What is a stablecoin?

Blockchain / 8 Min Read
Axi Team / 15 Sep 2021

Stablecoins play a significant role in the global cryptocurrency markets, providing a range of use cases for traders, investors, and active crypto users.

Stablecoins are a relatively new type of cryptocurrency but have exploded in popularity over the last few years. The first decentralised stablecoins were created with Bitcoin in mind, but today there are many projects based on Ethereum and other blockchain technology.

In this guide, you will learn everything you need to know to get started using stablecoins, including what they are, how they work, and where you can buy them.

What is a stablecoin?

A stablecoin is a digital currency that operates on a blockchain and retains a stable price value. Stablecoins typically achieve price stability through collateralisation with a fiat currency held in regulated bank accounts by the issuing entity. 

Scale displaying stablecoins and dollars

For example, the market-leading stablecoin Tether USD (USDT) is backed 1:1 by US dollars held in company bank accounts. Every time a new USDT is issued, one dollar is deposited in the issuing company’s bank accounts.

"Stablecoins act as a bridge between traditional finance and crypto finance, combining the trust, stability, and brand recognition of assets like the dollar with the openness and accessibility of cryptocurrency."

In addition to traditional currencies, such as the US dollar, stablecoins can also be backed by commodities, such as gold or silver, and even other cryptocurrencies. Dai, for example, is a popular crypto-backed stablecoin. 

Stablecoins’ price stability addresses the volatility issue of “traditional” cryptocurrencies, which allow them to be used as a store of value, for payments, as a lending asset, and more. 

Stablecoins are essentially a bridge between traditional finance and crypto finance, combining the stability and brand recognition of assets like the dollar with the openness and accessibility of cryptocurrency.

How do stablecoins work?

The majority of leading stablecoins are backed by US dollars held in regulated bank accounts to guarantee near-price parity with the US dollar. As a result, most stablecoins work in the same way. 

For example, if the stablecoin is backed by US dollars, for each stablecoin issued, one dollar is deposited in a bank. This means you will be able to redeem each unit of the stablecoin for one dollar. This is how the most popular stablecoins like USDT, USDC and BUSD work.

However, there are also stablecoins with different price stability mechanisms. The most famous one is Maker’s Dai. In the case of Dai, users deposit cryptocurrency into a smart contract that issues Dai (DAI) in exchange. As long as the right amount of collateral, which is automatically adjusted according to market demand, is held in the smart contract, DAI tracks the value of the US dollar almost exactly 1:1. 

No matter the stablecoin though, the ultimate aim is to keep the price stable in relation to another asset. 

What are stablecoins used for?

Primarily, stablecoins are used as trading capital and as a quotation currency for crypto traders. Professional and institutional crypto traders typically prefer to hold funds in stablecoins, like USDT, than to convert funds from fiat currency into cryptocurrency (and vice versa) every time they want to enter and exit a position. As dollar-backed stablecoins retain the same value as the dollar, they are an excellent way to store trading capital and to quote crypto prices in dollar terms. 

Additionally, stablecoins are also increasingly used in payments and international money transfers.

Let’s look into the most popular stablecoin use cases. 

Trading

Stablecoins account for about 70% of the bitcoin (BTC) trading volume because many traders use them to enter and exit bitcoin positions. 

Cheap and fast payments

You can send millions of dollars paying fees less than $1, which is almost impossible with the traditional financial system.

International money transfer

Stablecoins provide more flexibility than government-issued currencies. You can use them 24 hours a day, 7 days a week, anywhere in the world, and complete cross-border money transfers within seconds.

Savings: You can save a preferred currency without actually having a bank account. In a case where you can’t create a dollar bank account, for example, you could simply hold the stablecoin equivalent.

Lending and borrowing

Stablecoins have emerged as the preferred lending asset in the growing crypto lending market as they mitigate the risk of loss due to price volatility.

Types of stablecoins

Stablecoins can be categorised into four types, each differing in its approach to provide a digital currency with stable value. 

Types of stablecoins

Fiat-backed stablecoins

Fiat-backed stablecoins are backed by fiat currency like dollars, euros, or pounds. You use dollars (or any other fiat currency) to buy the stablecoins and can also redeem them for your original currency. The fiat currency backing a stablecoin is often known by the name of the token. For example, Tether USD is pegged to the US dollar while Tether EUR is pegged to the Euro.

Fiat currency-backed stablecoins aim to have small price fluctuations compared to their reserve currency. They are the most popular type of stablecoins.

