Understanding Stablecoins: The Crypto Currency That Stays Grounded

In this article, we'll provide essential information for cryptocurrency investors about stablecoins. We'll cover what stablecoins are, their purposes, types, safety levels, prominent stablecoins in the market, and their associated risks.

best stablecoins UK

What is a stablecoin?

Stablecoins are a type of cryptocurrency designed to match the value of another asset in a digital format. Most stablecoins aim to mimic the value of the US dollar, which offers advantages for investors. However, stablecoins can also represent other fiat currencies like the Euro, Yen, Yuan, Pound, and even commodities like gold, silver, or oil.

The most well-known stablecoins are those pegged to the US dollar. Among them, the most widely recognized and utilised ones are:

  • Tether USD (USDT), the stablecoin created by the Tether company, is the most used in the crypto market; not only to safeguard value, but also for other use cases such as funding trading accounts to trade cryptocurrencies exclusively.
  • USD Coin (USDC), developed and backed by Circle and Coinbase, is often considered one of the safest and best-backed stablecoins in the crypto market. While its use cases may not be as extensive as Tether, it is regarded for its reliability.
  • Binance USD (BUSD), Binance, the world's largest centralised cryptocurrency exchange, introduced this stable cryptocurrency. BUSD offers specific advantages for Binance exchange customers and users of the BEP20 blockchain, also known as the “Binance Smart Chain.”
  • DAI. Maker DAO is the creator of DAI, the most prominent decentralised stable cryptocurrency. What sets DAI apart is its 100% backing by digital assets stored on the Ethereum blockchain. This means that the assets supporting DAI are publicly visible on the blockchain, ensuring transparency and verification of their existence in a digital wallet managed by Maker.

Beyond stable cryptocurrencies pegged to the value of the dollar, we can also highlight some more interesting cases:

  • The famous stable cryptocurrency PAX Gold (PAXG), which replicates the value of gold, has become very popular among those investing in crypto assets. This asset is ideal for those who wish to have a part of their wealth preserved in a safe and low-volatility asset that does not lose value over time as happens with fiat currencies.
  • The stablecoin EUR Neutrino (EURN) belongs to the Waves blockchain and replicates the value of the Euro; we highlight the EURN, but in addition, in the Waves ecosystem there are also some other stable cryptocurrencies under the name of Neutrino that replicate the value of other fiat currencies.
Examples of stablecoinTicker
TetherUSDT
USD CoinUSDC
Binance USDBUSD
DaiDAI
TrueUSDTUSD
Pax DollarUSDP

👉 Find out how to invest in stablecoins, with our step-by-step guide

What is a stablecoin used for?

Stablecoins have different use cases that are aimed at “making life easier” in one way or another for the cryptocurrency investor.

Stablecoins are a type of cryptocurrency designed to have a stable value, often linked to an existing asset like a fiat currency (like the US Dollar). The main purpose of stablecoins is to provide a digital version of these traditional assets within the cryptocurrency world. This is useful because it allows people to move their money between different cryptocurrencies and stablecoins easily without needing to convert back to traditional money and move it outside the blockchain system.

For example, if someone has Bitcoin or another cryptocurrency and they want to switch to an asset with a stable value, they can convert their holdings to a stablecoin. This process is quicker and often cheaper than transferring their cryptocurrency to a traditional bank account. This ease of transfer without the extra costs and time makes stablecoins a useful tool for people dealing with cryptocurrencies.

In summary, stablecoins serve as a bridge between the traditional financial world and the crypto ecosystem, making transactions smoother and more efficient.

There is also the possibility that cryptocurrency investors take advantage of the tax benefits provided by holding assets in cryptocurrencies, although this will depend on the country in which each investor is located; for example, in some countries like Mexico, the cryptocurrency investor is not required to pay taxes on the capital gains obtained from cryptocurrencies as long as their assets do not leave the cryptographic market to fiat currency. However, in the UK, this does not apply – for crypto gains, you will have to pay between 10% to 20% tax, depending on your income level.

Some investors use stablecoins in combination with decentralised digital wallets and decentralised exchanges (DEXs) as a way to manage their assets. They do this to maintain privacy and potentially avoid government scrutiny or regulation. After making profits from cryptocurrency investments, these investors might convert their assets into stablecoins. This allows them to keep their profits in the crypto ecosystem without transferring them to centralised exchanges or traditional banks, where authorities could more easily track these assets.

