Cryptocurrencies like Bitcoin are known to be volatile. Their prices can fluctuate wildly over any given time frame.
Holding crypto can sometimes feel like riding a roller coaster.
Or listening to a Taylor Swift album. One minute, you’re up. And…the next minute, you’re down
When the price of cryptocurrencies keeps rocketing higher, this volatility is welcomed. But we all know what goes up, usually goes down.
For example, Bitcoin’s price volatility is legendary. It’s not uncommon for bitcoin (BTC) to plummet and crash 30-50% within a month.
Using our awesome MarketMilk™ tool, you can actually monitor bitcoin’s volatility in real-time over different timeframes.
To help deal with such price volatility, cryptocurrencies or tokens known as “stablecoins” were developed.
Stablecoins are altcoins that mimic the price stability of traditional or “fiat” currencies like the U.S. dollar.
Today, lots of stablecoins exist and have become one of the largest groups in the crypto market with a total market capitalization of over $150 billion.
Some stablecoins are actually in the top five largest cryptos.
What is a stablecoin?
A stablecoin is an altcoin that is designed to maintain a stable price over time.
Stablecoins are stable because they “peg” their value. to an underlying asset. The underlying asset varies depending on the specific stablecoin. Most are tied to the U.S. dollar, but there are stablecoins linked to other fiat currencies.
Stablecoins initially rose in popularity because they were easy to transfer between different crypto exchanges.
During the early years of trading, many crypto exchanges found it difficult to get banking access so you weren’t able to trade crypto/fiat pairs, like BTC/USD.
A way around this was to offer the ability to trade crypto against a stablecoin that was pegged to USD, like BTC/USDT.
This removed the need to have to deposit USD in order to trade. Now, you just needed a stablecoin. In this case, Tether (USDT). Which traders could easily and quickly transfer from another exchange that they had an account with.
How do stablecoins work?
Stablecoins are cryptocurrencies that maintain a “peg” or the same price as an underlying asset.
“Pegging” one asset to another means that you always ensure the two values stay the same.
Most stablecoins are pegged at a 1:1 ratio with traditional currencies, such as the U.S. dollar.
Other stablecoins are pegged to other kinds of assets, such as commodities like gold and even other cryptocurrencies.
To maintain this “peg”, stablecoins can be backed by external assets or use algorithms that dynamically adjust their supply relative to their demand at a given time.
For example, a stablecoin I mentioned earlier called Tether (USDT), can be swapped for $1 USD at any time because the entity behind Tether claims to have every USDT “backed” by $1 held in their reserves supposedly full of U.S. dollars or cash equivalents.
What is the purpose of stablecoins?
The purpose of a stablecoin is to be able to use a cryptocurrency without the usual volatility. They allow you to (digitally) store funds at a stable price without the need for a bank account.
Traders use stablecoins to safely store value when the crypto market is really volatile and protect themselves against the price swings.
For example, if they don’t want all their money in bitcoin (BTC) at the moment, they can hold a portion in stablecoin to limit their risk.
Many cryptocurrencies don’t trade against the U.S. dollar or other fiat currencies, but they do trade against stablecoins like Tether (USDT). So a lot of people use stablecoins to expand their choices of cryptocurrencies to trade.
Stablecoins also make it easy for traders to transfer funds between crypto exchanges, which is useful since some exchanges do not offer fiat currency deposits or withdrawals. They’re also much easier to move around than fiat currency within the crypto universe.
There are many more use cases for stablecoins, especially for lending and borrowing in decentralized finance (DeFi) but unfortunately, are beyond the scope of this lesson but will be explored in future lessons.
What are the different types of stablecoins?
Although all stablecoins are designed to offer price stability, they are not all the same. Different stablecoins achieve price stability using different approaches.
Stablecoins can be categorized into three types:
- Fiat-backed stablecoins
- Crypto-backed stablecoins
- Algorithmic. stablecoins
Fiat-backed stablecoins
Fiat-backed stablecoins are backed (or “collateralized”) by fiat currencies.
Fiat currencies are government-issued currencies like the British pound, Indian rupee, Japanese yen, Nigerian naira, South Korean won, and U.S. dollar.
Fiat-backed stablecoins are backed at a 1:1 ratio. This means 1 stablecoin is equal to 1 unit of fiat currency.
So in theory, for every unit of stablecoin that exists in circulation, there is one unit of real fiat currency being held in a bank account to back it up.
The entity behind a stablecoin will create a “reserve” where it safely stores the asset (or basket of assets) backing the stablecoin.
For example, if a stablecoin issuer has $1 billion USD in reserves stored at a bank, it can only create or “mint” 1 billion stablecoins, each worth $1 USD.
If you hold a fiat-backed stablecoin worth $100 and want to swap it for fiat currency, the entity that manages the stablecoin will give you $100 from its reserve and then “burn” or remove the $100 worth of stablecoin from circulation.
Crypto-baled stablecoins
Crypto-backed stablecoins are backed (or “collateralized”) by cryptocurrencies.
Crypto-backed stablecoins are similar to fiat-backed stablecoins where they maintain their peg with an asset. The difference with crypto-backed stablecoins is that the asset isn’t fiat currency but cryptocurrency.
When acquiring a crypto-backed stablecoin, you provide some cryptocurrency as collateral to obtain stablecoins of equal value. This process is done autonomously by a smart contract (a small software program that is deployed and runs on a blockchain).
Since cryptocurrencies are known to be volatile, to ensure that the value of the stablecoin maintains its peg, crypto-backed stablecoins are “overcollateralized“.The amount of cryptocurrency needed to “mint” or issue the stablecoin must be worth more.