Commodity-backed stablecoins

Commodity-backed stablecoins are backed by precious metals like gold and silver to maintain their value. These stablecoins are similar to fiat-backed stablecoins in the sense that they retain their value due to traditional assets held as collateral. 

Prominently, gold has long held its position as a hedge against stock market volatility and inflation, which is why it is the most common commodity-backed stablecoin. Gold-backed stablecoins have also made trading gold super flexible. In many places, buying a gold bar, securing, and selling it is complex and expensive. But with these stablecoins, anyone can move the digital version anywhere and sell it at any time. The most popular stablecoins in this category are Tether Gold (XAUT) and Paxos Gold (PAXG).

Crypto-backed stablecoins

As the name implies, crypto-backed stablecoins are backed by other volatile crypto assets. To compensate for the volatility, these stablecoins are typically overcollateralised to keep the price stable. 

For example, a $1 crypto-backed stablecoin is tied to an underlying $2 crypto asset, so if the crypto asset dips sharply but remains above a certain threshold, the excess collateral from the crypto asset can serve as a buffer and the stablecoin will still remain at $1.  

When buying this stablecoin, you have to lock your cryptocurrency into a smart contract to obtain stablecoins of equal value. You can put the stablecoin back into the same smart contract to redeem your crypto collateral. DAI is the most common stablecoin in this category. DAI’s price is pegged to the dollar but backed by cryptocurrencies.

Algorithmic stablecoins 

Algorithmic stablecoins are not backed by fiat currencies, cryptocurrencies or commodities. They employ a computer algorithm to control the coin’s supply and keep the value relatively stable. 

The algorithm releases more tokens into supply whenever the stablecoin price rises above its price peg and cuts supply when it falls below. These stablecoins are the most difficult to build and execute successfully, thus the least common in the crypto market.

List of stablecoins

There are dozens of stablecoins in the $100+ billion market for stable digital currencies. However, the top four - USDT, USDC, BUSD, and DAI - make up the vast majority of the market. Let’s look at each of these in more detail. 

Tether USD (USDT)

Tether is the largest stablecoin by market capitalisation and was the first stable digital currency to enter the market when it launched in 2014. Today, USDT is the go-to stable asset among professional and institutional traders, and most leading exchanges quote their crypto prices in USDT. 

USD Coin (USDC)

USD Coin has emerged as the second-largest stablecoin, following its launch in 2018. Backed by a consortium led by Circle and Coinbase, USDC has become the most popular stablecoin in the burgeoning DeFi market. 

Binance USD (BUSD)

Crypto exchange Binance launched BUSD in co-operation with Paxos in 2019 to provide a stablecoin to Binance ecosystem users and participants. Boosted by the increase in usage of Binance’s own blockchains, Binance Chain and Binance Smart Chain, BUSD has become one of the leading stablecoins in the market. 

Dai (DAI)

Launched as a crypto-collateralised stablecoins by Maker in 2017, DAI has established itself as a popular stablecoin in the DeFi market on the Ethereum blockchain. Dai is managed and operated by a decentralised autonomous organisation (DAO), making it the most decentralised stablecoin in the market. 

In addition to the four top stablecoins, TerraUSD (UST), TrueUSD (TUSD), Paxos Standard (PAX) also boast over $1bn in market capitalisation.

Recommended reading: How to trade cryptocurrency CFDs

How to buy stablecoins?

Buying stablecoins is essentially no different than buying bitcoin or any other cryptocurrency. The steps are as follows:

1. Select the stablecoin you want to buy

You need to first figure out the stablecoin you are looking to buy. Stablecoins tied to US dollars are the most common, so you are most likely looking to buy one too. Tether (USDT) is the biggest and most popular stablecoin, and you will find it on most exchanges. 

2. Choose a secure crypto exchange

The easiest place to buy a stablecoin is on a cryptocurrency exchange. You should find a local exchange that has a great reputation. Ensure the exchange accepts the payment method you want to use to make your purchase before creating an account with them.

3. Create an account

If you don’t have an account with a crypto exchange already, then you need to create one. The requirements and registration process varies by exchange, but it's often very simple and straightforward. It’s easier than opening a bank account.

4. Fund your account

Deposit fiat currency into the crypto exchange account or buy directly using payment methods like debit cards, credit cards, or PayPal. 

5. Buy the stablecoin

Select the stablecoin, input the amount you wish to buy, and confirm the transaction. There are typically some fees involved, but they won’t break the bank.

Once you have confirmed the purchase, the stablecoin is credited to your crypto wallet, where you can then transfer to other wallets or use it to purchase other cryptocurrencies.