However, it's important to note that this practice can be risky and is often frowned upon, especially if it's used to hide illicit activities or evade taxes. While the blockchain provides a degree of anonymity, it's not completely private. All transactions on the blockchain are recorded and publicly accessible. This means that authorities can, and do, use blockchain data to investigate and detect illegal activities, including economic and tax fraud.

In essence, while some may use stablecoins and DeFi platforms to try to evade detection, the transparency of blockchain transactions also provides a tool for law enforcement to track and uncover illegal activities. This dual nature of blockchain technology – promoting privacy while allowing for transparency – is a complex and evolving aspect of the cryptocurrency world.

One of the most important uses of stablecoins is to provide financial services to people who may not have easy access to traditional banking. This is especially valuable in emerging or undeveloped economies, where banking can be difficult to access for various reasons, such as remote locations, lack of infrastructure, or even economic barriers.

Stablecoins allow people to store their assets in a digital format without needing a traditional bank or broker. This means that anyone, regardless of their age, background, location, or economic status, can have a digital crypto wallet where they can keep their assets. This independence from traditional financial institutions can be particularly empowering for people in underserved or unbanked regions.

By using stablecoins, individuals can participate in financial transactions and access services that might otherwise be unavailable to them. This aspect of stablecoins is seen as a way to increase financial inclusion and democratise access to financial services. It's a significant step towards providing financial empowerment to people around the world, especially in areas where the traditional banking system is not easily accessible or efficient.

Advantages and disadvantages of stablecoins

Advantages of stablecoinsDisadvantages of stablecoins
✅ Stability in value❌ Depegging
✅ Faster transactions❌ Regulatory, technological risks
✅ Lower transaction costs
✅ Global accessibility
✅ Financial inclusion

Advantages

Stablecoins offer a major benefit for cryptocurrency investors by making it easier and faster to move money between different types of assets, especially within the crypto ecosystem. This is useful because it allows investors to quickly switch their investments from more volatile cryptocurrencies (like Bitcoin or Ethereum) to more stable assets (like those represented by stablecoins), which might be tied to fiat currencies or commodities.

By using stablecoins, investors can bypass the traditional banking system. This means they don't have to deal with the delays, fees, and sometimes complex procedures associated with transferring money between banks or buying and selling assets through traditional financial institutions.

Disadvantages

Stablecoins are designed to maintain a stable value, usually pegged to a fiat currency or another asset. However, there are situations where a stablecoin can lose its peg – meaning its value deviates from the asset it's supposed to mirror. This event is known as “depegging.”

It's also important to note that while depegging is a critical risk, there are other risks and drawbacks associated with investing in stablecoins. These can include regulatory risks, the risk of the issuer's failure, and technological risks associated with the blockchain platform they use.

How does a stablecoin work?

What does it mean to collateralise a cryptocurrency?

Collateralisation of a cryptocurrency means backing the currency with other assets to maintain its value. For stablecoins, which aim to mirror the value of another asset (like the US dollar), this involves holding reserves in that asset or other valuable assets.

While dollar-backed stablecoins might primarily use dollars as collateral, they can also include other assets like Bitcoin, gold, other cryptocurrencies, bonds, or different fiat currencies. The choice of collateral depends on the strategy of the company managing the stablecoin.

It's a common and prudent practice for stablecoins to be overcollateralised. This means having collateral worth more than the total value of the stablecoins issued. Overcollateralisation is desirable because:

  • It reduces the risk of depegging, where the stablecoin's value falls below its intended peg.
  • It provides greater security and confidence to investors, as there's a larger safety net in case of market fluctuations.

Types of stablecoins

Stablecoin collateralised by fiat money

Major stablecoins like USDT (Tether) and USDC (USD Coin) are primarily backed by fiat currency, particularly US dollars.

The main stable cryptocurrencies, like USDT and USDC, are mainly collateralised by dollars, although not entirely; Tether and Circle (the companies behind USDT and USDC), also use other assets such as money market funds and US Treasury bills.

However, these companies, Tether and Circle, do not solely rely on dollars for collateral. They also use other assets like money market funds and US Treasury bills to back their stablecoins. This diversification helps manage risk and ensure stability.

Stablecoin collateralised by commodities

PAX Gold (PAXG) is a notable example of a commodity-collateralised stablecoin. It's backed by physical gold bars, offering a digital representation of gold.

