What is a stablecoin?
Stablecoin is a type of cryptocurrency designed to provide price stability in the cryptocurrency market. Stablecoins tie their value to another fiat currency, a valuable asset, or an algorithmic mechanism. In this way, they are not or very little affected by the volatility in cryptocurrencies.
What are the advantages of stablecoins?
Stablecoins offer many advantages to cryptocurrency users. Some of these are those:
- Low transaction fees: Stablecoins can be transferred with much lower transaction fees than traditional payment systems. This advantage is especially important for international payments.
- Fast transaction time: Stablecoins can be sent and received in minutes via cryptocurrency exchanges and wallets. In traditional payment systems, the processing time can take days or even weeks.
- Price stability: Stablecoins are protected from fluctuations in the cryptocurrency market as they tie their value to a stable asset. In this way, users can reduce price risk and securely store or spend cryptocurrencies.
- Global reach: Stablecoins can be used by anyone connected to the internet. This is also beneficial for people who do not have a bank account or live in areas where the local currency is unstable.
What are the stablecoin types?
Stablecoins can be divided into three main categories based on how they hold their value:
- Fiat-backed stablecoins: Such stablecoins back their value with a certain percentage of fiat reserves. For example, 1 USDT (Tether) is equal to 1 USD and a US dollar reserve is held by the Tether company. The advantage of such stablecoins is that they are simple and straightforward. The downside is the lack of trust in a central authority and lack of oversight.
- Cryptocurrency-backed stablecoins: Such stablecoins back their value with another cryptocurrency at a certain rate. For example, 1 DAI (MakerDAO) is equal to 1 USD and a reserve of ETH (Ethereum) is held in return by the MakerDAO protocol. The advantage of such stablecoins is that they are decentralized and transparent. The disadvantage is that they are complex and risky, as sufficient liquidity must be provided against the fluctuations in the cryptocurrency market.
- Algorithmic stablecoins: Such stablecoins do not back their value with any asset, but adjust their prices according to supply and demand through an algorithmic mechanism. Terra (LUNA), for example, increases or decreases its supply to fix its price at 1 USD. The advantage of such stablecoins is that they are completely decentralized and autonomous. The downside is that there is uncertainty about the reliability and sustainability of the algorithms.