Understanding cryptocurrency and decentralized finance overall comes with an endless list of terminology. For those looking to expand their crypto assets while decreasing their volatility, stablecoins are a topic of interest worth adding to the list.
In this article, we share what you need to know about stablecoins and how they work.
What Are Stablecoins?
There’s no question that crypto investments are prone to rapid fluctuations in value. This change can be beneficial when value spontaneously increases, but it can also put users at a great disadvantage when value plummets.
Stablecoins have been seen as the answer for people interested in transitioning investments to crypto while remaining cautious of the associated risks. These cryptocurrencies are designed to maintain a stable price over time rather than experience sudden highs and lows.
The main difference that separates stablecoins from other tokens is that stablecoins have something backing them, such as the U.S. dollar or gold.
To ensure that stablecoin holders will actually be able to cash out on their assets, stablecoin creators use collateralization. In other words, they hold reserves of other currencies or assets to represent the crypto token.
Types Of Stablecoins
The way that stablecoins are collateralized will depend on the type of stablecoin in question. Still, each type of collateral aims to keep values consistent while the crypto is safe and secure with an exchange like Vauld.
At its simplest level, fiat-backed or fiat-collateralized stablecoins are backed by fiat currency, better known as sovereign money, like USD, used for everyday market exchanges.
When you purchase a fiat-backed stablecoin, such as Tether, one token is created. Once you cash out your assets, your respective stablecoins are destroyed and are no longer in circulation.
For many people, fiat-backed stablecoins are the easiest and most sensible to understand, contributing to Tether’s ranking as the most popular stablecoin. Tether tokens hold their value at a ratio of 1:1 to the underlying assets, making it a stable solution.
As a result of financial uncertainty brought on by the pandemic, Tether has seen an increase in popularity throughout 2020 and 2021.
Crypto-backed stablecoins are not too dissimilar from fiat-backed options. These tokens also hold their value to a pegged asset (the value it aims to stay at), but, as the name suggests, crypto is used as collateral in place of fiat money.
While you might think this would take us right back to the issue of volatility with cryptocurrency, crypto-backed stablecoins are over-collateralized to account for this fluctuation, meaning the ratio for the token will not be 1:1.
Let’s use Dai (DAI), the most popular crypto-backed stablecoin as an example for how this works. Since Dai is not backed by USD, it runs on Ethereum to better maintain a value of one U.S. dollar. For every $1.00 issued in stablecoin, the peg will be closer to $2.00.
Much like USD’s gold-backing prior to 1933, some stablecoins are backed by commodities as well. These range beyond just gold and include other precious metals, oil, and more.
Compared to fiat and crypto-backed stablecoins, tokens collateralized with commodities are more susceptible to price fluctuations. Still, the items used generally increase in value over time, making them a good asset for investors seeking appreciation.
Paxos Gold, for example, is backed by actual gold. Through Paxos, a for-profit New York company, each token can be redeemed for one troy fine ounce of gold. And the market value of Paxos Gold is structured to mirror the actual gold held as collateral.
As the final category, algorithmic stablecoins stand out from the previous three options because they do not have any associated collateral. Also known as non-collateralized stablecoins, these tokens are the newest of the group and aim to further improve crypto volatility.
Rather than any physical currency, commodity, or crypto backing these tokens, an algorithm automatically adjusts for supply and demand. If the price increases, then more coins are issued. If the price falls, then they are bought off of the market.
Algorithmic stablecoins are perhaps the most highly contested of the options mentioned. While tokens like Ampleforth offer true decentralization and improved capital efficiency, many claim that they are fundamentally flawed, especially once supply changes are taken into account.
Benefits Of Stablecoin
Along with decreased volatility, the benefits of stablecoins are similar to the benefits offered through other cryptocurrencies. These include features such as decentralization and 24/7 access to trading and other exchanges.
Although many of the perks might be shared, the advantages of stablecoins are not limited to those of general cryptocurrency.
Stability For Global Commerce
The stability of stablecoins has the opportunity to impact far more than just crypto investors. For people living in countries with extremely volatile currency and inflation issues, stablecoins offer trading options without facing financially detrimental fluctuations in value.
Paired with high liquidity and ease of use across crypto exchanges, stablecoins can easily be traded for other crypto options as well. This helps eliminate asset volatility while trading other tokens and can be beneficial for portfolio diversification.
Risks Of Stablecoins
The benefits of stablecoins compared to other cryptocurrencies are straightforward, but the absence of volatility can also have disadvantages.
At a basic level, this means that, although stablecoins will not see rapid decreases in value, they will not see much of an increase, either. It is truly an option for those seeking a very low-risk crypto endeavor.
The risks associated with stablecoins can be placed into two categories. First, many of the risks are shared with those of cryptocurrency. Second, stablecoins have risks unique to their less-volatile nature as well.
Stablecoins, just like any other cryptocurrency, face inherent security risks. Like Bitcoin or Ethereum, these more-stable counterparts are going to be held by a crypto exchange where they will accumulate interest.
While security is a factor to consider, choosing the right crypto exchange can ease any concern of cyberthreats and hacks. Here at Vauld, we take security seriously and have several measures in place to mitigate these risks.
Along with an arsenal of security features, from biometric authentication to video verification, we have partnered with BitGo, a leading digital asset trust and security company.
Through BitGo, we provide you with necessary coverage by moving funds from your wallet to a centralized lending pool that’s insured for $100 million in BitGo. Even if a major breach takes place, you can rest assured knowing you can recover stolen funds.
Since stablecoins are distinguished from other cryptos through reserves that back the tokens, it makes sense to question whether this might pose extra risks. The short answer is yes.
As of now, there are no regulatory standards to govern stablecoins. While companies might suggest or directly advertise that their crypto is fully backed by a fiat currency or commodity, this is not always 100% the case.
When deciding whether to invest in certain stablecoins, we recommend checking whether the issuer has reserve reports on the crypto in question. An absence of these reports might spell trouble for those looking to avoid risk as much as possible.
A risk that is specific to algorithmic stablecoins is the possibility of manipulation. The algorithm that essentially “backs” the tokens and gives them stability is susceptible to technological failure and even hacking by a third party.
Secure Your Assets With Vauld
While stablecoins may not offer the rate of growth more volatile crypto options do, for those wanting a low-risk decentralized investment option, stablecoins can be a safe choice.
Trusting the stablecoins you choose means being able to trust the exchange you invest them with. For a customer-first experience, competitive rates, and security measures that offer users financial confidence, choose Vauld for all of your crypto needs.
At Vauld, you can choose from more popular crypto options, like Bitcoin and Ethereum, or select stablecoins such as Dai, Paxos Gold, TrueUSD, and more for less volatility and all the benefits of earning high interest rates.