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Everything You Need to Know about Stablecoins

Stablecoins: Reducing crypto volatility, key types, risks, and regulations

Published in: One Trading · 5 min read

Stablecoins boast a market cap of approximately $130 billion (at the time of writing), and they facilitate billions of dollars in transactions every day. They are the most frequently used crypto-assets for trading pairs and have become a common method of payment for goods and services in numerous countries. We will take a deep dive into the intriguing universe of stablecoins and uncover how they maintain their balance in the ever-changing environment of digital assets.

Key Takeaways

  • Stablecoins are digital assets designed to maintain a stable value, with the intention of providing users with trust and preserving their investments.
  • Various forms of asset backing enable transparency and accountability for these assets.
  • Stablecoins offer numerous advantages, such as reduced volatility, increased liquidity relative to most altcoins & global accessibility. Investors must be aware of potential risks associated with them.
  • Stablecoins can be used as a risk-off play for traders who look to exit altcoins, for instance, in times of high volatility, during downward price corrections, or after taking profits in an altcoin or Bitcoin - ideally at a market top! 

Understanding Stablecoins: The Basics

Stablecoins are digital assets designed to maintain a stable value, typically pegged to a fiat currency or commodity, and hold a significant market capitalization in the digital asset space. There are several varieties of stablecoins, such as fully collateralized ones like USDC, and those that use a mix of algorithms, collateralization, or other means to sustain their value. Highly valued for their ability to address the issue of extreme price fluctuation associated with crypto-assets, stablecoins can be used for both daily transactions and long-term investments.

The Role of Stability in Digital Assets

Stability is a key aspect of digital assets, as it enables transactions, value preservation and helps reduce price fluctuation. Stablecoin tokens aim to solve these challenges by maintaining a stable value relative to a specific asset or currency. This steadiness aims to ensure that users can trust the digital asset's value for transactions and as a store of value without fearing significant price fluctuations common in other crypto-assets.

Without stability, digital assets may experience large price fluctuations, making them impractical for everyday use and difficult to manage in a bank account.

Types of Asset Backing

Stablecoins can be backed by various assets, including fiat currencies, crypto-assets, or commodities. Crypto-backed stablecoins use other crypto-assets as collateral to maintain their value. Fiat-backed stablecoins, for example, are digital assets collateralized by a fiat currency held by a regulated financial institution, such as TrustToken, the issuer of TrueUSD, providing daily attestations from an independent accounting firm to confirm that U.S. dollars are held in reserve, ensuring transparency and accountability.

Beyond fiat-backed stablecoins, commodity-backed stablecoins also exist, which are collateralized by commodities such as precious metals like gold. Holders of these stablecoins can redeem their tokens at the conversion rate specified in accordance with the applicable rules regarding the timing and amount of the redemption. Pax Gold, for instance, is a digital asset backed by physical gold.

How Stablecoins Maintain Their Peg

Stablecoins uphold their value through different strategies, such as:

  • Collateral reserves: ensuring that an equivalent amount of the reserve asset is held in reserve for every token in circulation.
  • Smart contracts: automatically executing transactions when certain conditions are met.
  • Algorithmic mechanisms: controlling the supply of the stablecoin through an algorithm.

USD Coin (USDC) is one such example of a fully collateralized token. This means that an equivalent amount of US dollars is held in reserve for every coin in circulation, essentially creating dollar-denominated assets. This ensures that the value of USDC remains stable and pegged to the U.S. dollar at a 1:1 ratio, providing a reliable form of digital asset for users.

The Various Forms of Stablecoins

As observed, there are several stablecoins, each with their unique approach to ensuring stability in the digital asset market. Whether it’s fiat-collateralized, crypto-collateralized, or algorithmic, these stablecoins aim to provide a stable value for users, making them an attractive alternative to highly volatile crypto-assets.

Fiat-Collateralized Stablecoins: The Traditional Approach

Fiat-collateralized stablecoins utilize conventional assets such as fiat currency or precious metals as their reference asset, with independent custodians and regular audits to ensure security. These stablecoins maintain their value by holding an equivalent amount of fiat currency or precious metals in reserve, providing a stable value that is less susceptible to the price volatility encountered in other crypto-assets. As a result, fiat-collateralized stablecoins offer users a more secure and reliable form of digital asset.

Examples of fiat-collateralized stablecoins include Tether (USDT), USD Coin (USDC), and TrueUSD (TUSD), which are pegged to the U.S. dollar and hold significant market capitalization in the digital asset space. These stablecoins provide users with a store of value and facilitate trades on crypto exchanges, acting as a buffer against the high volatility of other crypto-assets.

Crypto-Collateralized Stablecoins: A Decentralized Method

Crypto-collateralized stablecoins rely on other crypto-assets for backing and are governed via decentralized platforms and smart contracts. These stablecoins are usually over-collateralized, meaning the value of the crypto-asset held in reserves is greater than that of the stablecoins issued. This over-collateralization is employed to safeguard the stablecoin’s price in the event of a significant drop in the value of the collateral.

