Cryptocurrencies can be extremely volatile. However, cryptocurrencies called stablecoins are pegged to real-world assets and don’t rapidly fluctuate. Stablecoins can be great tools for investors who are looking for an on/off-ramp in the cryptocurrency markets. And market participants who are looking to hedge against their positions in volatile digital assets like Bitcoin and Ethereum. Let’s take a look at the different types of stablecoins and why you might want to use a stablecoin if you are trading cryptocurrency.
What Is A Stablecoin?
A stablecoin is a cryptocurrency whose value is tied to another asset. Generally, stablecoins can be sorted into four major categories, fiat-backed, asset-backed, crypto-backed, and economic-backed
Fiat-Backed Coins: Fiat-backed stablecoins are backed by a collateral reserve of fiat currency that should be equal to the circulating supply of the coin in a 1:1 ratio. For example, Tether claims to hold $1 for each USDT stablecoin in circulation. Theoretically, at any time a USDT holder can cash in their token for one dollar. After cashing-out their Tether, the holder receives the fiat, and Tether burns the tokens.
Asset-Backed Coins: An asset-backed stablecoin is a cryptocurrency that is backed by a real-world asset like gold, precious metals, real estate, and stocks. The value of the asset itself may not always be stable. However, coin holders will always be able to exchange their stablecoin for an amount equivalent to that of the asset, or in some cases, the asset itself.
Crypto-Backed Coins: Cryptocurrency-backed stablecoins are coins backed by other cryptocurrencies. For instance, the stablecoin Dai is pegged one-for-one to the U.S. dollar, but Dai issuers MakerDAO don’t have a reserve of fiat stashed as collateral. Instead, Maker uses smart contracts that lock up Ethereum and use it as collateral for the Dai tokens. Because Ethereum, like all other non-stable coins, experiences significant price volatility, Dai are overcollateralized to absorb price swings. This means that using Dai requires locking up an amount of Ethereum worth more than a 1:1 ratio to the dollar at the time you initially deposit your collateral.
Economic-Backed Coins: Economic-backed stablecoins are cryptocurrencies that maintain stability through their token economics. These projects use algorithms that expand or contract the coin supply to maintain a steady market-wide value. Economic-backed stablecoins are similar to how the U.S. Federal Reserve keeps the value of the dollar intact through expanding and contracting the money supply. Now-defunct project Basis used this model to issue stable Basecoins.
Why Use A Stablecoin?
Stablecoins offer their traders an easy on/off-ramp into cryptocurrency markets. Stablecoins offer traders a safe place to “park” their funds without actually withdrawing their wealth from the cryptocurrency markets entirely. This gives traders the liquidity they are looking for when it comes to entering and leaving the cryptocurrency markets. Yet, it removes the risk of their wealth rapidly fluctuating like it would if they kept their wealth in a cryptocurrency like Bitcoin.
When traders keep their wealth in stablecoins rather than withdrawing to fiat currency when they are worried about the market fluctuating, the trader has a fast, easily accessible, and often cheaper on/off-ramp to cryptocurrency exchanges. Instead of going through the lengthy and often costly process of turning fiat into crypto and vice versa every time they are looking to liquidate their volatile coins and tokens.
Stablecoins are great tools for traders who are looking to have easy access to the cryptocurrency markets but do not want to be exposed to the volatility that most cryptocurrencies experience. Traders can easily exchange their stablecoins for other cryptocurrencies and vice versa. Since stablecoins are pegged to real-world assets, traders can have peace of mind knowing that their wealth is not going to fluctuate rapidly when they store their wealth in these coins. If you trade cryptocurrency but are worried about your wealth rapidly fluctuating from trade to trade, then you might be interested in storing your wealth in a stablecoin when you believe the market is going to take a turn for the worse.