What is a stablecoin: understanding crypto's low-volatility assets

Cryptocurrencies like Bitcoin (BTC) are volatile compared to the relatively stable prices of major fiat currencies such as the US dollar, or other assets like gold.

Stablecoins are digital assets created to preserve consistent purchasing power, serving as valuable tools for cryptocurrency traders and individuals engaged in international transactions. These assets provide price stability, since they're pegged to a reserve asset — including the US dollar or gold. This peg lowers the volatility of the coins by offering a digital currency suitable for daily commerce and payments between exchanges.

With stablecoins representing an important part of the modern crypto machine, it's valuable to understand how they work. In this article, we explore what stablecoins are, chart their emergence, and outline their advantages for you.

TL;DR

• Stablecoins are digital currencies designed to maintain a stable value, often tied to assets like the U.S. dollar or gold.

• Stablecoins reduce volatility, making crypto trading and everyday transactions more predictable and reliable.

• Stablecoins bridge crypto and traditional finance, making integration smoother.

• They offer benefits like price stability, fast cross-border transfers, and accessibility for those without traditional banking.

• Synthetic USD aims to boost stability and expand the usefulness of stablecoins.

What is a stablecoin?

Stablecoins are digital assets that are intended to hold their value over time. They're often linked to the value of major currencies like the US dollar, a combination of currencies (basket), or a real-life commodity. Stablecoins aim to offer a substitute for the high volatility of most widely used cryptocurrencies, such as Bitcoin.

This volatility has made crypto assets less suitable for everyday transactions. Here's why. One Bitcoin will always be one Bitcoin, but not everyone's comfortable transacting in an asset that changes in value all the time. One Bitcoin might be worth $30,000 today, $20,000 tomorrow, and $60,000 next week.

For some, that volatility — and uncertainty — can be too much. And even HODLers might take after traders by selling high-flying assets after a spike in price. That’s the core benefit of stablecoins for blockchain participants — they offer liquidity, certainty, and safety for users of major blockchains and exchanges.

For many, that makes stablecoins a form of safe haven on blockchains, especially for users in emerging or more volatile markets. The economic fallout from the COVID-19 pandemic troubled the economies and currencies of various emerging and developed markets. One side effect, inflation, has been particularly troublesome for residents of numerous countries — many of whom have turned to stablecoins and self-banking to escape the rapid devaluation or censorship of their money.

This lesser-considered use case is an increasingly valuable one for stablecoins. Given the nature of the blockchain, the self-custody of stablecoins is sometimes a safer bet for people in countries facing economic challenges.

The rise of stablecoins

The world’s first stablecoin, BitUSD, was launched on July 21, 2014. BitUSD was issued on the BitShares blockchain as a crypto-backed stablecoin. The second stablecoin, NuBits (NUB), was also launched in September 2014. Similar to BitUSD, NuBits was crypto-collateralized, but this time using Bitcoin.

BitUSD and NuBits were followed in the same year by Tether (USDT) through Bitfinex. The stablecoin is pegged to the value of the US dollar. Currently, USDT stands as one of the most widely recognized and used stablecoins. Its substantial adoption in specific international markets underlines the benefits introduced by fiat-backed cryptocurrencies.

In recent years, stablecoin adoption has paralleled the continuous use of digital currencies. Some recent stablecoins include MakerDAO’s Dai (DAI), launched in 2017, and Terra (LUNA), an algorithmic stablecoin that crashed in 2022.

As of January 2024, CoinGecko lists 99 stablecoins with a combined market cap of more than $129 billion. Most of these stablecoins, which can also be called USD coins, aim to replicate the value of the US dollar. However, there are also blockchain-based versions of other fiat currencies, and some stablecoins are backed by precious metals like gold or a basket of currencies.

Top 10 stablecoins by market cap

Below are the top ten stablecoins by market cap as of January 2024, according to Coin Gecko.

1. USDT - $127.5 billion

2. USDC - $36.7 billion

3. USDS - $5.1 billion

4. DAI - $3.2 billion

5. USDE - 3.1 billion

6. FDUSD - $2.5 billion

7. USDD - $754 million

8. FRAX - $647 million

9. XAUT - $634 million

10. PAXG - $507 million

Stablecoin advantages

Stablecoins offer several advantages compared to conventional fiat currencies and crypto assets like Bitcoin. These advantages stem from their unique design, combining the stability of traditional currencies with the efficiency and security of blockchain technology. They include:

Price stability

Price stability is essential for crypto traders and decentralized finance (DeFi) users. Cryptocurrencies like Bitcoin and Ethereum (ETH) experience significant volatility, sometimes minute-by-minute. A more stable asset assures traders that the value of their tokens won't rise or crash sharply in the near future.

Cheap and fast transfer

Blockchain-based currencies — unlike conventional payment methods — cross boundaries with more speed than payments made through commercial bank networks. Stablecoins like USDC can be a fantastic option for sending money worldwide because of their quick processing times and low transaction costs.

