Cryptocurrency, including bitcoin, has one major drawback for investors: it is highly volatile. A form of crypto with its value tied to a currency or commodity, however, reduces this issue.
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Enter stablecoins: a type of digital currency with greater price stability than bitcoin and non-stable alt-coins because they are tied to the U.S. dollar, the price of gold or another commodity or currency.
How Stablecoins Maintain Relative Price Stability
Stablecoins maintain price stability by keeping their value tied, or pegged, to another, more stable form of currency or real-world asset.
Historical Comparison
This method for assigning value to currency has been used historically. Prior to 1971, the value of the U.S. dollar was tied to gold bars held by the U.S. Treasury, largely in the Bullion Depository in Fort Knox, Kentucky.
In 1971, president Richard Nixon eliminated the “gold standard,” and the U.S. dollar became fiat currency, which holds value because it is established as legal tender by the government. Basically, the U.S. dollar has value because the government says it has value and countries and people around the world accept its value.
Stablecoins Today
Stablecoins, like the U.S. dollar prior to 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. The developers of stablecoins hold an equal amount of that commodity, whether it’s gold or fiat currency or a combination, in collateral.
In the case of stablecoins pegged to other forms of crypto, they will hold an excess of the cryptocurrency in collateral to compensate for the volatility of that cryptocurrency.
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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, which makes them a riskier investment than other stablecoins.
One 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 sparked the current crypto winter. “Not all stablecoins are stable,” Nasdaq wrote.
But, if you are looking for a stable investment that allows you to easily perform digital transactions, you might consider making stablecoins — backed by assets of some kind — part of your portfolio.
Why Stablecoins Are Important
Bitcoin and alt-coins tend to have massive price fluctuations. For instance, bitcoin dropped from close to $65,000 per coin down to $23,452 per coin between December 2021 and July 2022 in the most recent crypto winter. Daily price fluctuations may also result in massive losses.
For investors looking to use cryptocurrencies as a medium of exchange, this creates lots of risk. If you make an agreement to purchase an item for one bitcoin, for instance, you could pay anywhere from $24,000 USD up to $60,000 USD. And price changes can happen quickly. For instance, bitcoin lost nearly $600 in just two hours on July 25, 2022.
That’s just a change of 2.65%. For a buy-and-hold investor, that type of loss or gain may not make a huge difference in their portfolio. But if you were looking to purchase an item using bitcoin, a $600 price difference is substantial. If you went to a car dealership and, just as you were about to sign the deal, the dealer increased the price on your car by $600 or $1,200, you’d probably be angry.
Of course, you can always purchase goods and services using fiat money like the U.S. dollar for price stability. But proponents of digital currency and decentralized finance see an important role for stablecoins as a means of exchange for goods and services, crypto lending and more.
Stablecoins are often used as a means of reducing transaction fees when trading other forms of cryptocurrency, since many exchanges don’t charge fees to exchange U.S. 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 the parties would prefer to use decentralized finance (DeFi) rather than traditional banks to exchange money.
These are some of the top stablecoins, based on market capitalization, popularity and overall perceived stability.
Tether
Tether (USDT) is a stablecoin pegged to the U.S. dollar. It is currently the top stablecoin based on market cap, according to CoinMarketCap.
Tether is backed by a variety of commodities, including gold, U.S. fiat currency and cash equivalent investments. It is widely used on many crypto exchanges.
USD Coin
USD Coin (USDC) is the second largest stablecoin by market cap and is pegged to the U.S. dollar. It launched in 2018 as a collaboration between crypto exchange Coinbase and Circle, a peer-to-peer payments company.
USDC has partnered with Visa and Mastercard as a viable payment method. It is supported across many popular blockchains, including Ethereum, further lending to its practical use.
Binance USD
Ranked third based on market cap, Binance USD is a stablecoin launched by the crypto exchange platform Binance and Paxos, a blockchain developer and proponent of decentralized finance. Like USDC, it is backed by U.S. fiat currency.
Final Take
Stablecoins have many uses in today’s economy, including a way for those who are risk averse to participate in decentralized finance activities. Stablecoins may also play a role in blockchain-based gaming and financial activities in the metaverse.
There are many different types of stablecoins and you can purchase the most popular stablecoins on crypto exchanges like Binance, Crypto.com and Coinbase.
FAQ
- Is bitcoin a stablecoin?
- Bitcoin is not a stablecoin. It was the first digital currency but is not backed by real-world assets or collateral. Bitcoin's current volatility exemplifies the difference between bitcoin and stablecoins.
- How many stablecoins are there?
- The Blockchain Council released a complete list of stablecoins in 2022. CBS News reported that there are roughly 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 who want to integrate digital currencies into their portfolio. However, their value will always be tied to specific currency or assets.
- Some may provide interest payments or be used for crypto lending, as well, making them useful for passive income. Stablecoins are also useful to minimize or avoid transaction fees when you're trading other forms of crypto.
This article originally appeared on GOBankingRates.com: Stablecoins Cryptocurrency: A Complete Guide
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
