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Stablecoins Explained—Are stablecoins safe, and what's their role?

Yayın RAIN EDITORIAL TEAM - May 23, 7:00 PM

The cryptocurrency market is known for its exciting ups and downs, which has deterred many investors from participating in this relatively new asset class. Stablecoins are a sort of cryptocurrency that intend to eliminate price fluctuations and can endure even the most extreme conditions—read on to learn all you need to know about these one-of-a-kind crypto assets.

So, what exactly is a stablecoin?

The answer is straightforward: a sort of cryptocurrency whose value is linked to a fiat currency, such as the USD, EUR, or CHF. Consequently, one stablecoin should be always priced close to the same as the fiat currency to which it is linked. 

Take Tether (USDT), the most prominent stablecoin with the largest market capitalization. This cryptocurrency is linked to the US dollar, therefore 1 USDT should always equal 1 USD. It's worth noting that there is frequently a small discrepancy between the fiat and stablecoin figures, although it's usually insignificant.

Stablecoins are divided into several categories.

While stablecoins share some qualities, they might differ in terms of fundamentals. We may differentiate between centralized, collateralized, uncollateralized, and undercollateralized stablecoins based on how they work and how they are architected. All of them will be described and shown using practical examples in the following sections.

Centralized stablecoins

Although many crypto currencies are decentralized, some are issued and administered by a single entity. Tether (USDT), and STASIS EURO (EURS) are all instances of the latter group, since their controlling bodies are all centralized. With a market valuation of over $112B, Tether is the most popular stablecoin and the third largest cryptocurrency overall.

Within the sector, centralized cryptos are a contentious subject. Some members of the community support the concept of combining the advantages of having a central agency, such as swift decision-making and efficient management, with the revolutionary qualities of cryptocurrencies. Many believe, however, that the entire objective of this asset category is to provide a completely trustless, decentralized money management and economy in general. According to this group, centralization forfeits this fundamental purpose, and therefore can’t be regarded as optimal.

Collateralized stablecoins

As the name implies, stablecoins in this category are backed by another asset, most commonly a fiat currency or other cryptocurrencies. Projects that issue collateral-backed tokens should normally have access to the underlying asset in an identical quantity.

For instance, if a corporation pegged their stablecoin to the US dollar and issued 100,000 tokens, the company would need to retain at least $150,000 in collateral for the tokens issued to safely protect their valuation. Dai (DAI) is a part of the preceding category, holding more in the underlying asset than DAI issued.

Uncollateralized stablecoins

Uncollateralized stablecoins, unlike their collateralized counterparts, are not backed by any asset and so have no inherent value in theory. The minting entity, the tokens' utility, market demand, or a mix of all of the above might serve as the basis of their valuation. Being steady in the case of such stablecoins is usually maintained by algorithmic balancing, in which the issuer works as a form of central bank, actively reducing or providing excess supply to enhance or decrease the asset's value. Ampleforth (AMPL) is a superb illustration of the above mechanism. 

Some may be surprised to learn that fiat currencies have remained uncollateralized since the gold standard was abolished in the United States in the second part of the twentieth century.

Fiat currencies have value because they are supported and acknowledged by authorities and legislative bodies, as well as widespread adoption within a nation or society.

Undercollateralized stablecoins

Stablecoins that are undercollateralized fall between the collateral free and collateralized categories. In essence, they are fully secured by an asset, but the issuer owns less of that asset than the value of the issued tokens. Many investors like this kind as a hedging strategy for the two other categories, while others say that any uncollateralized asset should not have been created in the first place since it increases the significant risk of misconduct and reduces investment protection.

Algorithmic balancing and underlying collateral are frequently used in undercollateralized systems. For example, Frax (FRAX), an undercollateralized stablecoin, uses an algorithm that adjusts the collateral backing FRAX determined by market conditions to maintain a constant value.

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