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While the crypto market presents excellent opportunities for investors, it can also spark reservations from those that prefer more conservative investments. That is because cryptocurrencies can often present price volatility. This is what allows some investors to make a lot of money quickly, but it is also what can make others lose a lot in a short period of time.
To reduce this volatility there was a new type of cryptocurrency created that has it's price fixed to a fiat currency. Stablecoins offer more stability, allowing investors to enter the crypto market while avoiding steep price variations.
In this article, you will learn what stablecoins are, the types of stablecoins, their different levels of risk, and why they are so important. So, let’s start from the basics, shall we?
By this point, we all saw how cryptocurrency can be a great investment opportunity. Yet, some investors are still afraid of joining this industry. Among the possible reasons for that, one of the main factors that make people think twice before entering the crypto ecosystem is its volatility.
Blockchain is a young technology. Consequently, so is the crypto market. As a result, this is still a very experimental and speculative market. This makes it normal for many cryptocurrencies to exhibit some amount of volatility. Investing in cryptocurrency typically means being exposed to the market's ups and downs. This volatility is what drives the great gains that could be achieved with cryptocurrency, as well as the losses that come with investing in a developing market.
Tokens without a purpose behind them, the infamous shitcoins, are more susceptible to high levels of price variation since they only serve the purpose of speculation. While coins and tokens that are part of a project and serve a purpose tend to be more stable, they can also suffer volatility with the market changes. Strong and respectable coins such as Bitcoin, Ethereum, and SOL all have seen high price variations - both positive and negative - during their existence.
Thus, before entering this market, one must know the risk involved in investing in cryptocurrencies and do the proper research. While this volatility can be exciting when the market is thriving, it can be scary for conservative investors that wish to focus on more reliable investments. That’s when stablecoins come in.
Stablecoins are cryptocurrencies that claim to be collateralized by the value of an underlying asset – usually fiat currencies. Different from cryptocurrencies such as Bitcoin and SOL, the price of a given stablecoin is fixed to the asset that backs them, thus avoiding fluctuations.
Usually, this collateralization is done by the entity behind the stablecoin creating a “reserve” where it stores the asset that backs its value. However, there are different types of stablecoins and not all of them guarantee their peg the same way. This will be discussed further in the article.
Most commonly, the underlying asset of a stablecoin is a fiat currency, such as US dollars, Euro, and Israeli shekels. However, some stablecoins are pegged by other types of assets like precious metals (gold, silver, etc.) or even other cryptocurrencies. In some cases, they might not even be collateralized. To better understand this, let’s look at the types of stablecoins.
As explained, stablecoins can peg their value to different assets, as well as maintain their value pegged in different ways. To make informed financial decisions on your investments, it is important to understand the difference between the types of stablecoins, especially since they present different levels of risk. Thus, these are the four types of stablecoins:
Fiat-collateralized stablecoins like USD Coin are the most common type of stablecoin – and the safest. They are backed by fiat currencies such as the US Dollar, Euro, or GBP. This is the most basic form of a stablecoin, having a 1:1 ratio backing to its equivalent fiat currency. USD Coin, for example, is backed by assets held at regulated financial institutions.
Fiat-backed stablecoins is to be collateralized by fiat currencies in a reserve. Thus, users can redeem their tokens by requesting that the entity behind the stablecoin transfers the equivalent amount of fiat cash from their reserve to the user's bank account. Simultaneously, the corresponding number of stablecoins are removed from circulation or destroyed. This structure makes fist-collateralized stablecoins an extremely safe cryptocurrency since they are as stable as the fiat currency they are pegged to.
Commodity-backed stablecoins, as the name suggests, are backed by various sorts of tradable assets such as precious metals, real estate, oil, and more. Gold is the most commonly utilized commodity as security for this type of stablecoin. Commodity-backed stablecoins’ holders essentially have ownership over a tangible asset with actual value, which is a great advantage. These stablecoins also enable the possibility for anyone in the world to invest in markets that are traditionally closed to the average person, such as precious metals and real estate.
This one might seem unexpected, since stablecoins coins are seen as a way to diverge from the instability of cryptocurrencies. However, crypto-backed stablecoins can be a great asset. For starters, crypto-backed stablecoins tend to be more decentralized than most of their counterparts, which means that there is no entity controlling your funds and therefore more transparency. Moreover, they are also extremely liquid assets.
To compensate for being backed by more volatile digital assets, crypto-backed stablecoins are usually over-collateralized. This allows them to absorb fluctuations and maintain a stable value. On top of that, some crypto-backed stablecoins are collateralized by multiple cryptocurrencies to better distribute their risk. Still, be sure you understand how the crypto-backed stablecoin you choose works. Also, keep in mind that, while they tend to be quite stable, there is a level of risk involved in this type of stablecoin.
An algorithmic stablecoin, also known as a non-collateralized stablecoin, doesn't have any assets backing them. So how are they considered stablecoins? Well, they follow an algorithm and smart contracts for managing the supply of stablecoins. This strategy is also known as seigniorage shares and it works like this:
As demand grows, additional stablecoins will be issued to bring the price back to normal. In the event of extremely low coin trading, coins on the market are acquired in order to reduce the circulating supply. Essentially, algorithmic stablecoins could provide stability based on market supply and demand.
While algorithmic stablecoins offer the maximum amount of decentralization, they rely on continuous expansion to ensure success. Since there is no collateral involved, in case of a crash – which has recently happened with USDT – investor might lose all their money. Thus, this type of stablecoin presents the highest level of risk among the four structures of stablecoin.
Stablecoins are a vital exception in the volatile market of crypto because of their price stability in most cases. They are valued assets that serve critical roles in the cryptocurrency ecosystem. Their ability to assist with transfers is staggering. In addition, they provide substantial stability and the capacity to hedge investors’ capital. They are especially important in today's market, where a plethora of stablecoins alternatives allow traders to diversify their portfolios.
On top of that, since digital assets from one blockchain can’t natively exist on another, stablecoins offer a sophisticated way to trade in and out of tokens on disparate blockchains and exchange value across the ecosystem. For example, if you wish to sell an ERC20 token to buy into SPL tokens, using a stablecoin can make this trade simpler and faster.
Stablecoins may not provide the returns that you are accustomed to seeing from other cryptocurrencies. They shine best, though, when the market is falling, and you are in need of some steadiness. Just make sure you know which type of stablecoin you are investing in and enjoy the advantages they can offer.
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Please note that none of this is to be considered financial nor investment advice. We highly advise you to always do your own research (’DYOR’) before interacting with any of the projects or tools we write about. Crypto is a highly dynamic and fast paced environment with lots of moving parts that can quickly change.