The cryptocurrency market is well-known for its high volatility, making it difficult for users to stay “alive”. The only “safe island” is stablecoins, which allow users to protect their deposits during a bearish cycle. Today, let’s find out what stablecoins are, how they work, and what types they are subdivided into.
What are stablecoins, and what are they for?
The cryptocurrency market is quite young and is still considered a high-risk investment sector. The total capitalization of all cryptocurrencies is under $900 billion. Comparatively, in the writing of this article, the capitalization of the Apple company is 2.17 trillion U.S. dollars.
The relatively small capitalization of the crypto market makes it extremely volatile. A few million dollars can significantly change the price of small-cap altcoins. This opens up speculative opportunities for big players to take advantage of. To counteract the constant price spikes and reduce the risk of losing money, cryptocurrency analogs to fiat money or physical assets – stablecoins – have been created.
Stablecoins are a specific type of cryptocurrency, tied to price and backed by physical assets (precious metals, oil, etc.), fiat money, or another cryptocurrency.
We will not consider commodity-type stablecoins, because they are hardly ever used in the cryptocurrency market.
Basic types of stablecoins
Fiat stablecoins are cryptocurrencies that are backed by and tied to the fiat money that is familiar to everyone. In the vast majority of cases, US dollars represent the collateral of stablecoins. The most popular stablecoins, USDT, USDC, BUSD, and DAI, are tied to the U.S. dollar price. However, not all of them are backed by a fiat currency. DAI belongs to cryptocurrency stablecoins, following we will clarify what they are.
Cryptocurrency stablecoins are stable cryptocurrencies that are backed by other cryptocurrencies. As a rule, the price of cryptocurrency stablecoins is always (in theory) equal to $1. The DAI Stablecoin we mentioned works according to this concept. Using this method of collateral, DAI becomes a more decentralized option compared to fiat stablecoins.
But everyone has to pay for everything, and get the advantage of decentralization, the developers of DAI, MakerDAO project, had to implement the principle of over-collateralization of cryptocurrency assets.
The principle of over-collateralization: to get 1,000 DAI, a user or project needs to put $1,500 worth of ETH coins into a smart contract address. This approach allows the creditor to protect against dramatic changes in the price of assets collateralized by cryptocurrency stablecoins.
Algorithmic stablecoins are a decentralized type of stablecoin with no physical assets, fiat money, or cryptocurrency as collateral. Their price is regulated by algorithms, that constantly aim to keep the stablecoin equal to one U.S. dollar. The most famous algorithm-type stablecoin is USTC from the Terra Luna project.
In May 2022, the cryptocurrency LUNA and its linked UST Stablecoin (today’s USTC) collapsed in value. Many people lost money as a result of the project’s crash. It has become obvious by now that there is no reliable algorithmic stablecoin. The current price of USTC is $0.02.
By the end
Stablecoins are a vital tool to survive the “storm” in the cryptocurrency market and connect the worlds of DeFi and traditional finance. Nevertheless, cryptocurrency developers have a lot of work to do to create a truly secure stablecoin, while preserving the main idea of cryptocurrencies – decentralization.
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