MakerDAO’s Dai (DAI) stablecoin is an example of a crypto-collateralized stablecoin. The value of DAI is maintained by locking other crypto assets in contracts as collateral, while the protocol adjusts borrowing and saving interest rates through smart contracts to ensure the stablecoin’s value remains close to $1.

Crypto-collateralized stablecoins offer a decentralized alternative to centralized stablecoins, relying on blockchain technology and smart contracts to manage the stability of their value.

Algorithmic Stablecoins: Innovative Price Stability

Algorithmic stablecoins:

  • Utilize sophisticated algorithms to manage supply and uphold a stable value.
  • May experience fluctuations due to the absence of central bank credibility.
  • Attempt to provide price stability through algorithmic mechanisms that adjust the supply of the algorithmic stablecoin according to the prevailing market price without the need for collateral backing.

However, algorithmic stablecoins can be more susceptible to volatility and loss of peg, as seen in the case of TerraUSD, which experienced a crash in May 2022, thus eliminating its peg to the U.S. dollar. Despite the potential risks associated with algorithmic stablecoins, their innovative approach to ensuring price stability continues to attract interest and development in the digital asset space.

The Significance of Regulation and Transparency

For stablecoin adoption, regulation and transparency play a crucial role, with oversight from financial institutions and independent audits ensuring trust and stability. As stablecoins continue gaining traction in the digital asset market, the need for regulatory clarity and accountability becomes increasingly important to ensure stability and credibility.

The Oversight of Regulated Financial Institutions

Regulated financial institutions contribute significantly to the stability and reliability of stablecoins by managing and safeguarding their reserves, ensuring that the assets backing the stablecoins are securely kept. The involvement of reputable financial institutions in the regulation and oversight of stablecoins provides users with confidence in the stability and security of these digital assets.

This oversight also helps to address financial risks, foster investor confidence, and reduce market manipulation and fraud associated with the stablecoin market.

Trading only with regulated bodies, such as One Trading, an entity registered with the Italian OAM, is strongly advised. 

Market Cap Leaders and Their Influence

Two major players in the stablecoin market, Tether (USDT) and USD Coin (USDC), have a substantial influence on the sector and foster widespread adoption. You can read more about Tether in our previous article here. Both of these, as well as EUROC (a stablecoin pegged to the Euro), can be utilized for trading on One Trading. The market capitalization of these stablecoins enables them to provide a store of value and facilitate trades on crypto exchanges, acting as a buffer against the high volatility of other crypto-assets.

Stablecoins for Trade and Savings

The use of stablecoins is on the rise, offering benefits such as:

  • Reduced volatility
  • Increased liquidity
  • Global accessibility
  • DeFi

They also serve as a hedge against crypto volatility by aiming to maintain a fixed value, which may be an option for risk-averse investors looking to minimize volatility.

Challenges of Stablecoins

Stablecoins also face risks and vulnerabilities, such as lack of regulation, transparency issues, and maintaining the peg to their underlying assets.

Minimizing Price Volatility

Stablecoins can be held in a portfolio to reduce price volatility from the crypto market by maintaining a stable value, often pegged to a fiat currency or commodity. This stability provides a buffer against the price fluctuations and volatility commonly seen in other crypto-assets, making them a potential option for investors seeking to protect their assets from market volatility.

Furthermore, stablecoins can also offer lower costs, global reach, and faster transaction speeds as a means of payment, making them a form of digital cash accepted in the digital economy.

Risks and Vulnerabilities

Investors need to consider the risks linked to stablecoins, such as:

  • Runs on the stablecoin, leading to fire sales of reserve assets
  • Embezzlement or unauthorized access to stablecoin holding accounts
  • Difficulty of sustaining the peg to the underlying asset
  • Incomplete attestations
  • Contagion risks associated with the crypto-asset market

It is worth noting that stablecoins do not qualify as, and thus cannot be compared to, a legal tender, security or other regulated financial product. Given the risks and vulnerabilities, such as those set out above, there remains a risk that stablecoins may lose some or all of their value. So identifying potential risks is crucial for informed decision-making, before entering into such assets.

Conclusion

From their inception to their growing adoption in the marketplace, stablecoins have come a long way in addressing the price volatility issues plaguing the digital asset space. With various forms, asset backing, and innovative mechanisms, stablecoins aim to provide a stable and reliable alternative to traditional crypto-assets. As blockchain technology advances and regulatory frameworks evolve, the future of stablecoins may look bright, with the potential to revolutionize the digital asset market and offer new opportunities for investors and users alike.

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Disclaimer: This material is for informational purposes only, and is not intended to provide legal, tax, financial, or investment advice. Past performance is not necessarily indicative of the future nor a reliable indicator of the likely performance of any investment. Recipients should consult their own advisors before making these types of decisions. One Trading has no responsibility or liability for any decision made or any other acts or omissions in connection with Recipient’s use of this material. 
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