Stablecoins have been in the spotlight lately for a variety of reasons. The recent collapse of Silicon Valley Bank (SVB) and the contagion involving crypto-friendly Silvergate Bank have brought stablecoins to the forefront of the crypto discussion. Moreover, through their straightforward utility among crypto-friendly institutions, stablecoins have demonstrated their importance in forming a practical bridge between traditional finance (TradFi) and the cryptocurrency ecosystem.
But what are stablecoins? To the new and crypto-uninitiated, they should be a topic of interest as they involve a crucial function in bringing two distinct finance worlds together. For the young investor looking to expand investment options into traditional and decentralized finance (DeFi), stablecoins can be a vital on-ramp or off-ramp for either platform. They are also an alternative way to store USD without relying on a bank.
Stablecoins also have other exciting uses. They are fast and easy to move. They can also function to earn rewards and play an essential role in yield farming or passive income crypto platforms.
But first, one should understand the definition of stablecoins and their place in the overall crypto taxonomy.
What are stablecoins?
The reduced volatility in the design of stablecoins gives way to several distinct and practical uses. They are also a method of tapping into the benefits of both worlds—harnessing the relative stability of traditional assets and the innovative flexibility of crypto assets.
Taxonomy of Stablecoins
There are different types of stablecoins, each with a mechanism to maintain its value or peg. While the most commonly known ones peg themselves to the US dollar, other stablecoin designs are more attractive, if not practical.
The following are the available types of stablecoins:
1. Fiat-collateralized or fiat-backed stablecoins
2. Crypto-backed stablecoins
Other cryptocurrencies can back cryptocurrencies. How does this model maintain its stability? In decentralized finance or DeFi, reliance on traditional fiat is discouraged. Instead, crypto-backed stablecoins maintain their stability through a different mechanism.
3. Commodity-backed stablecoins
Commodities can also back stablecoins. This model offers additional stability, as you can support the cryptocurrency with precious metals like gold. Gold is less volatile than many other assets and tends to keep its value over time.
Commodity-backed coins can be backed by other commodities like oil, precious metals outside of gold, and even real estate. One exciting thing about this kind of asset is that it can represent ownership of the underlying asset and benefit from appreciating value over time.
4. Algorithmic stablecoins
The most complex of the stablecoins are called algorithmic stablecoins. Unlike the other three, they do not have backing from any particular currency, commodity, or asset. Instead, they follow algorithms to control their supply. They depend on the regulation of supply and demand.
The approach used in algorithmic stablecoins is called seigniorage shares. The algorithm controls the levers that react to supply and demand. When demand rises, the system mints new stablecoins to return the price to its baseline level. When demand is low, the system repurchases any excess coins to remove them from the circulating supply.
This model type has inherent weaknesses, as demonstrated by the Terra/Luna crash in 2022. This was when the algorithmic stablecoin TerraUSD spiraled out of control and drastically depegged, losing nearly all its value.
Top Stablecoins by Market Cap
According to the most recent data from CoinMarketCap, the top stablecoins today are:
- Tether (USDT)
- USD Coin (USDC)
- Binance Coin (BUSD)
- Dai (DAI)
- TrueUSD (TUSD)
- Pax Dollar (USDP)
- USDD (USDD)
- Gemini Dollar (GUSD)
What’s in the News?
Be More Crypto-Savvy, Understand Stablecoins
Stablecoins represent an innovative way to store and transfer value. They form a vital bridge between traditional assets and crypto assets. They may also present a method to indirectly invest in commodities and real property, as in the case of commodity-backed stablecoins.
As with any cryptocurrency asset, you should conduct due diligence to ensure that a stablecoin has a good chance of holding its peg or value over some time. While designed to maintain a relatively level or less volatile price, a stablecoin’s stability is subject to many factors, whether systemic issues in traditional and decentralized finance or weaknesses in its own design.
Any crypto investor should be able to integrate stablecoins into their overall portfolio as an on-ramp tool, hedging instrument, or convenient way to store value.