What Are Stablecoins and Why Do They Exist?

Cryptocurrencies, including Bitcoin, Solana, and Ethereum, would be bad investments without stablecoins. When you buy crypto using your credit card, you pay a certain amount in USD to get it in its relative current market value. You might expect this to rise with time before pulling profits. Exchanging or selling your crypto this way is only possible because of stablecoins.

What are stablecoins, and why do they exist in crypto?

What Are Stablecoins and Why Do You Need Them?

Stablecoins are cryptocurrencies linked or pegged to other commodities, typically more stable financial entities like gold and fiat currencies. Although variants exist, stablecoins offer a more stable way of collateralizing the more volatile cryptos like Bitcoin, Avalanche, Ethereum, and Solana.

Generally, the stablecoin purpose is to check the volatility of non-fiat counterparts. While cryptocurrencies can be more or less valuable than fiats, stablecoins are the entities that make them meaningful and tradable.

The Relevance of Stablecoins

Future uncertainty is a headache for every crypto trader. If you've charged $1600 for a service, for instance, and someone pays you its equivalent in Ethereum, you get about 1 Eth. That's about the price of Ethereum as of writing. It might've tanked or risen in value as you read. Crypto value flips in a matter of split second. So while you might profit, you also stand a chance of counting your losses. And you might end up realizing lesser than the actual monetary value of your service. Nobody deserves that in a real-life business unless they ask for it.

Getting paid in a stablecoin allows you to get the fiat equivalent of your charge in crypto since it retains the associated fiat value. For example, you get 1600 USD if someone pays you 1600 USDT.

Fiat-backed cryptos, including Tether (USDT), USDC, BUSD, and many more, are pegged to the value of USD. It means their reserves are in real money rather than depending on real-time trading. Invariably, there's one fiat (USD) reserve for every one of these stablecoins in circulation. Trading activities don't affect fiat-collateralized stablecoins. However, this may not be true for algorithmic and crypto-collateralized stablecoins.

In addition to stabilizing the crypto economy, stablecoins make crypto regulations possible. For instance, according to Binance, BUSD is fully regulated by the New York State Department of Financial Services (NYDFS). Paxos even releases a monthly reserve report of the BUSD stablecoin to ensure transparency.

Types of Stablecoins

While stablecoins check the crypto volatility, their reliability depends on what backs them. There have been issues in the past where stablecoins get detached from their reserves, resulting in huge financial losses for investors. You might be able to avoid this if you know the types of stablecoins there are.

1. Fiat-Backed Stablecoins

A fiat-backed stablecoin is a cryptocurrency pegged fully to a leger tender regulated by a government's financial institution. They maintain a one-to-one ratio (1:1) with their associated fiat money. So as earlier mentioned, there's one fiat money in reserve for every fiat-collateralized stablecoin.  

Fiat-collateralized stablecoins are the most trusted type of stablecoins in the crypto market since they're pegged against fiat money. Examples of fiat-backed stablecoins are Tether (USDT), USDC, BUSD, and USDP.

2. Algorithmic Stablecoins

Algorithmic stablecoins are non-collateralized stablecoins that depend on smart contract algorithms to check market volatility. While their purpose is to stabilize a particular blockchain's ecosystem, algorithmic stablecoins are prone to value loss since they also operate on a decentralized ledger. Another disadvantage of algorithmic stablecoins is there may be less transparency.

UST, a Terra protocol-governed stablecoin, is still the most-popular algorithmic stablecoin. However, it crashed in 2022 when Terra's native cryptocurrency tanked and flooded the market. UST couldn't hold the crashing crypto, leaving experts to question the integrity of algorithm-based stablecoins. Another example of an algorithmic stablecoin is Vai, a stablecoin built on the Venus protocol.

3. Crypto-Backed Stablecoins

Crypto-backed stablecoins peg their value to unstable cryptocurrencies like Solana, Bitcoin, and Ethereum, among many others. Such stablecoins often operate an overcollateralized reserve. This is to check the impending volatility of associated cryptocurrencies.

Instead of a 1:1 reserve system, crypto-backed stablecoins typically ensure more cryptos in reserve than the stablecoin in circulation. The reason for this is so that the reserved crypto can guide against value crashes. Hence, liquidation of the excess reserve is imminent if the crypto value drops beyond a permissible limit.

An example of a crypto-backed stablecoin is DAI, a stablecoin pegged to Eth.

4. Commodity or Asset-Backed Stablecoins

As the name sounds, commodity-collateralized stablecoins are stablecoins pegged to tangible assets, including gold, diamond, or some other valuable assets. These stablecoin types aren't usually prone to price fluctuations and are more stable than their fiat-backed counterpart.

Besides, tangible assets typically appreciate when compared to real money. Asset-backed stablecoins are more crash-proof. Invariably, investors can liquidate a reserve to resuscitate an inflated cryptocurrency. With that said, a commodity-pegged stablecoin can be hard to market during liquidation.

Examples of well-known stablecoins backed by gold include Tether Gold (XAUT), Digix Gold (DGX), and Pax Gold (PAXG). SwissRealCoin (SRC) is a real-estate-backed stablecoin.

What Are the Best Stablecoins?

As of writing, CoinMarketCap stats put the market cap of fiat-backed stablecoins ahead of the others. So they're more popular and trusted than the algorithmic and crypto-based counterparts. However, while asset-backed stablecoins are uncommon, they can be worth a fortune.

For example, according to CoinMarketCap, one PAXG goes for about 0.084 BTC ($1,900) as of writing. While PAXG remains stable and depends on Gold price, BTC keeps fluctuating, giving PAXG its foothold even if bitcoin tanks. As earlier stated, asset-collateralized stablecoins are more valuable and steadier than their fiat-based counterparts.