What Are Stablecoins?

Cryptocurrencies are known for many reasons, including their decentralized nature of providing fast and low-cost international transfers. But not all cryptocurrency assets work in the same way. You may be familiar with assets such as Bitcoin or Ethereum, but do you know about stablecoins?

Like traditional cryptocurrencies, they operate on blockchain networks but they have some unique features that set them apart.

So what are they exactly? Let’s dive in

What Are Stablecoins?

Unlike traditional crypto assets, the value of a stablecoin is pegged to a certain currency or commodity. It could be pegged to a fiat currency, such as the Euro, Yen or Pound Sterling, or a stablecoin may be pegged to the value of a commodity, such as gold. Although there’s a neverending list of assets you could peg a stablecoin to, most stablecoins are pegged to the US Dollar.

What are Stablecoins For?

Stablecoins are useful for all sorts of reasons, but the following are some of the most common reasons to own and use them.

Taking Profits Without Moving Funds Off-Chain

If you’re a crypto trader or crypto artist, you may want to realize your profits when the market is performing well. Swapping your traditional cryptocurrencies for stablecoins can be a great way to take profits for any service you offer for crypto, guaranteeing you see some funds before a market downturn. Using stablecoins in this way is especially useful for traders, who may swap between various volatile cryptocurrencies several times a day or week. In short, these types of assets allow you to hedge against market volatility without bothering with the burden of off-ramping.

Financial independence

Crypto also offers users financial independence. To explain, since the blockchain is decentralized, users can transfer funds peer-to-peer without the need for a middleman. Not only that, users can actually own their funds, using non-custodial wallets which operate without a bank or central entity’s interference. Since stablecoins act like fiat currencies but benefit from the peer-to-peer nature of blockchain transactions, they are a game changer for remittances. Using stablecoins, you can send a monetary gift anywhere in the world without waiting extra processing time to cross borders. In short, stablecoins give financial independence to those living in places with economic and political instability.

Types of Stablecoins

The main way to classify stablecoins is by how they are backed. To explain, some are backed one-to-one by whatever they are representing. Others use algorithms to keep the price stable. Each of these methods has its advantages and disadvantages. So, let’s explore the different types.

Fiat Collateralized stablecoins

Fiat collateralized stablecoins are backed by fiat currencies, such as Euros and dollars. Issuers of these coins claim to have a reserve of that currency, to collateralize the on-chain stablecoin. These coins are pegged to the value of the currency in reserve. You can also collateralize stablecoins with precious metals such as gold or silver, but US dollars are by far the most popular.

Tether (USDT)

A great example of a fiat-backed stable is Tether (USDT). Tether claims they have one US dollar in reserve for each USDT coin they have created. Today, USDT is the biggest stablecoin in terms of market capitalization.

USD Coin (USDC)

Another good example of a stablecoin backed by fiat reserves is USDC. This stablecoin is issued and managed by the financial company Circle. Circle stores its fiat reserves in centralized financial institutions, which means using USDC introduces counterparty risk.

Crypto Collateralized Stablecoins

Some issuers opt to collateralize their stablecoins with cryptocurrencies instead. This is possible, but a little tricky, as cryptocurrencies can be extremely volatile. To ensure they have enough liquidity to cover withdrawals, issuers over-collateralize. This allows the currency to drop in value while leaving a sort of insurance amount to cover assets as needed.

DAI

A good example of a Crypto Collateralized stablecoin is MakerDAO token DAI. While this coin is pegged to the US dollar, DAI is backed by Ether and some other cryptocurrencies, including fellow stablecoin USDC. Although DAI is fully backed, relying heavily on crypto and stablecoins with counterparty risk means it’s vulnerable to depegging. For example, market downturns or illiquid reserves could impact DAI’s price.

Algorithmic Stablecoins

Algorithmic Stablecoins use computer programs to keep the price consistent. This means they may not hold real reserves. Essentially they work much as traditional banks do. Instead of holding the asset, an algorithm controls the supply, which in turn controls the price.

However, it’s not always so easy. While banks have control over what happens on their network, the blockchain is decentralized. That means if the programming is bad, there’s no single entity that can help restore the price peg.

Risks and Criticisms

There are several concerns regarding interacting with stablecoins. While they may seem just like digital dollars, they are much more complicated than that. Before you steam ahead, it’s important to understand the risks of using any stablecoin.

Centralization Concerns with Fiat-Backed Stablecoins

While some issuers may claim their token is fully backed one-to-one with fiat currencies, where are their reserves stored? Unfortunately, keeping access to those kinds of funds is almost impossible without using the traditional banking system. And that’s exactly what stablecoin issuers do. In fact, many coins backed by fiat have their reserves sitting in the very banks we’re trying to avoid. That means if the bank goes bust, your stablecoins’ value goes along with it. Yes, even though that goes against the very ethos of blockchain technology!

Risk of failure with crypto-collateralized stablecoins

Crypto-collateralized stablecoins don’t have to worry about banks failing. Instead, they have the crypto market to worry about. As previously mentioned, if they are backed by crypto, these coins are usually over-collateralized to overcompensate for potential volatility. However, if a cryptocurrency decreases in price significantly, this can pose a problem.

Regulatory Uncertainty

Right now, stablecoins are getting a lot of attention. Mainly, crypto users are noticing that they aren’t all as secure as others. But that means governing bodies are noticing too. As a result, around the world governments are calling for tightened regulation on these types of coins.

Future of stablecoins

For now, it’s unsure how the stablecoins will play out. While regulation is still so unclear, it’s impossible to know what the future holds. That said, stablecoins offer a real tangible solution for beginners using cryptocurrencies. If you want to transfer value in a decentralized and secure way without using banks or having to watch cryptocurrency price fluctuations, then stablecoins are a good option. In essence, stablecoins have all of the benefits of the asset they represent but they also benefit from the way the blockchain works. Since the blockchain is unhackable, this is a huge plus point for some financial services. Believe it or not, TradFi firms get hacked all the time, and stablecoins could offer them a welcome solution.

Manage Your Stablecoins Securely With Ledger

As mentioned previously, most stablecoins operate as tokens on blockchains belonging to a different cryptocurrency. By far most of these are on the Ethereum network (being ERC-20 tokens such as USDT, USDC, DAI or TrueUSD), but they can equally be found on others like the Tron blockchain (using TRC20 standard). At all rates, it is important to keep all of your digital assets secure and out of reach from anyone that would want to steal your hard-earned money.

That’s where Ledger comes in.

At Ledger, our mission is to provide top-notch security for your critical digital assets. Our hardware wallets keep the key to unlocking your crypto wealth offline, away from online hacks. It’d even be protected against a wide array of physical attacks against your hardware wallet since Ledger uses cutting-edge Secure Element chips to keep access to your crypto secure.

Not only do we provide security, but you can also manage a plethora of different coins directly in our all-in-one software solution: Ledger Live.