> Blog > Understanding Stablecoins And Their Purpose

Published October 20, 2022

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Cryptocurrency is known for its volatility, but you don’t have to expose yourself to the crypto market’s dramatic price swings to interact with the space. Enter stablecoins. These cryptocurrencies provide crucial stability needed in the industry. Rather than dropping and rising in value on any given day, stablecoins aim to remain at a stable price, as the name implies.

So, what are stablecoins? How do they work, and why are they essential to the crypto ecosystem?

What is a Stablecoin?

Stablecoins are cryptocurrencies that are backed by a “stable” reserve asset, typically to fiat currency reserves. This means you can transact with confidence knowing that its price won’t drop and rise on any given day.

Stablecoins are integral to the cryptocurrency ecosystem. They leverage smart contracts, which are self-executing contracts coded into the blockchain, to maintain their value.

As cryptographic digital assets, stablecoins live on the internet, which makes them programmable. With the stability of fiat, stablecoins enable developers to create more advanced financial instruments with less risk, such as decentralized lending platforms, yield farming protocols, and more.

There are several stablecoin options today, including DAI, USDC, and Tether (USDT).
Stablecoins reside on nearly all popular blockchains out there, such as Solana, Avalanche, Cardano, and more. They bring the best of both worlds to the cryptocurrency ecosystem, offering the price stability of fiat currency while maintaining the benefits of cryptocurrency, such as accessibility, speed, security, and privacy.

What is a Stablecoin Market?

Stablecoins can be bought and sold on cryptocurrency exchanges just like any other digital asset. However, traders do not buy stablecoins to make a profit, but rather to have stable dollars stored on the blockchain. This enables crypto investors to secure their profits while remaining within the decentralized finance (DeFi) ecosystem.

There isn’t one specific market specializing solely in stablecoins, but you can buy these assets from most popular cryptocurrency exchanges, like FTX.

What’s the Purpose of Stablecoins?

Three purposes of stablecoins

Stablecoins serve three valuable purposes for cryptocurrency users:

  • Instant processing: Stablecoins allow cryptocurrency traders to seamlessly transact between dollars and cryptocurrencies while remaining on the blockchain.
  • Privacy and security: They protect users from censorship and tampering by hosting spendable dollars on immutable, decentralized blockchains.
  • Hedge against volatility: They are free from volatility, ensuring stable valuations that are pegged to a precious metal like gold or in some cases, the US dollar. In rare instances, they can even be tied to physical commodities like oil.

Since President Richard Nixon removed the US Dollar from the gold standard in 1971, fiat currencies themselves haven’t been backed by underlying assets. This makes them subject to inflation and market manipulations, like quantitative easing and tightening.

Stablecoins are here to serve as the connecting bridge between the legacy financial system and the emerging digital asset landscape. They allow for proper valuation of cryptocurrencies by enabling traders to swap their tokens for tangible and spendable currencies that have a historical valuation behind them.

Whether you’re trading derivatives or simply sending money, stablecoins can make cryptocurrency more practical for everyday transactions. They also provide an easy on-ramp into the digital asset space, as people are more likely to transact using something they’re already familiar with.

Risks of Stablecoins

Despite their benefits, stablecoins aren’t free from risk. They are a new digital technology, and not impervious to software bugs and vulnerabilities.

In addition to the possibility of technical issues, stablecoins are subject to some of the same risks as other digital assets. For instance, users must protect their private keys. If private keys fall into the wrong hands, hackers can access a user’s wallet and funds.

Regarding regulations, stablecoins may be subject to rapidly changing financial rules, depending on the jurisdiction. While most governments have yet to release specific regulations for stablecoins, it’s important to stay up-to-date on future developments, as they could impact how you use and store your assets.

Stablecoins are also subject to the risk of de-pegging. Being built on code, misdesigns in the code can break the stablecoin’s peg, causing it to lose its stable valuation and collapse. This was most recently seen in the case of the Terra blockchain’s native stablecoin, TerraUSD (UST).

Types of Stablecoins

Types of stablecoin collateralization sitting in a bank vault

Stablecoins can generally be separated into four categories: fiat-collateralized, cryptocurrency-collateralized, commodity-collateralized, and algorithmic.

Fiat-collateralized stablecoins use a fiat currency reserve, like the US Dollar, to issue their coins. These reserves are managed by independent custodians and are audited on a regular basis. Doing so establishes trust and ensures stability of the stablecoin. Tether (USDT) is a popular stablecoin that is backed by US dollars.

Cryptocurrency-collateralized stablecoins differ from fiat in that they use a cryptocurrency reserve. Depending on the cryptocurrency backing it, such reserves can be volatile. Cryptocurrency-collateralized stablecoins work around this by keeping a larger reserve available to release smaller amounts of stablecoins. As an example, DAI is backed by Ethereum (ETH) in the form of collateralized debt.

Commodity-collateralized stablecoins choose to peg the asset to a real world commodity, such as gold or oil, rather than a fiat currency. PAX Gold (PAXG) is a popular type of commodity-collateralized stablecoin that’s backed by gold, and can be redeemed in fiat currency or directly in gold that’s custodied by Pax Trust Company.

Algorithmic stablecoins take a different approach entirely. They use algorithms from smart contracts and set parameters to decide the level of over/under-collateralization, how much volatility they allow the stablecoin to deviate from its peg, and other programmed measures to ensure its stability.

Understanding Stablecoins with FTT DAO

The world of cryptocurrencies is constantly evolving. With new developments and market swings, stablecoins provide an anchor in the digital asset space.

To learn more about crucial components of a flourishing crypto ecosystem, check out the FTT DAO blog for educational resources to help you navigate the crypto waters.

Be sure to follow FTT DAO on Twitter and subscribe to the FTT DAO YouTube channel to keep up with the latest FTX news and crypto developments.

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