What is the US Dollar? It’s a stable currency.

Why? It is pegged to gold, which offers stability and maintains the currency’s value. 

However, it is not a stablecoin because it is not issued on the blockchain, and this is one of the differences between the US Dollar and stablecoins like USDT, DAI, and USDC.

Stablecoins are an integral part of the crypto financial space. They are the inseparable pairs of every coin or token because they give measurable or quantifiable value to the digital assets on the blockchain.

This quick guide is dedicated to help you, whether you’re a crypto beginner or an expert, to understand what stablecoins are, how they work, their types, and how important they are to the growth of the crypto space.

What Crypto Stablecoins Are

A crypto stablecoin is a cryptocurrency whose value is tied to another asset class’s value, like fiat or precious metals.

An example of metal-backed stablecoins is PAXG, a crypto token pegged to gold that simulates a crypto version of gold.

Another example is a Fiat-based stablecoin, the US Dollar Tether, USDT, which is pegged to the US Dollar to stabilize the cryptocurrency and provide a decentralized crypto version of the US Dollar to crypto traders and investors.

How Stablecoins work

Stablecoins are designed to tackle price fluctuations by pegging the value of cryptos to other more stable assets like fiat or gold. Fiat is the official currency issued by the government, such as dollars or euros, and we’re all used to using it daily.

Typically, the issuer of the stablecoin will set up a “reserve” where it securely stores the asset or group of assets backing the stablecoin – for example, one troy ounce of fine gold stored in a bank to back up one unit of a gold stablecoin.

This is one way stablecoins are linked with real-world assets. The money in the reserve is the stablecoin’s collateral – meaning whenever you withdraw your stablecoins, an equal amount of the asset backing it is withdrawn from the reserve.

There is still a more complex type of stablecoin that is collateralized by other cryptos rather than fiat yet designed to track a mainstream asset like the US dollar.

MakerDAO, one of the most famous stablecoin issuers, uses this mechanism through its proprietary service, “Vault” (formerly called Collateralized Debt Position). 

The vault locks up your crypto collateral for a period.  

Once the smart contract verifies the collateral is secured, you can use it to borrow freshly minted DAI tokens, MakerDAO’s stablecoin.

A third type of stablecoin, known as an algorithmic stablecoin, isn’t collateralized; instead, coins are either burned or created to maintain the coin’s value in line with the target price. 

Let’s say the stablecoin pumps from the target price of $1 to $1.56. The algorithm will automatically create or mint new tokens to add to the market to create more supply, thus pushing down the price of the stablecoin to balance with the target price.

This type of stablecoin protocol is yet to be a success. Many companies have tried but have yet to get it right.

Why stablecoins are essential in the crypto space

Cryptocurrencies such as Bitcoin, Solana, and Ethereum, offer several benefits, such as eliminating third parties or centralized authorities to allow limitless and borderless transactions. But one key drawback is that the prices of these cryptocurrencies are unpredictable and highly volatile.

Unfortunately, this makes these cryptos hard for everyday people to use. Generally, people want to be able to predict an estimated worth of their money even three weeks from now, both for their security and their livelihood.

Cryptocurrency’s unpredictable nature contrasts the generally stable prices of fiat currencies, such as euros and US dollars, or assets like gold. Values ​​of Fiat currencies, like the US dollar, change gradually over time, but daily changes are often more volatile for cryptocurrencies.

The most popular crypto stablecoins

Most upcoming stablecoins, like the BiLira, are still in their experimental phases, but a few have existed for some time. These are the most popular and widely used stablecoins:

USD Tether (U.S.D.T.)

Tether (USDT) is one of the first stablecoins, launched in 2014, and is the most popular today. It’s one of the largest cryptocurrencies by market capitalization, worth more than $96.8 billion.

The USDT was primarily created for crypto arbitrageurs to quickly move money across crypto exchanges with price differences and take advantage of arbitrage opportunities.

Besides arbitraging, USDT has found other applications; it is now widely used for cross-border commercial trades. Chinese importers stationed in Russia have used USDT to transact goods worth millions of dollars across the border by bypassing strict capital controls in China.

