What are Stablecoins?

What Are Stablecoins?

For investors interested in gaining exposure to cryptocurrency but worried about rampant volatility, stablecoins may be worth a look.

While cryptocurrencies such as Bitcoin and Ethereum have disrupted the way many investors interact and think about money, traditional investors may opt to steer clear as prices can change drastically from one moment to the next.

Stablecoins, on the other hand, are less subject to volatility. Stablecoins are cryptocurrencies that are backed by an asset, most often a fiat currency. They maintain much of the appeal of other cryptocurrencies, however, allowing investors access to a new and evolving asset class.

Here’s what you need to know about stablecoins:

  • What are stablecoins?
  • Fiat-backed stablecoins.
  • Crypto-backed stablecoins.
  • Commodity-backed stablecoins.
  • How to use stablecoins.
  • How to make money with stablecoins.

What Are Stablecoins?

A stablecoin is a digital currency that is linked to an underlying asset such as a national currency or a precious metal such as gold. The main types of stablecoins include fiat-backed, cryptocurrency-backed and commodity-backed stablecoins.

“Stablecoins are a type of cryptocurrency that are designed to maintain a fixed value, often pegged to a fiat (government-backed) security,” says Adam Lowe, chief innovation officer of CompoSecure, designer and manufacturer of premium financial cards.

Cryptocurrencies are a new asset class evolving rapidly in an increasingly tech-driven economy. As a consequence, cryptocurrencies are subject to major volatility, which can change their value in a matter of seconds.

“With a centralized third party, the organization that created the stablecoin entity, you have to trust that they have the corresponding dollars they issued the stablecoins for,” says Mike Scanlan, co-founder and chief technology officer at CoinMover, a cryptocurrency ATM operator.

Fiat-Backed Stablecoins

Popular fiat-backed stablecoins include Tether (USDT), which is backed one-to-one on the U.S. dollar. Tether is the first stablecoin that came to market and the most used and adopted stablecoin with the largest market capitalization. USDC is another stablecoin backed by the U.S. dollar. It was launched in 2018 by Coinbase and Circle. These are centralized stablecoins, which means the stablecoin is held by an entity or exchange. In the case of USDC, this stablecoin is managed by Circle and Coinbase.

One of the risks with stablecoins that have a central authority is trusting that they can maintain their supply of dollars equal to the supply of stablecoins. This can be seen as going against the concept of decentralization.

“With a centralized third party, the organization that created the stablecoin entity, you have to trust that they have the corresponding dollars they issued the stablecoins for,” says Mike Scanlan, co-founder and chief technology officer at CoinMover, a cryptocurrency ATM operator.

The concern is the third-party entity shaping the value of the stablecoin, Scanlan says.

Crypto-Backed Stablecoins

DAI is a decentralized, crypto-backed stablecoin. Maker, a smart contract platform built on the Ethereum network, backs and stabilizes the value of DAI through a dynamic system of collateralized debt positions, autonomous feedback mechanisms and appropriately incentivized external actors, according to a whitepaper from the Maker team.

This digital asset’s goal is to try to keep its value respective to the U.S. dollar and is maintained on the Ethereum blockchain network. This is done by allowing people to use their Ethereum assets to generate DAI on the Maker platform without an intermediary. This means anyone can help maintain the blockchain, which is not controlled by any one single person or entity.

Commodity-Backed Stablecoins

These stablecoins are backed by precious metals such as gold or oil. Some of the most well-known stablecoins in this category are Tether Gold and Paxos Gold. Commodity-collateralized stablecoins are more susceptible to price movements, but since commodities should increase in value over the long run, investors can buy and hold this asset for capital appreciation.

How to Use Stablecoins

One of the chief ways to use stablecoins is for quick and cheap payments or money transfers on a global scale. Stablecoins provide a fast way to transfer deposits or withdrawals between fiat currencies to cryptocurrency exchanges.

“One of the most powerful uses of stablecoins is payments,” says Nemil Dalal, head of crypto at Coinbase.

With stablecoins, Dalal says, users can send money anywhere in the world in a matter of seconds. Given that they’re a stable currency, stablecoins provide an easy payment flow, making it simple for businesses to securely send money to their employees.

When crypto users observe major price movements, they could move their money to stablecoins and wait for the market to stabilize. “When cryptocurrencies are down, people generally seem to buy stablecoins and use them to get out of the volatility,” Dalal says.

As volatility-shy investors wait for the markets to calm, they can keep purchasing stablecoins with fiat money, and that value will not change until they want to move it into Bitcoin or other cryptocurrencies.

Another advantage of stablecoins is the ease of use across cryptocurrency exchanges. “They are highly liquid and tradable, making them easy to exchange into other cryptocurrencies or fiat currencies if desired,” Lowe says.

It’s not easy to transfer cash in and out of cryptocurrencies. Even if you place a sell order, it can take days for the withdrawal to finalize. But if you convert your money to stablecoin, you maintain its value.

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