A common overcollateralization ratio is 200%. This means that a $1 worth stablecoin is backed by crypto that is worth $2. If the value of the underlying crypto decreases, the stablecoin’s value can still remain at $1
For example, if you wanted to acquire $1,000 worth of stablecoins, you would need to deposit $2,000 worth of ether (ETH). The stablecoins are now 200% collateralized.
In the event that the price of ETH drops by 40%, the $1,000 worth of stablecoins is still backed or collateralized by $1,200 worth of ETH. If ETH keeps falling, the ETH will automatically be liquidated.
Examples of crypto-collateralized stablecoins are Dai (DAI), Alchemix USD (alUSD), and Magic Internet Money (MIM).
Algorithmic Stablecoins
Algorithmic stablecoins do not have any assets backing them.
Algorithmic stablecoins, also known as non-collateralized stablecoins or “algostables” are stablecoins that are NOT backed by fiat or cryptocurrency as collateral. Instead, they depend on an algorithm to maintain their price by managing the supply of stablecoins in circulation.
The algorithm uses the basic market forces of supply and demand to maintain the price of the stablecoin. In other words, units of the stablecoin are either created or destroyed to keep the value stable.
If the stablecoin rises above the price of the fiat currency it tracks, the algorithm will increase the number of stablecoins in circulation. If the stablecoin falls below the price of the fiat currency it tracks, the algorithm will reduce the number of stablecoins in circulation.
In a simplified example, if the value of an algorithmic stablecoin is pegged to $1 USD, and starts to rise, more of that stablecoin will automatically be “minted” (created) and released and this increase in supply will bring the price down.
If the price begins to fall below $1, the algorithm will automatically “burn” (destroy) stablecoins and this decrease in supply will bring the price back up.
The concept of an algorithmic stablecoin is an attempt to have a fully decentralized currency that doesn’t have to be backed by a centralized issuer like a government or central bank.
When the crypto market is volatile, the risk is that the algorithm can’t react quickly enough so algorithmic stablecoins are prone to losing their pegs.
There have been multiple examples of this actually occurring and the stablecoin is abandoned by users due to loss of confidence.
This means that algostables are the riskiest out of the three types and it remains to be seen whether algostables actually work in the long term.
What are popular stablecoins?
Let’s take a look at some of the most popular stablecoins.
Tether (USDT)
Launched in 2014, Tether was the first stablecoin. Like Bitcoin is to cryptocurrencies, Tether is to stablecoins. The OGs of their kinds.
Tether (USDT) is a fiat-collateralized stablecoin that’s pegged to the price of the U.S. dollar.
The stablecoin is supposedly backed by actual U.S dollars in a 1:1 ratio, meaning for every 1 USDT, Tether Limited, the company behind Tether, kept 1 USD.
But there has been controversy over these claims. Eventually, Tether revealed that most of its assets were not U.S. dollars but commercial paper (short-term corporate debt), certificates of deposits (CDs), and U.S. Treasuries.
In 2021, Tether was even fined for “making untrue or misleading statements” that its USDT was backed 100% by corresponding fiat currencies.
Regardless, Tether remains the most popular and largest stablecoin. It’s so popular that it’s also the third-largest cryptocurrency, only behind bitcoin (BTC) and ether (ETH).
USD Coin (USDC)
Launched in 2018, USDC is a fiat-collateralized stablecoin that runs on the Ethereum blockchain and is pegged to USD.
One USDC is pegged to one U.S. dollar, and every USDC in circulation is backed by financial assets (mainly cash and bonds) held by the founding group, the Centre consortium.
TerraUSD (UST)
Launched in 2020, TerraUSD is the algorithmic stablecoin of the Terra blockchain. Its value was designed to be pegged at 1:1 to the U.S. dollar.
Fiat-backed stablecoins are backed by holding the equivalent amount of fiat currency in reserves. Instead of fiat currency, UST was backed by an algorithm that incorporated LUNA, the native cryptocurrency for the Terra blockchain (now known as luna classic).
UST’s peg is maintained by an automated process in which traders can swap UST for $1 worth of LUNA.
1 UST can always be exchanged for $1 worth of LUNA. If you want to mint 1 UST, $1 worth of LUNA is burned. Conversely, minting 1 LUNA requires burning 1 UST.
If UST falls below $1, you can buy the discounted UST, swap it for $1 in LUNA and then sell the newly-minted LUNA on the market for a profit. Each time this swap is made, the sold token is burned
The idea is that traders can either create or destroy UST if its value rises or falls and this is what enables the value of UST to maintain its peg to $1.
For a while, it worked…until it all came crashing down in early May 2022.
Unfortunately, while UST grew to be the largest algorithmic stablecoin so far, it ultimately failed.
Binance USD (BUSD)
Binance USD (BUSD) is a stablecoin, pegged to and backed by the U.S. dollar.
It is pegged 1:1 with the U.S. dollar where 1 BUSD is equivalent to $1 in value.
While BUSD s named after Binance, the largest crypto exchange, another company, Paxos, is actually the issuer of BUSD, since all the U.S. dollars backing up BUSD are kept in its custody.
Dai (DAI)
Dai is a crypto-backed stablecoin that aims to maintain a stable value relative to the U.S. dollar.
It was developed by MakerDAO, a DAO, and runs on the Maker Protocol, a system of smart contracts that maintains Dai’s peg to USD.
Dai differs from fiat-backed stablecoins because it is backed by crypto collateral held on the Maker platform as opposed to U.S. dollars held in a bank account.
You can acquire DAI by depositing ether (ETH), as collateral, enabling DAI to be “minted” and entered into circulation.
It works similarly to a loan. You lock up some ETH (deposit it into a smart contract) and receive DAI in return. To withdraw your locked ETH, you simply return the amount of DAI (plus a small interest fee).
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