PETRO, issued by the Venezuelan government, is another example. It's a more unique case, being backed by the country's oil reserves. However, PETRO's acceptance and success have been limited, and it's subject to considerable controversy and scepticism, especially given Venezuela's economic situation.

Stablecoin collateralised by other cryptos

DAI is a prominent example of a stablecoin collateralised by other cryptocurrencies. It maintains its value close to the US dollar. DAI is unique because it's entirely backed by digital assets like Ethereum and other cryptocurrencies. These assets are held in smart contracts on the Ethereum blockchain, making them transparent and publicly verifiable.

Stablecoin collateralised by other assets (real estate, gold, investment funds)

Besides fiat currency and other cryptocurrencies, stablecoins can also be backed by a variety of other assets, including real estate, gold, and investment funds.

Some companies are engaging in what is known as “tokenisation of real estate.” This involves acquiring properties and issuing tokens that represent a fractional value of these properties. When an investor buys these tokens, they essentially own a fraction of the property.

The advantage for investors is not just the potential to sell these tokens at a higher price but also to earn a share of the rental income. The companies managing these tokens rent out the properties and distribute the rental income among the token holders. This approach democratises real estate investment, making it accessible to a broader range of investors. Since the properties are divided into many tokens, the price per token can be quite affordable, sometimes even less than $100.

In conclusion, the concept of using stablecoins backed by real estate and other non-traditional assets is an innovative approach in the cryptocurrency world. It opens up new investment opportunities and makes certain assets like real estate more accessible to a wider range of investors.

What is an algorithmic stablecoin?

Algorithmic stablecoins differ significantly from other stable cryptocurrencies, and many consider them riskier. In this case, cryptocurrencies lack collateral or a guarantee but maintain their value through computer algorithms designed to incentivise investor behaviour and control or potentially manipulate the asset's price.

These algorithms' mechanisms are transparent and accessible on the blockchain for anyone to examine. The primary mechanism employed by algorithmic cryptocurrencies to maintain stability is the creation or burning of the stablecoin. This means adjusting the coin's total supply automatically based on its supply and demand at any given moment. Sometimes, a secondary non-stable cryptocurrency or token can be introduced, with its total supply also being manipulated to support the stability of the stable cryptocurrency.

The failure of Terra USD and Luna

Additionally, there's the option of a partly algorithmic and partly collateralised stablecoin, exemplified by Terra USD (UST). UST, created by Terra, combines algorithms developed by top blockchain developers with backing from other crypto assets like Bitcoin and Avalanche.

However, UST faced challenges in maintaining its peg to the dollar for two main reasons. Firstly, there was a significant and sudden sell-off of a substantial amount of UST within a short timeframe, with some suspecting it may have been preplanned and executed by powerful institutions interested in the stablecoin's failure. Secondly, this issue was exacerbated by the sharp decline in prices of various crypto assets held in Terra's treasury, which provided collateral for UST.

In an effort to uphold UST's peg to the dollar, the Terra Foundation sold the crypto assets in its treasury, alongside creating a significant amount of LUNA, Terra's primary non-stable cryptocurrency. LUNA's role, among other functions within the ecosystem, was to increase its supply if the UST peg to the dollar was at risk. However, even with these measures, including selling depreciated assets and generating additional LUNA, UST was unable to regain its peg to the dollar.

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Summary

In conclusion, stablecoins have emerged as a vital component of the cryptocurrency landscape, offering stability and utility to investors and users alike. They come in various forms, from those backed by real assets to algorithmic counterparts, each with its unique set of advantages and risks.

While some stablecoins have proven their reliability and widespread adoption, like Tether and USD Coin, others have faced challenges in maintaining their pegs, highlighting the complexity and potential vulnerabilities of the crypto market.

As the cryptocurrency ecosystem continues to evolve, understanding the nuances of stablecoins and their associated dynamics remains crucial for investors and participants in this ever-changing digital financial landscape.

FAQs

Which stablecoins are the most widely used and recognised?

Tether (USDT), USD Coin (USDC), and Binance USD (BUSD) are among the most popular and recognised stablecoins.

What are the main use cases for stablecoins?

Stablecoins are commonly used for trading, as a store of value, for remittances, and as a bridge between traditional finance and cryptocurrencies.

Can stablecoins replace traditional fiat currencies?

Stablecoins can serve as a digital alternative to fiat currencies for specific use cases, but their widespread adoption as a full replacement for traditional currencies is still evolving and subject to regulatory developments.

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