VSCryptocurrency, including bitcoin, has one major drawback for investors: it is highly volatile. However, a form of crypto whose value is tied to a currency or commodity reduces this problem.
Enter stablecoins: a type of digital currency with greater price stability than bitcoin and non-stable alt-coins because they are pegged to the US dollar, gold price, or another commodity or currency.
How Stablecoins Maintain Relative Price Stability
Stablecoins maintain price stability by keeping their value tied, or pegged, to another more stable form of money or real asset.
This method of assigning value to currency has been used historically. Prior to 1971, the value of the US dollar was tied to gold bullion held by the US Treasury, largely at the Bullion Depository in Fort Knox, Kentucky.
In 1971, President Richard Nixon eliminated the “gold standard” and the US dollar became a fiat currency, which has value because it is established as legal tender by the government. Basically, the US dollar has value because the government says it has value and countries and people around the world accept its value.
Stable coins, like the US dollar before the introduction of fiat currency, peg their value to commodities, such as gold or silver, fiat currencies, or even other cryptocurrencies. Stablecoins can also be backed by a variety of investments. Stablecoin developers hold an equal amount of this commodity, whether gold or fiat currency or some combination, as collateral.
In the case of stablecoins tied to other forms of crypto, they will hold an excess of the cryptocurrency as collateral to offset the volatility of that cryptocurrency.
Algorithmic stablecoins: not as stable as you might think
Some stablecoins determine their value with sophisticated software algorithms. Although these stablecoins are pegged to a real-world asset, they are not actually backed by an asset, making them a riskier investment than other stablecoins.
An algorithmic stablecoin, TerraLab’s Luna, recently lost all of its value, subsequently dragging the value of bitcoin and the alt-coin into a crash that triggered the current crypto winter. “Not all stablecoins are stable,” Nasdaq wrote.
But, if you are looking for a stablecoin that allows you to easily transact digitally, you might consider making stablecoins – backed by any asset – a part of your wallet.
Why stablecoins are important
Bitcoin and alt-coins tend to have massive price swings. For example, bitcoin fell from nearly $65,000 per coin to $23,452 per coin between December 2021 and July 2022 during the last crypto winter. Daily price fluctuations can also lead to massive losses.
For investors looking to use cryptocurrencies as a medium of exchange, this creates a lot of risk. If you make a deal to buy an item for one bitcoin, for example, you can pay between $24,000 and $60,000. And price changes can happen quickly. For example, bitcoin lost nearly $600 in just two hours on July 25, 2022.
That’s just a 2.65% change. For a buy-and-hold investor, this type of loss or gain may not make a huge difference to their portfolio. But if you were looking to purchase an item using Bitcoin, a price difference of $600 is substantial. If you went to a car dealership and just as you were about to sign the deal, the dealership raised the price of your car by $600 or $1,200, you would probably be angry.
Of course, you can still buy goods and services using fiat currencies like the US dollar for price stability. But proponents of digital currency and decentralized finance see an important role for stablecoins as a means of exchange for goods and services, crypto lending and more.
Stablecoins are often used as a way to reduce transaction fees when trading other forms of cryptocurrency, as many exchanges do not charge a fee to exchange US dollars for stablecoins.
The most popular stablecoins
Stablecoins can be used as a medium of exchange for cross-border transactions and in all cases where parties would prefer to use decentralized finance (DeFi) rather than traditional banks to exchange money.
These are some of the best stablecoins, based on market capitalization, popularity, and overall perceived stability.
Tether (USDT) is a stablecoin pegged to the US dollar. It is currently the best stablecoin based on market cap, according to CoinMarketCap.
Tether is backed by a variety of commodities, including gold, US fiat currency, and cash equivalent investments. It is widely used on many crypto exchanges.
USD Coin (USDC) is the second largest stablecoin by market capitalization and is pegged to the US dollar. It was launched in 2018 as part of a collaboration between crypto exchange Coinbase and Circle, a peer-to-peer payment company.
USDC has partnered with Visa and Mastercard as a viable payment method. It is supported on many popular blockchains including Ethereum which further enhances its practical use.
Ranked third based on market capitalization, Binance USD is a stablecoin launched by crypto exchange Binance and Paxos, a blockchain developer and supporter of decentralized finance. Like USDC, it is backed by US fiat currency.
Stablecoins have many uses in today’s economy, including a way for those who are risk averse to participate in decentralized financial activities. Stablecoins can also play a role in blockchain-based gaming and financial activities in the metaverse.
There are many types of stablecoins and you can buy the most popular stablecoins on crypto exchanges like Binance and Coinbase.
- Is bitcoin a stablecoin?
- Bitcoin is not a stablecoin. It was the first digital currency, but it is not backed by real-world assets or collateral. Bitcoin’s current volatility illustrates the difference between bitcoin and stablecoins.
- How many stablecoins are there?
- The Blockchain Council released a comprehensive list of stablecoins in 2022. CBS News reported that there are approximately 200 varieties of stablecoins in the world, with a total market value of $163 billion.
- Are stablecoins a good investment?
- Stablecoins have less volatility than other cryptocurrencies, making them a less risky investment for those who wish to incorporate digital currencies into their portfolio. However, their value will always be tied to a specific currency or assets.
- Some can also provide interest payments or be used for crypto lending, making them useful for passive income. Stablecoins are also useful for minimizing or avoiding transaction fees when trading other forms of crypto.
This article originally appeared on GOBankingRates.com: Stablecoins Cryptocurrency: A Complete Guide
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.