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What are stablecoins and how do it work?

In the world of cryptocurrencies, there are digital coins whose value is tied to a specific physical asset. The first such digital currency, USDT from Tether, appeared in 2015. It is pegged to the value of the US dollar at a ratio of 1:1.

Unlike traditional cryptocurrencies such as Bitcoin and Ethereum, stablecoins are designed to mimic the value of fiat currencies. This option makes them more attractive to users looking for a stable store of value or a secure means of payment.

In this article, we will look at what stablecoins are, how they work, and why they are gaining popularity in the cryptocurrency market.

What are stablecoins?

Stablecoins are a type of digital asset that should have a value comparable to that of fiat currency such as the dollar or euro. They allow users to move their assets around the world quickly while maintaining the value of the currency.

Unlike traditional cryptocurrencies such as Bitcoin or Ethereum, which can fluctuate significantly in value, stablecoins are designed to provide a more stable store of value and a means of exchange for users.

What are stablecoins for?

Initially, only cryptocurrencies and native project tokens were traded on the crypto market. The market was characterized by low capitalization and high volatility. All trading pairs on exchanges consisted of either a volatile asset or a volatile asset and a fiat currency.

Stablecoins emerged as a solution to these problems and allowed:

Fix income in cryptocurrency without resorting to CEX or exchanges.
Increase liquidity in the market. Stablecoins form the majority of exchange pairs on CEX and DEX.
Launch reliable DeFi instruments. With stable liquidity pools, staking and farming programmes, stablecoins owners can generate income with less risk of volatile losses.

Stablecoins have become «dollars on the blockchain», a link between fiat and cryptocurrency that has eliminated the need to constantly use CEX to enter stable fiat.

How stablecoins work

One of the drawbacks of cryptocurrencies is considered to be volatility — a measure of how much an asset's price has risen or fallen over time. Stablecoins are designed to solve this problem and bring reliability to the cryptocurrency space.

There are different methods to achieve more stable market prices, and to date, there are three types of stablecoins that use different strategies to achieve price reliability:

Secured by fiat money (centralized). It is backed by fiat currencies and centralized. That is, behind each stablecoin in circulation there is an equivalent in dollars, which is held in a bank. For example, a unit of a coin such as USDT, USDC or TUSD is backed by one US dollar. The purpose of these coins is to alleviate investor concerns about sharp fluctuations in quotes and to create a system that is more convenient for everyday purchases.
Stablecoins backed by precious metals. Use gold and other precious metals to maintain their value. These stablecoins are centralized, which some in the cryptocurrency community may see as a drawback, but it also protects them from cryptocurrency volatility. Gold has long been seen as a hedge against stock market volatility and inflation, making it an attractive addition to portfolios in fluctuating markets. CACHE gold (CACHE) is one of the most popular «gold» stablecoins. Each CACHE is backed by 1 gram of pure gold.
Algorithmic stablecoins (decentralized). The value of these coins is backed by smart contract algorithms rather than backed by paper money or other digital assets. This can provide a number of advantages, such as faster settlement, lower transaction costs and greater liquidity. A popular example of an algorithmic stablecoin is Maker DAO's Dai (DAI).

Advantages of stablecoins

Stablecoins have a number of advantages over traditional cryptocurrencies, making them an attractive investment option.

Here are some of the benefits of stablecoins:

Price stability. As the name implies, stablecoins offer price stability, making them a great alternative for investors looking for a reliable option to deposit their funds. This sustainability is achieved by backing coins with a reserve asset, such as fiat currency, gold or cryptocurrency.
Low volatility. Stablecoins have lower volatility compared to other cryptocurrencies. This makes them a safer investment option, especially for risk-averse investors who prefer stability to potentially high returns.
High transaction speed. Stablecoins are built on blockchain technology, which allows for faster transactions than traditional banking systems. Transactions with these coins are also transparent and secure, making them a great option for cross-border transactions.
Low transaction fees. These coins do not require the payment of high transaction fees compared to classic payment methods such as credit card payments or bank transfers. This makes them a cost-effective alternative for sending and receiving payments.
Accessibility. Stablecoins are available to anyone with an internet connection, making them a great investment option for residents of countries with unstable fiat currency or limited access to banking services.

Disadvantages of stablecoins

While stablecoins have a number of advantages over traditional cryptocurrencies, they also have some cons to consider:

Centralisation. Some stablecoins rely on centralized organizations to maintain a peg, such as fiat currency or precious metals. This means that their stability depends on the reliability and trustworthiness of these organizations. If the issuer of a centralized stablecoin fails or is hacked, the value of the coin can plummet.
Lack of transparency. Some stablecoin issuers do not provide sufficient information about the collateral the coins are secured with. This makes it difficult to assess the true risk of holding such assets.
Counterparty risk. A stablecoin issuer could default or go bankrupt. This risk only applies to fiat stablecoins and coins backed by precious metals.

It is therefore important to weigh up the advantages and disadvantages of stablecoins before deciding to invest in them, just like any other asset.

Options for the use of stablecoins

Stablecoin trading volumes are on the rise — and there are many viable use cases that could interest holders. Here are some potential uses for these assets:

Payments. Stablecoins offer a quick and convenient way to make payments. They can be used for everyday transactions, such as buying goods in shops or paying for online services.
Money transfers and cross-border transactions. Stable assets can be a cost-effective and efficient option for cross-border payments, especially in regions with limited access to traditional banking services.
Decentralized finance (DeFi). Stablecoins have become a critical component of the DeFi ecosystem, providing traders with a secure asset to use as collateral and liquidity providers to earn interest.
Trading. Stablecoins are often used as a trading pair for other cryptocurrencies as they provide a sustainable base currency for trading pairs.
Value storage. Offer a way to store value in cryptocurrency without the price fluctuations associated with traditional digital assets (e.g., Etherium).

Examples of the most popular stablecoins

Tether (USDT) is a cryptocurrency token that was developed and launched by Tether Limited. It first appeared in 2015 and was soon integrated into the Bitfinex cryptocurrency exchange. It is currently one of the most prominent dollar-linked stablecoins, with a market capitalization in excess of $82.38 billion. Tether can also be used on the DSF platform as an initial deposit.

Binance USD (BUSD) is a 1:1 USD-backed stablecoin issued by the cryptocurrency exchange Binance in partnership with Paxos Trust Company. It is approved and regulated by the New York State Department of Financial Services (NYDFS). Binance USD has a current market capitalization of $5.80 billion.

USD Coin (USDC) is a joint project between Circle Internet Financial and cryptocurrency exchange Coinbase. USDC is a stablecoin created on the Ethereum blockchain using the ERC-20 standard. In fact, the coin is a tokenized USD as it is fully pegged to its value. USD Coin has a market capitalization of $30.15 billion.