Stablecoins Simplified: Everything You Need to Know to Stay Ahead of the Game

The cryptocurrency market is known for its high price volatility, making it a challenging investment option for many. The sudden, often unpredictable changes in value can make it difficult for both users and merchants to confidently transact in crypto.

However, stablecoins offer a solution to this problem by being pegged to a more stable asset, such as the U.S. dollar or gold. This theoretically means that no matter what happens in the crypto market or broader economy, the value of stablecoins remains consistent.

With over 200 globally distributed stablecoins, including popular options like USDC, BUSD, and DUSD, it's easier than ever to protect your investments from market volatility. Read on to discover the benefits of stablecoins and how they are changing the game for the crypto community.

What are stablecoins?

Stablecoins are a type of cryptocurrency designed to offer stability through their value being pegged to another currency, commodity, or financial instrument. Unlike cryptocurrencies such as Bitcoin (BTC), which are known for their high volatility and unpredictability, stablecoins aim to provide a more stable and reliable option for common transactions. By eliminating the fluctuations of traditional cryptocurrencies, stablecoins offer a solution that is more suitable for everyday use.

Why are stablecoins important, and what’s their purpose?

Bitcoin, the most well-known cryptocurrency, is characterized by its high price volatility. This volatility can lead to significant fluctuations in exchange rates. For example, in just a year, the price of Bitcoin rose from US$5,000 to over US$63,000, only to drop nearly 50% over the following two months. Additionally, intraday swings can be substantial, with the cryptocurrency often experiencing changes of more than 10% within a few hours.

While this level of volatility can be attractive to traders, it can make routine transactions like purchases highly speculative for both buyers and sellers. Long-term investors seeking appreciation of their holdings do not want to risk paying an exorbitant price, such as 10,000 Bitcoins for two pizzas. Meanwhile, merchants face the risk of taking a loss if the price of the cryptocurrency they receive payment in plummets after the transaction.

For a currency to serve as a reliable medium of exchange, it must remain relatively stable. This stability is essential to ensuring that those who accept the currency can have confidence in its short-term purchasing power. In comparison, even daily movements of 1% are relatively uncommon among traditional fiat currencies in forex trading.

Which types of stablecoins are there?

Stablecoins have emerged as a potential solution to the high volatility of traditional cryptocurrencies. While some argue that stablecoins are unnecessary due to the widespread acceptance of the U.S. dollar, others believe that digital currencies not controlled by central banks will become increasingly prevalent in the future. There are three distinct categories of stablecoins, each with a different mechanism for maintaining stability in value.

Fiat or commodity backed stablecoins

The first and most widely used method of creating stablecoins is through backing each coin in circulation with an equivalent value in fiat currency or cash equivalents, referred to as fiat-backed stablecoins. This entails holding an equivalent of 1 USD in reserve for each stablecoin in circulation, in U.S. bank accounts owned by the issuer. To ensure transparency and accountability, these reserves are routinely audited by independent accounting firms, typically on a monthly basis, with the details of their holdings published for public viewing.

Cryptocurrency-backed stablecoins

Another method for maintaining the value peg of stablecoins is through crypto-collateralization, where stablecoins are supported by reserves of other cryptocurrencies. However, given the high volatility of cryptocurrencies, stablecoins backed by crypto are often overcollateralized to counteract market fluctuations. An example of such a stablecoin is the DAI, issued by MakerDAO, which is collateralized at 150%, meaning that each DAI in circulation is backed by 1.5 times its equivalent value in Ethereum (ETH) or other cryptocurrencies.

Algorithm-backed stablecoins

The third and final approach to preserving the value peg of stablecoins is through algorithmic regulation, where smart contracts dynamically adjust the circulating supply based on market conditions. If the price of an algorithmically-backed stablecoin starts to drop, the smart contract reduces its supply to increase scarcity and thus increase its value. Conversely, when the price exceeds the peg, the smart contract expands the supply to maintain stability. Holders of fiat-backed stablecoins have the ability to exchange their stablecoins for an equivalent amount of fiat currency at any moment, and vice versa.

Yet there are also hybrid models like algorithm-backed and cryptocurrency-backed stablecoins like DUSD that combine the best of both worlds. Similar to DAI, DUSD –– the stablecoin of DeFiChain –– is also overcollateralized by at least 150% by various top cryptocurrencies to maintain its value stability. On the other hand, though, its value is also algorithmically backed.

What are the most popular stablecoins?

There are approximately 200 stablecoins in existence today, with some of the most popular including Tether (USDT), USD Coin (USDC), Binance Dollar (BUSD), Dai (DAI), and Defichain's DUSD.

Tether (USDT) is the world's first stablecoin and has the largest market capitalization among its peers, with a value of nearly $68.2 billion as of February 2023. As far as stablecoin history is concerned, its breaking of its peg in May 2022 was a pivotal event.

USD Coin (USDC) is a stablecoin backed by the U.S. dollar and operates on the Ethereum (ETH) blockchain. It's managed by a consortium called Centre, formed by Circle and Coinbase. Circle is a peer-to-peer payments company supported by investors like Goldman Sachs, while Coinbase is one of the most well-known cryptocurrency exchanges.

Binance Dollar (BUSD) is a stablecoin backed by the U.S. dollar and operates on the Ethereum (ETH) blockchain. It was created through a partnership between Binance, the world's largest cryptocurrency exchange, and Paxos, a leading crypto infrastructure provider. BUSD is one of the first government-regulated stablecoins approved by the New York State Department of Financial Services (NYDFS).

Dai (DAI) is a decentralized cryptocurrency operating on the Ethereum (ETH) blockchain, maintained by MakerDAO, a decentralized autonomous organization (DAO). Dai is one of the earliest examples of decentralized finance (DeFi) that has gained widespread adoption.

Defichain's DUSD is yet another example of a stablecoin, offering a secure and reliable way to store and transfer value.

How to use stablecoins?

Stablecoins, with their stability in value, present various use cases beyond those of traditional currencies. They can be utilized as a store of value, a low-cost tool for cross-border transactions, and offer unique opportunities for passive-income generation through activities such as crypto lending and staking.

Holders of stablecoins can earn interest rates, which are often higher than traditional bank rates and can range between a few per cent and more than 10 per cent per year, by locking up their assets within a specific network or protocol. However, it is crucial to note that these rates are subject to fluctuations and that staked assets are most of the time not insured by federal programs like the FDIC.

Cake DeFi users are also able to invest in blockbuster stablecoins like USDT, USDC and DUSD through various cash flow generating products. With the “Lending” product, users can generate up to 10% interest a year. “Earn” combines the best parts of liquidity mining with lending and offers an interest rate north of 10% a year.