Stablecoins: Definition and Reasons To Use Them

Written by: smm

on: 15/05/2023

Stablecoins are cryptocurrencies with a fixed value that is pegged or tied to the price of another real-world asset, e.g. fiat money, precious metals, and even oil.

Normally, the price of an asset used for pegging has low volatility. This, for instance, can be a U.S. dollar or an ounce of gold, which is why these coins are referred to as stable.

USDT is the largest stablecoin whose price is pegged to the U.S. dollar at a 1:1 ratio. The asset was released in 2014, although its exchange rate to the dollar has not seen any major changes since then.

Here’s how stablecoins work:

Stablecoins are issued by a certain company, e.g., USDT tokens are issued by Tether. This company also ensures that the holders of its stablecoins can exchange their assets for U.S. dollars whenever they need.

Based on the operation principle, there are several types of stablecoins:

1. Assets backed by fiat currencies

This type of token is backed by reserves in the currency they are pegged to and highly liquid assets. The largest stablecoin issuers do regular audits of their own reserves in order to strengthen user confidence. Stablecoins pegged to hard assets, such as gold, work in a similar fashion. Their holders can exchange them for assets these stablecoins are tied to at any time.

2. Crypto-backed assets

These coins are issued by smart contracts, while user tokens serve as collateral. Users send their preferred cryptocurrency to a smart contract by freezing it and receive stablecoins in return. Similarly, they can get their deposit back. This virtually eliminates the question of trust. Different mathematical theories, game theory, and other techniques form the backbone of the mechanisms for pegging coins to a real-world asset. Thanks to these, members of the system maintain the exchange rate stability. DAI works in a similar manner, as this stablecoin is pegged to the U.S. dollar but is also fully backed by cryptocurrencies.

3. Assets backed by goods

These stablecoins are backed by gold, silver, gas, oil, and other traditional assets. Their value may fluctuate as the prices of the said goods can also change.

4. Algorithmic stablecoins

The issue of these assets is tackled by a decentralized protocol. However, the price is backed by the native token belonging to a certain blockchain network. The exchange rate stability is ensured by complex software algorithms and smart contracts that control their issue. 

These are basically non-backed stablecoins, even though some of these systems still imply having a reserve for a rainy day.

Why do we need stablecoins:

Stablecoins are notable for high transfer speed and easy conversion. Along with a stable exchange rate, this is what makes them an excellent tool for cross-border transfers, e-commerce, investment operations, and exchange trading.

On top of that, they have a number of other plus points, such as simple transaction procedures, increased data privacy as well as low transaction fees.

Where can we use stablecoins:

Stablecoins are widely used by investors and traders in cryptocurrency exchanges and as a tool to take profits, hedge portfolios, and tackle other related tasks.

Smart insurance is one of the ways stablecoins can be used by regular people. With smart contracts, you can, for example, track down whether the flight is canceled or delayed, and therefore use stablecoins to compensate the cost of purchased tickets and other insurance liabilities automatically.

Most popular stablecoins:

Upon a close examination of the cryptocurrency market, we see a variety of stablecoins. That said, this post aims to explore only the most popular ones that demonstrate the largest market capitalization.

1. Tether (USDT)

This stablecoin pegged to the U.S. dollar is the most used one in the crypto market. Issued by Tether Limited, this token has been in the market since 2015. It is currently available on all leading blockchain platforms.

2. USD Coin (USDC)

This token is the world’s second most popular stablecoin pegged to the U.S. dollar. USDC was created by Circle, Coinbase, and Center Consortium in 2018. It was clear right from the get-go that USD Coin is Tether’s key competitor, though it aims to ensure transparency of all transactions, enhanced security, and lower volatility.

3. Binance USD (BUSD)

This stablecoin is also among the wildly popular assets in this class. BUSD is pegged to one U.S. dollar at a 1:1 ratio. Binance USD is the brainchild of Paxos and Binance which is the most popular cryptocurrency exchange.

4. PAX Gold (PAXG)

This stablecoin is issued by Paxos Trust Company whose business activities are monitored by the New York State Financial Services Authority (NYSDFS) and the U.S. Securities and Exchange Commission (SEC). PAXG is a stablecoin pegged to a troy ounce of gold. All tokens are fully backed by actual gold bars that are kept in Brink’s Gold Vault located in London. In other words, PAX Gold is tokenized gold that operates on the Ethereum blockchain.

The difference between major stablecoins:

Currently, there is a bunch of various stablecoins in the market, and all of them are slightly different from each other depending on a number of factors, such as:

1. Issuing company

A lot depends on the organization or a company that is working on the release of stablecoins. It must have good relations with regulating authorities in different countries, ensure the promised ratio between digital and physical assets, etc. The credibility and popularity of a particular stablecoin also depend on how the issuer and how it acts.

2. Type of stablecoin

As we already know, there are several types of stablecoins and each one has its own benefits, drawbacks, and special features. Most people use stablecoins whose value is pegged to the U.S. dollar. However, there are coins that are treated as gold and oil. The volatility naturally depends on the type of stablecoin.

3. Popularity 

You have to understand that market capitalization and the extent to which a stablecoin is used in stock exchanges and money exchangers, along with the convenience of its usage when tackling financial transactions depend on how popular a particular stablecoin is.

Benefits and drawbacks of stablecoins:

Here are the key benefits:

These tokens are the most stable ones in the cryptocurrency market which is known for its volatility.

Stablecoins can serve as the safety net for investors and traders during corrections of various cryptocurrencies since you can exchange them for stablecoins right away to preserve your capital.

You can use stablecoins to make transactions in the real world; this generally promotes global acceptance of cryptocurrencies.

Stablecoins are less susceptible to various hacker attacks since the underlying asset is stored outside the blockchain.

In years to come, these assets may become a go-to settlement option for transactions in countries whose local fiat money is quickly losing its value.

That being said, stablecoins do have a few drawbacks as well:

A high level of centralization, which, in part, goes against the concept of the cryptocurrency world. This also means that the entire viability of the project virtually depends on the issuer.

Users have to entrust their money to the company that issued the tokens; this, in turn, poses many risks.

Stablecoins get a lot of attention from state authorities that check whether the issuing companies comply with the laws.

Development prospects:

It goes without saying that stablecoins have incredible growth potential in the cryptocurrency market despite the existing downsides. If the cryptocurrency industry continues to expand, these tokens have every chance to establish a leading place as a multi-purpose asset for exchange and various payments.