, without needing physical collateral. Instead of being backed by collateral, these stablecoins use supply and demand mechanisms to stabilise their value based on market conditions. However, they are more experimental and prone to collapse, as seen with TerraUSD (UST), which lost its peg during extreme market conditions and caused major losses.
Key Factors to Consider
Transparency: Look for stablecoins that provide clear, regular audits of their reserves.
Regulatory Compliance: Stablecoins regulated by trusted financial authorities (e.g., USDC) are generally safer.
Liquidity and Adoption: Highly adopted stablecoins like USDT and USDC with huge market capitalization offer liquidity, making them easier to trade.
Decentralisation vs. Centralization: If decentralisation is important, USDS offers a decentralised option, but it comes with market risks.
Conclusion
Stablecoins have quickly become a cornerstone in crypto, offering a stable and versatile alternative to more volatile digital assets. We recommend users to do their own due diligence in risk appetite and understanding of the token backings before using any stablecoin. It is also advisable to not put your trust in a single stablecoin — a good practice is to diversify across multiple stablecoins to balance risks.