Conversely, you can also mint new stablecoin tokens directly with the issuing entity. To mint Tether USD (USDT), for example, you have to create an account on www.tether.io and send them dollars to receive newly minted USDT tokens.

Why have stablecoins become so popular?

Stablecoins have existed for over seven years but have started to gain substantial popularity since the beginning of 2020, largely driven by institutional interest in cryptocurrencies as an asset class. 

Dollar-backed stablecoins act as a secure bridge between old finance and new finance, allowing professional and institutional trading counterparties to enter the crypto markets using an asset they know and trust - the US dollar. 

As a result, dollar-pegged stablecoins, most notably USDT, USDC, BNB, and DAI, have become extremely popular in decentralised trading and lending. 

But the interest for stablecoins doesn’t only come from crypto trading market participants. An increasing number of non-US based businesses are starting to adopt dollar stablecoins to enable them to hold and transfer funds in US dollars without the need for a US dollar account setup with local banks in each of the countries they operate in. 

In the future, we can expect stablecoins to become part of the digital payments space in the same manner as PayPal and Stripe, in light of the growing demand for price-stable digital currencies. 

What are the advantages of stablecoins?

Many crypto advocates argue that stablecoins are money 2.0 as they possess all the features of “traditional” currency but come with lower fees, fast settlement times, global accessibility, and are programmable. 

Let’s dive into each of these features in a bit more detail.

Low volatility

The value of stablecoins is stable, which makes them a great way to hedge against a weakening national currency and an excellent transactional currency. 

Transaction processing speed

Stablecoins are built on the blockchain, which removes many of the limitations of the traditional banking system. Transactions are processed at any time of the day and can take only a matter of seconds. 

Global

You can’t access your bank from any part of the world. Even online banking comes with limitations. With stablecoins, you move with your money everywhere regardless of who or where you are.

Open and transparent

Anyone can see the state of a transaction on the blockchain. This means you can easily trace a transaction without spending all your time talking to customer support. Also, companies that issue stablecoins typically publish an audit of their reserves to remain accountable.

Low fees

Fees for buying, selling, and transferring stablecoins are often negligible compared to the major credit card companies charge.

Programmable

Stablecoins operate as digital currencies on open blockchain networks, which means they can be incorporated into smart contracts to create programmable payments, such as salary payments that execute on the first of each month.

Advantages of stablecoins

What are the risks of stablecoins?

While stablecoins take away the volatility of “traditional” cryptocurrencies like bitcoin, they still come with certain risks. Let’s take a look at the main risks that stablecoin users need to know about. 

Regulations

Fiat-backed stablecoins are not immune from government policies that affect national currencies and banking laws. Several governments have spoken about new regulation laws for stablecoins in their jurisdiction, and we can expect some form of stablecoin regulation in the coming years. Whether new regulation will help to harm stablecoins remains to be seen.

Crash in the underlying asset

There’s always the risk that the asset backing a stablecoin crashes in value. There are stablecoins that could also suffer from the liquidation of stablecoin reserve holdings. Some of these reserve holdings are linked to traditional financial instruments like fiduciary deposits, government securities, and commercial papers. If these underlying assets were to become illiquid and drop in value, these could impact the value of the stablecoin since each token is meant to be redeemable for cash.

For crypto-collateralised stablecoins, the same issue arises when the value of the cryptocurrencies held as collateral drops sharply in a matter of days. 

Centralisation

Unlike cryptocurrencies like bitcoin, stablecoins are mostly created and managed by a centralised organisation that issues the digital currency. The insolvency of that company could have a negative impact on its stablecoin. 

Also, not all stablecoins are fully transparent and auditable, which means we just have to trust that they have the reserve to redeem the tokens. 

Not all stablecoins are 100% stable

Not all stablecoins are 100% price-stable. Despite most dollar stablecoins having a 1:1 backing with US dollars and near-cash dollar assets, there are always some price fluctuations in stablecoins, leading to price movement away from $1.00 to $0.99 or $1.01 or even further.

Conclusion

In conclusion, stablecoins play an integral role in the global crypto markets and are poised to become an established digital payment method in the future.

 

Get more information on funding your Axi trading account with stablecoins and start trading cryptocurrency CFDs today!

 

 

 

The information is not to be construed as a recommendation; or an offer to buy or sell; or the solicitation of an offer to buy or sell any security, financial product, or instrument; or to participate in any trading strategy. Readers should seek their own advice. Reproduction or redistribution of this information is not permitted.

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