Stablecoins: Should you buy them?
January 26, 2023
If you haven’t read our previous article on stablecoins, I’m sure you are a bit lost. Not to worry, you can read about it here.
But before we look at if you should buy stablecoins, lets see what the type of stable coins are.
What are the types of stablecoins?
The most widely used and typically safest stablecoins are those that are backed 1:1 by fiat money like the US dollar, euro, or British pound.
How does this work? Each fiat-backed stablecoin has a reserve with an equal amount of fiat collateral held by a central bank or regulated financial institution. Numerous well-known exchanges, including Coinbase and Gemini, provide stablecoin products backed by fiat. E.g. USDC, GUSD, BUSD, USDT.
The next is:
Stablecoins backed by cryptocurrencies are usually supported by other cryptocurrencies instead of traditional currencies.
Crypto-backed stablecoins are overcollateralized to ensure the stable coin’s value because the backing asset may be unstable. For instance, a $1 crypto-backed stablecoin might be linked to a $2 underlying crypto asset, giving the stablecoin a built-in safety net that allows it to stay at $1 if the value of the underlying crypto drops.
These assets are less reliable than fiat-backed stablecoins, so it is advisable to monitor the performance of the underlying crypto asset that underpins your stablecoin. Dai is a cryptocurrency-backed stablecoin that is based on the Ethereum blockchain and pegged to the US dollar.
Commodity-backed or asset-backed stablecoins:
Stablecoins that have a physical asset backing, such as precious metals, oil, or real estate, are called “commodity-backed stablecoins” or “asset-backed stable coins.” It’s crucial to remember that, although commodities markets may not be as volatile as cryptocurrencies, commodity-backed stablecoins still carry a higher level of risk than stablecoins backed by fiat.
Having said that, they do have the potential to produce a high yield. The majority of commodity-backed stablecoins are used as a means of accessing asset classes that were previously inaccessible to small investors, despite not being particularly well-liked by the general cryptocurrency community. E.g., this includes Tether gold (XAUT) and Pax gold (PAXG).
With the help of gold-backed stablecoins like Digix, investors can purchase gold without having to worry about storing and transporting it.
Algorithmic or hybrid stablecoins
These are not backed by any assets. To prevent excessive price fluctuations, these stablecoins use a computer algorithm. The algorithm would automatically add more tokens to the supply to lower the price if the price of an algorithmic stablecoin rose higher than the fiat money it was pegged to.
Also, to raise the price of an algorithmic stablecoin, the supply would be reduced if its price dropped below the price of the fiat money it is pegged to. Your ownership of tokens will fluctuate, but they will still represent your share. AMPL is an algorithmic stablecoin that, according to its developers, is more resilient to fluctuations in demand.
Algorithmic stablecoins require enough demand to maintain value, as shown by the ground-breaking crash of Terra. Although algorithmic stablecoins are a good idea, there is still a lot to learn in this area.
So what are stable coins used for?
They can be used for many things. We will cover 3 of the most important ones here.
- They serve as a safety net for investors against the volatile nature of cryptocurrencies.
- Stablecoins, though not covered by any form of government insurance, is now used as a means of lending and loaning money as they offer better interest rates than traditional banks.
- They are used in making payments, e.g., salaries,
Should you buy stablecoins?
This is the million-dollar question and probably why you are reading this article.
Stablecoins are an excellent way to gain exposure to cryptocurrency without the high risk, but it is important to note that before purchasing, you must conduct your research, decide for yourself which coin suits your purpose, and analyze how well that coin did during a market crash. Fiat-backed stablecoins tied to major exchanges are a good bet as they seem to offer the least risk, but this is not financial advice and should not be taken as such.