Stablecoins are cryptocurrencies that are pegged to a specific asset class, such as commodities or fiat currencies. This allows investors to jump into the world of crypto without having to worry about depreciation or the volatility generally associated with the crypto asset class.
However, just because the price remains stable doesn’t necessarily mean they are risk-free. In fact, investors need to fully understand the underlying asset risk behind stablecoins before investing in one. There are primarily 4 types of stablecoins:
- Fiat-backed stablecoins: Fiat-backed stablecoins are backed by fiat currency such as the U.S Dollar, and are relatively steadier than the others due to this correlation. However, the downside is that these currencies are not truly decentralized, since the underlying asset is linked to a centralized institution such as the Central Bank. A great example of a fiat-backed stablecoin is USDC or U.S Dollar Coin by Coinbase.
- Crypto-backed stablecoins: crypto-backed stablecoins use cryptocurrencies as collateral in order to keep the price stable. In most cases, these will be overcollateralized, meaning that there will be an over-allocation of the underlying crypto asset to deal with any selling pressure. The main risk here is that if the underlying assets drop enough, then these stablecoins will ultimately lose their value. So as an investor in crypto-backed stablecoins, it may be a good idea to also keep an eye on how the underlying asset is doing. An example of a crypto-backed stablecoin is DAI, which uses ETH as the underlying crypto asset.
- Precious-metal stablecoins: Precious-metal stablecoins use commodities such as gold as the underlying asset for the crypto token. The price doesn’t necessarily have to remain stable for these tokens and can instead track the underlying commodity in a 1:1 ratio. In a way, they can act almost as ETFs for the commodity, allowing investors to gain access to a financial asset such as gold without having to take on the burden of storing it. Digix is an example of a stablecoin that tracks the price of gold.
- Algorithmic stablecoins: Algorithmic stablecoins use algorithms in order to bring stability to prices. Many coins will use algorithms that increase or decrease supply based on the demand in order to accomplish this. Some examples of algorithmic stablecoins are AMPL and FEI.
So why do we need stablecoins?
Stablecoins provide an entry point for traditional investors who are interested in dabbling with crypto. Since there is a familiar underlying asset behind these coins, traditional investors can feel relatively more comfortable buying them when compared to something new such as Bitcoin or Ethereum. The volatility, or lack thereof, is also attractive for a lot of investors who just want to get started with crypto and earn some yield by holding or lending their money.
Beyond that, stablecoins also provide functionalities such as fast transfers that don’t require financial service fees or traditional banking applications. Centralized stablecoins can also be thought of as simple digital forms of fiat currency that don’t require a bank account to store. For individuals who want to be truly bankless, stablecoins are the perfect solution.