What are Stablecoins?

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What are Stablecoins

The cryptocurrency space is ever-evolving. Bitcoin, the pioneer in cryptocurrency completely transformed the world of finance. However, it posed one major drawback – the high volatility, which bothers investors.

A new set of coins emerged to tackle this problem – The Stablecoins.

If you wish to understand what are stablecoins, their types of collateral, and more, this article is for you.

Let’s get started.

What are Stablecoins?

Stablecoins are specially designed cryptocurrencies whose price is pegged or tied to an external reference asset. The reference could be a fiat currency like USD or Euro, another cryptocurrency, exchange-traded commodities, or financial instruments. 

Blockchain-based cryptocurrencies like Bitcoin excellently addressed the challenge of intermediaries’ involvement in financial transactions through decentralization. However, the key issue that investors face with cryptocurrencies like Bitcoin is the extremely high volatility and unpredictability associated with it. It poses a great risk in short-term investing as the price swings are drastic.

To combat the volatility issue, stablecoins were introduced. As they are tagged to an external reference asset like the US dollar, their price depends on the asset’s price. This imparts a good degree of stability to the stablecoins.

Stablecoins Explained –

Stablecoins address the volatility challenge by tying the cryptocurrency to a more stable asset like a fiat currency. The underlying entity sets up the reserve to store the asset backing the stablecoins – for instance, $1 million in a bank to store one million stablecoins.

This way the reserve acts as collateral and whenever a stablecoin holder wishes to cash out their tokens, an equal amount of the asset backing the stablecoin is taken out from the reserve.

Another example is that of Maker, the popular stablecoin issuer which uses a mechanism called ‘Vault’ that locks up the cryptocurrency collateral of the user. It works on code statements automatically executed on Ethereum, known as smart contracts. Once the smart contract knows that the collateral is secured, it lets the user borrow the platform’s freshly minted stablecoin, DAI.

Types of Stablecoin Collateral

Based on the collaterals used, stablecoins are of different types:

Fiat-based 

Fiat currency collateral stablecoins are the most common ones. The US Dollar is the fiat currency popular in use. However, companies are also exploring other options to peg as collateral.

Precious metals 

Some stablecoins are also pegged to precious metals like gold or silver.

Other Cryptocurrency 

Some stablecoins are pegged to other cryptocurrencies like Ether, the native token of the Ethereum blockchain platform.

Let’s take a look at some of the common stablecoins.

Tether 

Launched in 2014, Tether is the most popular stablecoin which is pegged to the U.S. dollar. Tether is a highly valuable cryptocurrency that enjoys a very high overall market capitalization.

The most common use of Tether is to move money between exchanges and exploit arbitrage opportunities when the cryptocurrency prices differ across exchanges. Traders make money through this discrepancy.

USD Coin 

Launched in 2018 jointly by the crypto firms Circle and Coinbase through the Centre Consortium, USDC is similar to Tether and is pegged to the US dollar. USDC is an open-source protocol that can be used by individuals or businesses to develop their own products.

Dai 

Created in 2015 by MakerDAO, the stablecoin Dai rests on the Ethereum platform. It is pegged to the US dollar and backed by Ether, the native token of the Ethereum network.

Final thoughts

Stablecoins – Tether, USDC, or Dai- all serve as alternatives to highly volatile cryptocurrencies. They are a new wave of cryptos that offer better stability and thus provide safer investment choices.

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