*obligatory not financial advice*
Hi,
In this series I want to explain some terms that are relevant to the amazing world of cryptocurrencies to help newcomers understand it better. Today I want to talk about stablecoins.
Previous Parts:
Crypto Basics #1: What even is a Blockchain?
Crypto Basics #2: What are Smart Contracts?
Crypto Basics #3: What is a Cryptocurrency Wallet?
Crypto Basics #4: What is Mining and Proof of Work?
Crypto Basics #5: What is Staking and Proof of Stake?
Crypto Basics #6: What is Decentralized Exchange? And how do they work?
What are Stablecoins? And How do they work?
In short, a stablecoin is a cryptocurrency that copies the value of a fiat currency, most often the US dollar.
They are available on most smart contract blockchains and they exist because they make it possible to use a far more stable currency on DeFi applications like Aave and Compound, which can give you the advantages of crypto but without its volatility. Stablecoins also allow people to take profits and trade their cryptocurrencies for an US dollar equivalent on a DEX like Uniswap without the need of moving their funds to a centralized exchange. Depending on where you live you could have tax advantages if you swap your crypto for stablecoins instead of selling them for fiat, because you are technically just exchanging one cryptocurrency for another.
There are different types of stablecoins that can be differentiated based on how they keep their peg to their fiat currency.
The most common type are stablecoins that are backed by real life dollars (or bonds or the like) and are issued by a centralized entity. USDT and USDC both fall in that category. The advantage of this stablecoins is that they can be exchanged for real dollars at a rate of 1:1, so their value shouldn't be able to fall much below $1, except for short periods of time on individual exchanges if a lot of trading is going on. However, the problem with them is that they depend on a centralized entity, which destroys the entire point of DeFi. The institutions behind them also need to be constantly audited to make sure that their stablecoins are being backed by enough real-life dollars and some of them can be very untransparent in that regard. For example: Tether, the company behind the USDT token, is infamous for not being transparent enough.
Another popular type are stablecoins that are overcollateralized by other cryptocurrencies, like DAI, MAI and Magic Internet Money. They usually depend on a DeFi application that allows its users to supply cryptocurrencies as collateral to take loans by minting their stablecoin. Such a loan is useful for things like leverage trading, where you use the borrowed stablecoin to buy even more crypto, or for people that need money right now but don't want to sell an asset they are bullish on. The stablecoins keep their peg because their DeFi application always assumes their value to be $1 and thru various other mechanisms and they cannot be not backed by enough funds because they require their collateral to have more value than the borrowed stablecoin and should the value of the collateral fall to a certain point it will be sold automatically to buy back and burn the stablecoin. The advantage here is that the stablecoins are decentralized and don't depend on a company like Tether. However, because their supply depends on people to take risky loans with their crypto as collateral, their circulating supply could be rather limited especially during bearish times.
Another decentralized type of stablecoin are the now infamous algorithmic stablecoins, like UST from the failed LUNA blockchain and also USDD from Tron and cUSD from Celo. This stablecoins are backed by $1 worth of another cryptocurrency. UST for example was always able to be burned for whatever amount of LUNA equals $1 at that time. The advantage of this type of stablecoins is that they can be decentralized, and they also don't depend on risky DeFi loans, meaning that there is barely a limit to how much liquidity the stablecoins can have, However, this type of stablecoins have gained a lot of infamy because UST has recently completely failed at keeping its peg, which is because the LUNA that was backing it was volatile. This has shown that such stablecoins are quite risky especially during bear markets and it’s unlikely that this type of stables will get much support in the foreseeable future.
Every type of stablecoin has its issues and they still need further improvement, maybe we will soon find a way to have decentralized and safe stablecoins with lots of liquidity. But even now they are already an essential and useful part of DeFi. If you want to try out some dApps but don’t want to hold a coin or token that is extremely volatile, then you could use a stablecoin for that but make sure you pick one that you can trust to keep its peg.
I hope that short explanation was helpful for some newcomers. I will keep writing more such short articles about various crypto terms. Feel free to follow me if you are interested.
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