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Beginner’s Guide to Stablecoins

By Brian Nibley · May 21, 2021 · 4 minute read

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Beginner’s Guide to Stablecoins

Stablecoins are digital currencies that maintain a fixed value. They are designed to function like fiat currencies that exist on the blockchain. This brings with it several benefits in terms of usability, speed, and regulatory compliance. There are several different types of stablecoins, each defined by the mechanism used to maintain their 1-to-1 peg to their respective fiat currencies.

What is a Stablecoin?

Stablecoins are digital coins that maintain a stable value. Most stablecoins are pegged to popular fiat currencies like the US Dollar, Chinese Yuan, or the Euro. Some are pegged to commodities like gold, too. In theory, a stablecoin could have its value linked to anything—however, coins pegged to a fiat currency are the most commonly used type. When someone uses the term “stablecoin,” they are most likely referring to fiat currency coins.

The most stable cryptocurrency will by definition be a stablecoin. Some of these coins see their values fluctuate by small amounts during times of intense trading volume, but they tend to correct back to their normal value in short order.

If there is any volatility in a stablecoin, it’s certainly much less than that seen in other different types of cryptocurrencies.

What is The Point of a Stablecoin?

Stablecoins have a variety of benefits and uses. The main idea is to have a cryptocurrency that isn’t subject to the volatility of currencies like Bitcoin and the many hundreds of altcoins.

Beyond that, there are other benefits that make using a stablecoin preferable to using regular fiat currency in some situations. Some of the most commonly cited reasons for the creation and use of stablecoins are:

•  Regulatory compliance for crypto exchanges

•  Utility in decentralized finance (DeFi)

•  Ease of use for traders

•  The ability to make fast cross-border payments with low fees

Let’s look at each of these in detail.

Stablecoins Make Things Easier For Exchanges

With stablecoins, cryptocurrency exchanges get to sidestep the complex financial regulations involved with institutions that deal with fiat currencies. (Crypto regulations are very different.) This gives their users the convenience of having stablecoin trading pairs while keeping everything within the cryptocurrency ecosystem.

Stablecoins are Essential to Decentralized Finance (DeFi)

Stablecoins are also becoming a necessary component of the DeFi space. Transactions like peer-to-peer lending, where people make direct loans to each other via blockchain, can be done with stablecoins.

Some users might prefer this option to other cryptocurrencies, which could hurt their rate of return if the price goes down. A stablecoin adds an element of predictability to financial arrangements.

Stablecoins Make Trading Easier

One group of people who often use stablecoins to their advantage are cryptocurrency traders.

When moving money between multiple volatile cryptocurrencies, holding onto profits can be difficult. While traders can always put their gains into Bitcoin (BTC), the largest cryptocurrency by market cap, it also has bouts of volatility.

Stablecoins provide an easy solution to this problem. Traders can simply move into a stablecoin like USD Coin (USDC) or Tether (USDT) to immediately lock in gains. Or, they can take advantage of arbitrage opportunities when the same cryptocurrency has a different price on two different exchanges.

Crypto exchanges have begun offering more stablecoin/altcoin pairs to make things easier for traders.

For example, rather than having to sell Cardano (ADA) for BTC and then sell BTC for USDT, a trader could simply trade the ADA/USDT pair and go directly into that stablecoin, if the ADA/USDT pair is provided. (These coins were chosen at random for the sake of explaining a concept).

Stablecoins Enable Fast, Cheap Cross-Border Payments

Traditional bank transfers typically take anywhere from 3–5 business days and can cost anywhere from a few dollars to a few dozen dollars. International transfers tend to be the most expensive.

Stablecoin transactions can confirm within minutes or less at very little cost. Two people with stablecoin wallets can transact with each other from anywhere in the world at any time without the need for a bank or other third-party intermediary.

Different Types of Stablecoins

Stablecoins are categorized by the mechanism used to maintain their currency peg. There are three main categories:

•  Centralized coins backed by fiat currency

•  Decentralized coins backed by cryptocurrency

•  Decentralized algorithmic coins

At the time of writing, the stablecoin market is dominated by coins that use a centralized model and back the issuance of new tokens with fiat currency at a 1-to-1 ratio. USDT and USDC are examples of this type of stablecoin.

Other coins, like DAI, an ERC20 token on the Ethereum blockchain, are newer but have been gaining popularity due to their decentralized model. Rather than maintaining their stable value through fiat reserves, users can lock up cryptocurrency as collateral for borrowing DAI on the Maker DEcentralized Autonomous Organization (DAO) platform. DAI is governed by network consensus rather than a centralized team, and maintains a value equal to one US dollar.

Decentralized algorithmic coins are very new and are different from the other types of stablecoins in that they don’t involve any type of collateral backing. Instead, they rely on algorithms to maintain their price.

What is The Best Stablecoin?

For the most part, all stablecoins perform the same functions. The choice comes down to user preference.

Some claim that decentralized stablecoins like DAI are the best because they don’t rely on a central team or company to manage their currency peg. Rather, the peg is maintained by programming and math. Then again, there have been times when DAI has fluctuated in value more than most other stablecoins, so it might not be the most stable cryptocurrency.

There are potential security risks as well. A flaw in the Ethereum smart contracts that govern DAI also resulted in $8 million in theft in 2020.

The argument could also be made that whatever stablecoin has seen the greatest adoption is the best. By this metric, Tether (USDT) would be the best stablecoin, followed by US Dollar Coin (USDC) and DAI. As of 2020, these three coins together make up for about 90% of the entire stablecoin market.

USDT is also thought to be one of the most-traded coins, consistently having the highest daily volume of any coin according to coinmarketcap.com.

But USDT has a controversial history, and it’s uncertain whether or not the tokens are 100% backed by real dollars. For this reason, some might argue that Tether is not the best stablecoin.

Stablecoin Wrap-Up

Stablecoins are cryptocurrencies that keep their value stable in relation to another asset—most commonly, an existing fiat currency such as the US Dollar.

Issuing these coins on a permissionless blockchain removes the barriers to entry associated with banks and the legacy financial system at large, providing greater access to those who may not otherwise have the opportunity to participate in the financial world.

Everyone from the unbanked to day traders and those braving the rough new world of decentralized finance may have a potential use case for stablecoins.

Interested in buying cryptocurrency? With SoFi Invest®, members can buy and trade cryptocurrencies like Bitcoin, Ethereum, and Litecoin, from the convenience of the mobile app.

Find out how to invest in crypto with SoFi Invest.

Photo credit: iStock/Vertigo3d


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