Though Bitcoin remains the most popular cryptocurrency, it tends to suffer from high volatility in its price or exchange rate. For instance, Bitcoin's price rose from just under $5,000 in March 2020 to over $63,000 in April 2021, only to plunge almost 50% over the next two months. Intraday swings can also be wild; the cryptocurrency often moves more than 10% in a few hours.
As the name implies, stablecoins aim to address this problem by promising to hold the cryptocurrency's value steady in various ways.
Stablecoins in a Nutshell
These are tokens that are not volatile and do not change the price. Every stablecoin is pegged to 1 dollar, meaning 1 Stablecoin = 1 USD. Unfortunately, most of them are not equal to 1 USD.
This is because stablecoins are created using different mechanisms and determine if the coin would be stable (pegged to 1 USD).
Mechanisms That Create a Stablecoin
1. Fiat Backing
Stablecoins created using this mechanism are backed by U.S. dollars (Fiat). As such, for every $1M Stable coin created, there is $1M in cash or cash equivalent locked up somewhere.
Examples of such stablecoins include;
USDT
USDC
BUSD
TUSD
However, such stablecoins have various associated risks. One is that since the Fiat backing the stablecoins are off Chain, there's no way to confirm if they exist. Additionally, the government and other entities could freeze Fiat since they are mostly locked in banks.
2. Crypto Collateral
This mechanism involves the creation of stablecoins by locking up another crypto asset as collateral. Here stablecoins backing is over-collateralized by 150% in case the collateral loses value. They are done using smart contracts.
Such include:
DAI
MIM
LUSD
One of the disadvantages of such stablecoins is that it is susceptible to being exploited by smart contracts. Additionally, Collaterals may lose value affecting the stablecoin peg. There is also the risk of over-collateralization. In simpler words, to get $1M DAI, I will have to lock up $1.5M equivalent in $ETH or $BTC. Therefore, it is not capital efficient.
3. Algorithms
Here stablecoins backings are UNDER collateralized or not collateralized at all making them completely decentralized. They can maintain peg through arbitrage incentives. The most popular Algorithmic stable coin is TerraUSD (UST).
One of the disadvantages is that a significant sale or buy could easily depeg them. On the other hand, they are volatile and, therefore, not a good way to store funds. Its structure collapses if the arbitrage incentives no longer trigger people. Lastly, such a stablecoin cannot withstand a stress test.
4. Semi-Algorithms
This mechanism combines Collateral and algorithmic backings. Stablecoins under this category is currently the safest, with very low risks of losing their peg. An example is Frax Finance.
The Need for Stablecoins
Hedge against Volatility to avoid loss in bear markets.
You can earn yields on stablecoins by simply staking them.
You can store funds as Stablecoins, which are easily accessible
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