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Cryptocurrencies, including bitcoin, have one major drawback for investors: they are highly volatile. However, a form of crypto with its value tied to a currency or commodity reduces this problem.
Enter stablecoins: a type of digital currency with greater price stability than bitcoin and unstable altcoins because they are pegged to the US dollar, the price of gold, or another commodity or currency.
How stablecoins maintain relative price stability
Stablecoins maintain price stability by keeping their value pegged or tied to another, more stable form of real-world currency or asset.
This method of assigning value to currency has been used historically. Prior to 1971, the value of the US dollar was tied to gold bullion held by the US Treasury, primarily at the Bullion Depository in Fort Knox, Kentucky.
In 1971, President Richard Nixon eliminated the “gold standard” and the US dollar became fiat currency, which has value because the government established it as legal tender. Basically, the US dollar has value because the government says it has value and countries and people around the world accept its value.
stable coins today
Stablecoins, like the US dollar before the introduction of fiat currency, peg their value to commodities, such as gold or silver, fiat currencies, or even other cryptocurrencies. Stablecoins can also be backed by a variety of investments. Stablecoin developers hold an equal amount of that commodity, be it gold or fiat currency or a combination, as collateral.
In the case of stablecoins tied to other forms of crypto, they will hold an excess of the cryptocurrency as collateral to offset the volatility of that cryptocurrency.
Algorithmic stablecoins: not as stable as you might think
Some stablecoins determine their value with sophisticated software algorithms. While these stablecoins are pegged to a real-world asset, they are not actually backed by one, making them a riskier investment than other stablecoins.
An algorithmic stablecoin, TerraLab’s Luna, recently lost all of its value, subsequently dragging down the value of bitcoin and alt-coin in a crash that triggered the current crypto winter. “Not all stablecoins are stablecoins,” Nasdaq wrote.
But, if you’re looking for a stable investment that allows you to easily transact digitally, you might consider making asset-backed stablecoins of some kind a part of your portfolio.
Why stablecoins are important
Bitcoin and altcoins tend to have massive price fluctuations. For example, bitcoin fell from around $65,000 per coin to $23,452 per coin between December 2021 and July 2022 in the most recent crypto winter. Daily price fluctuations can also lead to massive losses.
For investors looking to use cryptocurrencies as a medium of exchange, this creates many risks. If you make a deal to buy an item for one bitcoin, for example, you could pay anywhere from $24,000 USD to $60,000 USD. And price changes can happen quickly. For example, bitcoin lost almost $600 in just two hours on July 25, 2022.
That’s just a 2.65% change. For a buy-and-hold investor, that kind of gain or loss may not make much of a difference in his portfolio. But if you were looking to buy an item using bitcoin, a price difference of $600 is substantial. If you went to a car dealer and, just as he was about to sign the deal, the dealer raised the price of his car by $600 or $1,200, he would probably be mad.
Of course, you can always buy goods and services using fiat money like the US dollar for price stability. But advocates of digital currency and decentralized finance see an important role for stablecoins as a means of exchanging goods and services, crypto loans, and more.
Stablecoins are often used as a means of reducing transaction fees when trading other forms of cryptocurrencies, as many exchanges do not charge fees to exchange US dollars for stablecoins.
The most popular stablecoins
Stablecoins can be used as a medium of exchange for cross-border transactions and in any case where parties prefer to use decentralized finance (DeFi) instead of traditional banks to exchange money.
Here are some of the top stablecoins, based on market cap, popularity, and overall perceived stability.
Tie (USDT) is a stablecoin pegged to the US dollar. It is currently the top stablecoin based on market cap, according to CoinMarketCap.
Tether is backed by a variety of commodities, including gold, US fiat currency, and cash equivalent investments. It is widely used in many crypto exchanges.
USD Coin (USDC) is the second largest stablecoin by market capitalization and is pegged to the US dollar. It was launched in 2018 as a collaboration between crypto exchange base of coins and Circle, a peer-to-peer payments company.
USDC has partnered with Visa and Mastercard as a viable payment method. It is compatible with many popular blockchains, including Ethereum, which further contributes to its practical use.
Ranked third based on market cap, Binance USD is a stablecoin launched by crypto exchange platform Binance and Paxos, a blockchain developer and advocate for decentralized finance. Like USDC, it is backed by US fiat currency.
Stablecoins have many uses in today’s economy, including a way for those who are risk-averse to participate in decentralized finance activities. Stablecoins can also play a role in blockchain based games and financial activities in the metaverse.
There are many different types of stablecoins and you can buy the most popular stablecoins on crypto exchanges like Binance and Coinbase.
Frequently asked questions
- Is Bitcoin a stable coin?
- Bitcoin is not a stable coin. It was the first digital currency, but it is not backed by real-world assets or collateral. The current volatility of Bitcoin exemplifies the difference between Bitcoin and stablecoins.
- How many stablecoins are there?
- The Blockchain Council released a full list of stablecoins in 2022. CBS News reported that there are approximately 200 varieties of stablecoins in the world, with a total market value of $163 billion.
- Are stablecoins a good investment?
- Stablecoins have less volatility than other cryptocurrencies, making them a less risky investment for those looking to integrate digital currencies into their portfolio. However, its value will always be tied to a specific currency or assets.
- Some can provide interest payments or also be used for crypto loans, making them useful for passive income. Stablecoins are also useful for minimizing or avoiding transaction fees when trading other forms of crypto.
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