Stablecoins are cryptos that are usually backed by a fiat currency such as the US dollar, pound, yen, etc. The idea behind being backed by fiat is that stablecoins’ prices will remain steady and face lesser volatility. They are used as units of account or stores of value, and in other applications that prefer less volatile tokens. Each stablecoin has a different strategy to maintain price stability, which includes centralized and decentralized pricing strategies.
How do stablecoins work?
The most vital function of a stablecoin is to keep its price pegged at the required level. Any significant changes at this level will make the crypto token seem unreliable for any financial transactions or applications. So how does this work? Fiat stablecoins maintain reserves of the fiat currency they are backed by. For example, if you want to buy USDT tokens, you have to send US dollars to Tether’s account, and you will be sent USDT tokens back.
Users must deposit crypto tokens as collateral into the Smart contracts of a platform to acquire crypto-backed stablecoins. Users receive stablecoins after the approval of a smart contract. Algorithm-backed stablecoins do not have reserves, so they depend on the algorithm to maintain steady prices by managing supply and demand.
Stablecoin issuers must prove that they have sufficient reserves to exchange tokens for USD or any other collateral. Thus, reserves are held in smart contracts that are publicly viewable or controlled by a trusted third party. Independent sources also audit the stablecoins reserves frequently.
Types of stablecoin collateral
There are many types of stablecoins, and they use a variety of assets as backing:
- Fiat currency is the most common type of collateral for stablecoins, and the US dollar is the most popular fiat currency used as collateral. Companies are exploring other fiat currencies to back their stablecoins.
- Some stablecoins are tied to precious metals such as gold or silver.
- Other stablecoins use cryptos such as Ether (ETH) as collateral.
- Stablecoins can also be backed by an algorithm. The idea is to maintain a steady value of the stablecoin by controlling its supply using an algorithm.
What are stablecoins used for?
Stablecoins can be utilized in many ways.
- Minimize volatility: The value of traditional cryptos like Ether and Bitcoin can fluctuate a lot quickly. Investors prefer to invest in a crypto asset such as stablecoins because their value will not rise or crash unpredictably in the short term.
- Save or trade crypto assets: Users do not need a traditional bank account to hold stablecoins. They are easy to transfer around the world, including to locations where the local currency is unstable.
- Earn rewards: You can earn higher returns on a stablecoin investment than what a bank would offer.
- Cheap money transfer: Users have transferred large amounts of USDC with transfer fees of just a dollar.
- International transfer: Stablecoins are an ideal choice for international transactions due to their fast processing and low transfer fees.
Stablecoin risks
Regulatory Concerns
No central entity or authority regulates stablecoins. You cannot expect government support if a stablecoin project fails. There is no standardized reporting by a central authority for stablecoin platforms.
Counterparty
Counterparty risk occurs when a stablecoin platform does not have sufficient reserves to return your collateral. This risk can lead to a dramatic collapse in value and threaten the main advantage of stablecoins. This risk is avoided through regular audits by an independent entity to ensure reserves match the tokens in circulation.
Liquidity
Liquidity risks occur when stablecoin platforms cannot issue tokens fast enough to match user demand. This risk can lead to hurdles in many transactions and cause delays in several functions. This risk is usually resolved quickly when the platform catches up to user demand.
Are stablecoins safe?
They are relatively stable and safe, as they are usually backed by fiat currencies. This results in less volatility in the value of stablecoins.
How to invest in stablecoins?
Users need a digital wallet and a login to the crypto exchange to buy stablecoins directly. Centralized exchanges have stablecoins listed but are usually fiat-backed. You can trade crypto to obtain a stablecoin using decentralized exchanges.
Why are stablecoins important?
Stablecoins are less volatile to price fluctuations compared to traditional crypto, but they inherit several powerful crypto properties.
- Stablecoins are global, open, and accessible to any user 24/7.
- They offer a cheap, fast, and secure way to transact.
- They are digitally native and programmable.
Conclusion
Stablecoins are immune to the volatility of non-pegged crypto while retaining some valuable crypto properties like cheap, fast, and secure transactions. They have proved to be a vital innovation in crypto as they enable several use cases that were otherwise not feasible. They are especially vital to the DeFi space as they create many opportunities for crypto trading and investment. They can increase crypto adoption in our everyday lives as there is a low risk of volatility. New price stability strategies and innovations in stablecoin technology can help reduce risks and improve their adoption and usability.
You can buy stablecoins like USDT on ZebPay. Visit ZebPay blogs to stay up to date about crypto.
Disclaimer: Crypto products and NFTs are unregulated and can be highly risky. There may be no regulatory recourse for any loss from such transactions. Each investor must do his/her own research or seek independent advice if necessary before initiating any transactions in crypto products and NFTs. The views, thoughts, and opinions expressed in the article belong solely to the author, and not to ZebPay or the author’s employer or other groups or individuals. ZebPay shall not be held liable for any acts or omissions, or losses incurred by the investors. ZebPay has not received any compensation in cash or kind for the above article and the article is provided “as is”, with no guarantee of completeness, accuracy, timeliness or of the results obtained from the use of this information.