Hedge against inflation

Stablecoins are considered by some to be suitable for fighting inflation due to their unchanging, unconstrained nature. For people who want to keep their money's worth while still being able to transact regularly, stablecoins may be the solution.

Catering to the unbanked

Stablecoins' ability to serve the unbanked is another disruptive quality. Today, there are around 1.7 billion people without a bank account, according to the World Bank. By enabling the use of stablecoins by anybody with a device that can house a digital wallet, stablecoins have proven their ability to reach this overlooked populace.

How are stablecoins used?

Stablecoins are intended to solve the volatility problem that plagues many mainstream cryptocurrencies. The coins therefore have a variety of uses.

Medium of exchange

The main benefit of stablecoin technology is its use as a medium of exchange. This efficiently bridges the gap between fiat and cryptocurrency. Many retailers will accept stablecoins in return for goods and services, just like they do with fiat currency. Similarly, non-fungible tokens (NFTs) and other on-chain products can be purchased and sold using USDT, USDC, and other stablecoins.

Store of value

Stablecoins are intrinsically stable assets, making them an ideal store of value. As a result, they're often used to complete regular transactions. Stablecoins also increase the mobility of digital assets across the network.

DeFi integration

Stablecoins steer the way towards integrating the rapidly developing DeFi sector with conventional financial markets. Stablecoins, which inherited much of the utility previously reserved for only fiat currency, are the primary driver of cryptocurrency adoption in loan and credit markets as a force for market stability.

Used with smart contracts

Stablecoins can be used with smart contracts — an electronic contract that automatically executes when all of its conditions are met. The digital currency's stability also aids in avoiding disputes that could develop when dealing with more volatile cryptocurrencies.

What can I do with my stablecoins?

If you’re holding a trusted stablecoin — like USDC — you can probably rest easy knowing that it’ll likely be worth a dollar. That'll remain the case so long as its issuer, Circle, maintains its reserves.

As a result, many believe that the purest play with your stables is to hold them. For maximum security, you can self-custody them in a smart wallet and only you will have access to your coins.

Alternatively, you could stake stablecoins on various DeFi protocols. Though there are various risks that come with staking your assets, you could earn rewards.

How do stablecoins earn rewards?

Centralized stablecoins like USDT and USDC generate gains in many ways, including short-term lending and investing. The entities behind these coins carry out revenue-generating activities through fractional reserve banking. This is done by taking a portion of reserve assets and lending them out to earn rewards. Fractional reserve banking is done in the hope that a large number of stablecoin holders won’t withdraw their assets at once.

Stablecoins: integral to the crypto markets

As Bitcoin becomes more known and accepted by individuals and institutions, there's an increasing demand for simpler, less volatile, and easily understood currencies. Despite not being perfect solutions, stablecoins have been embraced and backed by some of the biggest institutions in the world. They can offer a haven for crypto traders and the unbanked population.

Stablecoins may appear to be low-risk, but they're not. A stablecoin may experience a run-on-the-bank kind of experience and lose the peg to its target currency — if it isn't sufficiently supported by hard assets — particularly cash.

That's what happened to the algorithmic stablecoin TerraUSD in 2022, since it wasn't backed by cash but rather by other cryptocurrencies. As users lost faith in the stablecoin's capacity to uphold the peg, its price collapsed.

Stablecoins still make up less than 10% of the whole market for crypto assets. Despite their market cap rising from just under $23 billion in early 2021 to about $129 billion in late 2023. However, they've become an important part of the crypto ecosystem due to their regular use in crypto asset trading and as liquidity providers in DeFi.

Is synthetic USD the future?

Some believe that synthetic USD could be the future for stablecoins. In short, synthetic USD is a form of stablecoin that provides exposure to USD prices without requiring a relationship with traditional financial institutions. So, it's ideal for crypto purists that value decentralization.

So how do synthetic dollars work? The basic premise sees users hold two inversely related assets. In doing so, they should be able to maintain a stable price. It helps to illustrate the concept with an example.

• Let's say you purchase 500 USD worth of Bitcoin by opening a hedge position through a derivatives exchange.

• If the price of Bitcoin rises, the value of the hedge goes down proportionally.

• If the price of Bitcoin falls, the value of the hedge goes up proportionally.

• When you close the hedge position, the value of your purchased Bitcoin should be 500 USD — the same as the position you opened.

Synthetic USD builds on the promise of a more stable asset that's at the heart of stablecoins and their emergence. As more users enter the crypto space, synthetic USD could be a comfortable bridge to ease them into digital asset exposure — supporting the vision of DeFi.

The final word

Price stability is crucial for crypto users trading highly volatile digital assets. Meanwhile, supporting trading pairs using fiat currencies issued by central banks is challenging from a logistical and regulatory perspective. However, thanks to stablecoins, traders may easily leave markets when there's significant price volatility.

Combining traditional assets' permanence with digital assets' flexibility has been well-received. Stablecoins like USDC and USDT, which are some of the most widely used means of storing and exchanging value in the crypto ecosystem, have seen value flow into the billions of dollars.