Many people wanting to explore the cryptocurrency ecosystem get cold feet. Why? Because they don’t feel comfortable with Bitcoin’s volatility. But what if we told you there is a way to convert your physical US dollars to crypto format? Luckily, stablecoins provide a gateway to cryptocurrency without having to put your value at risk.
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First things first: What are stablecoins?
Stablecoins are cryptocurrencies tied 1:1 to any physical financial asset. Although they frequently represent fiat currency (in most cases, the US dollar), some other tokens follow the value of gold, securities, and even other cryptos. If you read our article about wrapped tokens, then you’ll know what we mean.
Stablecoins have come a long way since they first appeared, growing in popularity and diversity. The crypto community quickly adopted them because of their ease of use and their practicality.
So far, everything seems marvellous. But how do these tokens work? Who issues them? And what guarantees their parity with the assets they represent?
How do stablecoins work?
There are many different stablecoins according to how they back their value. That said, the most common type of collateral is fiat currency.
Being backed by fiat means that every stablecoin minted by any organization has one genuine, physical US dollar as collateral. Take Coinbase, for example. The renowned crypto exchange partnered with Circle to issue a token worth one dollar called USD Coin (USDC). Users can exchange one USDC for one US dollar anytime. The tokens are merely a representation of a real dollar locked up in their reserves.
On the other hand, MakerDAO created a crypto-backed stablecoin called Dai, whose collateral consists of other cryptocurrencies. The game-changer here is that the process of minting, locking up collateral, and redemption is 100% executed through smart contracts. Everything happens on the blockchain. When someone locks crypto as collateral, the smart contract automatically mints and delivers the stablecoins to their wallet.
Now, you might be wondering how could extremely volatile crypto act as collateral for a coin always worth the same. The answer is simple. These stablecoins are over-collateralized, meaning that the value locked is always worth more than the value of the coins minted. Dai, for example, has a backing of $1.5 worth of crypto per coin.
Finally, we have algorithmic tokens like Ampleforth (AMPL). Contrary to the ones we’ve mentioned, these don’t have collateral. Instead, they use a complex set of algorithms and smart contracts. These keep the price stable by changing the token’s available supply. That way, whenever the price goes up, smart contracts increase supply to drive it back down and vice versa.
You can track USDC, Dai and many other stablecoins using The Crypto App to check their total market capitalization and trading volume. Download the app here.
Utility and opportunities of stablecoins
Now that we’ve covered how these cryptos work, let’s dive deeper into use cases.
The most significant contribution stablecoins provide is accessibility. You only need to convert your physical money to these tokens to experience the benefits of cryptocurrency. Digitalization, security, transparency, agility. All while avoiding the most significant crypto risk: volatility.
Thanks to stablecoins, people who don’t want to give up their fiat currency can access DeFi platforms. For example, by switching $1K in your bank account to 1K USDC, you can operate in Aave and enjoy around 10% APY. That’s 20 times higher than what any regular bank offers. And you wouldn’t lose a penny of your dollar value. You can forget about pump and dump schemes.
Another advantage is agility. Traders can use them to jump in and out of their positions in seconds. That way, they can catch every opportunity and secure their profits. Imagine that if a trader wanted to buy a BTC dip, they needed to do a bank transfer and wait for the funds to be credited. The delay would easily make them miss the train. Instead, they can keep a stablecoin position in their accounts, ready to trade anytime.
Finally, in countries with unstable economies, stablecoins are an escape from inflation and devaluation. In Argentina, for example, the government doesn’t allow people to buy USD, and the Argentinian Peso lost 30% of its value last year alone. However, people can purchase crypto, so they can still protect their savings.
Stablecoin potential risks
Like any other cryptocurrency, stablecoins come not without drawbacks. In the case of fiat-backed tokens, there is always the risk of centralization. The issuer may go bankrupt, be involved in some fraudulent scheme or even disappear. Also, most companies tend to be very secretive regarding the exact reserves they hold as collateral for their tokens. This has been a recurrent topic with Tether and their stablecoin, USDT.
As for crypto-backed coins, risks rely on the smart contracts implemented in their minting and functioning. Should there be faulty code, a hacker could exploit it for their benefit. Luckily, MakerDAO holds an open-source policy, so anyone can review their code to ensure everything is in order.
Embrace the new era of currency
If you are willing to enter the cryptocurrency environment but have your doubts about price action or are not comfortable with risks, you have your chance with stablecoins. They provide the perfect opportunity to explore crypto without getting burnt. You can also start with small amounts to try it out. Just make sure that, as we always say, you educate yourself to know where you are putting your money.