Tether Ltd., the issuer of the USDT, was caught up in a 22-month legal battle with the New York Attorney General over allegations that a Tether sister company, Bitfinex, tried to cover up an $850 million account deficit using funds from Tether.

Eventually, the case was closed on February 13th, 2021, with Tether and Bitfinex asked to pay $18.5 million and submit quarterly reports of Tether’s stablecoin reserves for the next two years.

USD Coin (USDC)

USD Coin was launched by Circle and Coinbase in 2018 through the Centre Consortium.

Similar to USD Tether, USD Coin is pegged to the U.S. dollar. USDC is an open-source protocol, meaning any person or company can build their products with it.

Circle announced plans to launch publicly through a $4.5 billion SPAC merger deal with Concord Acquisition Corp on July 8th, 2021. The news came one month after Circle concluded a $440 million funding round with big industry brands like FTX, Fidelity Management and Research Company, and Digital Currency Group.

DAI

Dai is a crypto stablecoin on the Ethereum blockchain built by MarkerDAO protocol. It was created in 2015. The Dai stablecoin is pegged to the U.S. dollar and backed by ether, the native token of the Ethereum Blockchain.

Unlike other stablecoins like USDT and USDC, MakerDAO intends for dai to be completely decentralized; no central authority controls the system. Instead, they’ll be controlled by Ethereum smart contracts.

However, this stablecoin model still has some hurdles to cross. For example, if MarkerDAO’s smart contracts don’t work exactly as anticipated, it can lead to serious consequences like the 2020 hack, which led to losses of $8 million.

Types of stablecoin collateral

Stablecoins come in different types, and collateralized stablecoins use a variety of assets as backing:

Fiat-backed Stablecoins

Most stablecoins are fiat-backed. The most popular fiat currency the U, the S. dollar, is the backing of most stablecoins used today. However, companies are experimenting with stablecoins pegged to other fiat currencies, such as BiLira, which is pegged to the Turkish lira.

Crypto-backed Stablecoins

Some stablecoins use other cryptocurrencies, such as ether, as collateral. An example is DAI. DAI is pegged to the US Dollar but backed by Ethereum and other cryptocurrencies worth 150% of the total DAI stablecoin in circulation.

Rare metal-backed Stablecoins

Rare metals like gold or silver serve as collateral for crypto stablecoins. A good example is PAXG, which is equivalent to the price of gold.

Other investment

Tether’s USDT was initially meant to be backed 1-for-1 with US dollars, but it has shifted over time due to collateral mix. In a breakdown in 2021, Tether Ltd. said nearly half its reserves are in commercial paper, a type of short-term corporate debt. 

Tether Ltd. has not revealed the issuers of this paper but claims it is all rated A-2 or higher. 

Like other stablecoins, Circle and Coinbase’s USDC invest the money they hold in “approved investments” at federally insured banks.

Difference between a stablecoin and a CBDC

Stablecoins and Central Bank Digital Currencies (CBDCs) are similar in that they are both digital currencies backed by a stable asset. 

However, the key difference is that stablecoins are created and issued by private entities or Decentralised Autonomous organizations (DAOs) and CBDCs are created and issued by a nation’s central bank.

Do stablecoins have drawbacks?

As beneficial as they are, stablecoins have some drawbacks. Because of how stablecoins are typically built, they have more pain points than other cryptos.

One central concern is that some stablecoins may store their reserves with banks or another third party, raising counterparty risks. This leaves people to wonder if the third party has the collateral it claims to have.

Tether has been faced with this question multiple times. Does Tether maintain a 1-1 backing between USDT tokens and the United States dollars?

In the worst-case scenario, the reserves backing a stablecoin could be insufficient to redeem every unit, potentially shaking the coin’s confidence.

Cryptocurrencies were created to replace middlemen, third parties, and centralized authorities typically trusted with our money. By nature, these intermediaries have control over that money; for example, they can block or freeze a transaction. 

Some stablecoins also have the ability to block transactions. USDC openly has a way to block payments if the coins are used illicitly. In July 2020, Circle, a firm behind USDC, confirmed that it froze $100,000 of the stablecoin at the request of law enforcement.