What Are Stablecoins And How Do They Work?
As global inflation rates continue to rise, more and more people are looking for ways to protect their wealth. One option gaining in popularity is investing in stablecoins. In June 2022, the market share of stablecoins rose to a historic high of 17%, with a market capitalization of $946 billion.
But what are stablecoins, and why is there a growing interest in them? We’ll take a closer look at it in this article. Let’s get started!
- Stablecoins are digital assets pegged to another existing asset
- Four of the most common reserve assets that can be used to back a stablecoin: fiat currencies, cryptocurrencies, commodities, algorithms
- Stablecoins are considered to be less volatile than traditional cryptocurrencies
- These can be used to hedge against inflation
What is a stablecoin?
Stablecoins are digital assets that are pegged to other existing assets, such as the US dollar or gold. This peg ensures that the value of the stablecoin does not fluctuate wildly like other cryptocurrencies, making it a more attractive option for investors looking for stability.
How do stablecoins work?
Stablecoins achieve their stability by being backed by a reserve asset. The issuer of the stablecoin holds this reserve in order to maintain the 1:1 peg with the real-world asset.
For example, the stablecoin Tether (USDT) is backed by the US dollar, meaning that for every USDT in circulation, there is $1 held in reserve. This reserve ensures that if the price of USDT falls, the issuer can buy back tokens to maintain the peg.
Types of stablecoin reserve assets
There are different reserve assets that can be used to back a stablecoin. The most common are:
Stablecoins like USDT, USDC, and Paxos Standard (PAX) are backed by the US dollar. Other examples include EURS (backed by the euro), GBPUS (backed by the British pound), and KRWb (backed by the South Korean won).
Some stablecoins use other cryptocurrencies as their reserve asset. The most popular example is DAI, which is backed by Ethereum (ETH).
Other stablecoins are backed by commodities like gold and silver. The first such stablecoin was Digix Gold Token (DGX), which is backed by 1 gram of gold. There is also Tether Gold (XAUT), which is backed by one troy ounce of gold.
For algorithmic stablecoins, there is no reserve asset. Instead, they use smart contracts to stabilize the price. The most popular examples are MakerDAO (MKR) and Synthetix Network Token (SNX).
What is the difference between stablecoins and other cryptocurrencies?
There are two main differences between stablecoins and traditional cryptocurrencies. Unlike stablecoins which derive their value from other existing assets, traditional cryptocurrency values are determined by other factors, such as the underlying blockchain technology, the team behind the project, and investor speculation.
The second difference is that stablecoins are issued by a central authority, while traditional cryptocurrencies are decentralized. Some refer to stablecoins as digital IOUs, because they represent a claim on an underlying asset.
Why should I consider investing in stablecoins?
There are several reasons why stablecoins are an attractive investment for crypto traders.
They offer a haven from volatility
As their name suggests, stablecoins are designed to be stable. This is in contrast to cryptocurrencies, which can be very volatile. For example, the value of Bitcoin skyrocketed to over $64,000 in 2021, only to drop to around $20,000 in March of 2022.
They can be used to hedge against inflation
Inflation occurs when the price of goods and services increases, but wages remain the same. This event erodes the purchasing power of your currency, which means you need more money to buy the same things. If you’re holding onto cash that is losing its value due to inflation, stablecoins can provide a way to preserve your wealth.
They offer easy entry and exit points
Because they are pegged to real-world assets, stablecoins can be converted back into fiat currency (e.g. USD) easily and without incurring any fees. This makes them ideal for investors who want to cash out quickly or those who want to hedge their portfolios against market volatility.
They have low fees
One of the biggest advantages of stablecoins is that they have low transaction fees. This is because they are not subject to the same volatile market conditions as other cryptocurrencies, so there is no need to charge high fees to protect against price fluctuations.
You can earn interest on them
While the value of stablecoins may not fluctuate as much as other cryptocurrencies, they still offer the potential for earnings through interest. Many exchanges and protocols offer interest-bearing accounts for users who hold their digital assets in them.
How to buy stablecoins?
Stablecoins are offered in most major cryptocurrency exchanges. To buy them, simply create an account on an exchange. Then, deposit funds into your account and use them to buy the stablecoin of your choice.
What are the risks associated with stablecoins?
Remember that stablecoins are still cryptocurrencies and thus are subject to the same risks as other digital assets. Some of the risks associated with stablecoins are:
- Storing them securely: Like other digital assets, stablecoins too must be securely stored somewhere. And these platforms can have their own vulnerabilities.
- Instilling confidence in investors: Although they are not as volatile as most crypto assets, their value still fluctuates periodically. And stablecoin issuers need to ensure robust reserve asset management to instill confidence in investors.
Be sure to do your own research before investing in any stablecoin, as there are other risks you may come across depending on your investment goals or your appetite for risk.
Recommended: How safe are stablecoins really?
As an investor, you can take advantage of certain tools to help you manage your investment portfolio better. For eg: the automated trading capabilities of the BOTS app can buy and sell cryptocurrencies for you at the right time, so you can make a profit even when the market is volatile. We do recognize that stablecoins are gaining more recognition globally, so stay tuned, the BOTS app may consider launching it soonn.
The future of stablecoins
As the world becomes increasingly digitized, it’s likely that stablecoins will play a bigger role in the global economy. In the U.S., lawmakers recently voiced concerns over the unique risks stablecoins pose to the country’s financial stability. This has led to speculation about whether or not the government will decide to regulate stablecoins.
If stablecoins do become subject to regulation in the future, they will become the first cryptocurrency to be regulated in the U.S. This could pave the way for traditional fiat currencies to shift to digital ones, resulting in a major impact on the global economy. It remains to be seen how everything will play out.
This blog is for educational purposes only. The information we offer does not constitute investment advice. Please always do your own research before investing.
Any views expressed in this blog and by BOTS do not constitute a recommendation that any particular cryptocurrency (or cryptocurrency token/asset/index), portfolio of cryptocurrencies, transaction, or investment strategy is suitable for any specific person.