What are Stablecoins?
The Beginner’s Guide
Stablecoins are a type of cryptocurrency programmed to track the value of another asset like government monies or gold.
Many investors are drawn to stablecoins because they offer the efficiency and transparency of cryptocurrencies, while providing relief from the sometimes extreme volatility of these assets.
However, traders and investors should note that not all stablecoins are created equal.
As of 2020, there are two main classes of stablecoins, cash-collateralized stablecoins and crypto-collateralized stablecoins, both of which are available on exchanges like Kraken.
Still, stablecoins come in a wide range of varieties. By some counts, there are over 200 active stablecoin projects, which together process more volume than even Venmo, PayPal’s mobile peer-to-peer payments platform,
Not sure where to begin with this crypto asset class? Below we explain how stablecoins work and why they might be a compelling addition to your crypto asset portfolio.
Why Do Stablecoins Have Value?
By eliminating the volatility associated with cryptocurrencies, stablecoins allow investors another tool for managing risk in their portfolio.
Additionally, stablecoins may offer traders the ability to buy and sell from a wider selection of trading pairs, all without the restrictions of traditional capital markets which may only be open during business hours on weekdays.
However, some proponents see stablecoins as eventually extending financial services, allowing users to circumvent the gatekeepers that may block access to global payment services today.
For example, borrowers can avoid the credit evaluations and expensive fees of financial institutions and instead collateralize their crypto holdings using certain types of stablecoins.
How Do Stablecoins Work?
All stablecoins seek to mimic the price of another asset, but they don’t all accomplish this in the same way. This means that some stablecoins may be riskier than others and more prone to the price fluctuations they claim to provide safety from.
Cash-collateralized stablecoins are cryptocurrencies backed 1-to-1 by an underlying government currency (like USD or EUR) stored in a traditional financial institution.
This type of stablecoin was first introduced in 2014 when startup Tether Limited released USDT, a dollar-backed cryptocurrency designed to trade 24/7 on the global crypto market. As of 2020, Tether remains the most widely used stablecoin around the world.
Like USDT, cash-collateralized stablecoins are generally managed by a central operator, who tracks their circulation and allows users to mint and redeem tokens in their custody.
In some cases, these reserves are even regularly audited to ensure that the amount of tokens traded is equal to the reserves held by the firm.
Examples of cash-collateralized stablecoins include USDT and USDC (pegged to the USD).
Crypto-collateralized stablecoins are collateralized by one or more cryptocurrencies.
These assets generally lack a central administrator, and instead rely on an open software to enable borrowers to lock crypto assets (thus collateralizing them) and generate new stablecoins in the form of loans.
To account for the volatility of the underlying cryptocurrency, these stablecoins are often over collateralized, meaning that the deposit amount required is typically a higher percentage than the value of the stablecoin.
If borrowers wish to redeem their locked cryptocurrencies, they have to return the stablecoins to the protocol and pay a fee.
Due to their design, the stablecoin supply cannot be altered by anyone in the network. Instead, contracts are programmed to respond to changes in the market price of the locked assets.
Examples of crypto-collateralized stablecoins include DAI, Havven, and BitUSD.
Algorithmic stablecoins are digital assets that rely on smart contracts to regulate their stability.
Rather than using deposits of cryptocurrencies or issuing and redeeming debt, the software behind algorithmic stablecoins programmatically adjusts the supply of the cryptocurrency as the demand for it fluctuates.
If demand is high, the price of each stablecoin will exceed the intended peg, and the software will increase the supply. Alternatively, if demand is low, the supply will decrease.
Kraken's Crypto Guides
- What is Bitcoin? (BTC)
- What is Ethereum? (ETH)
- What is Ripple? (XRP)
- What is Bitcoin Cash? (BCH)
- What is Litecoin? (LTC)
- What is Chainlink? (LINK)
- What is EOSIO? (EOS)
- What is Stellar? (XLM)
- What is Cardano? (ADA)
- What is Monero? (XMR)
- What is Tron? (TRX)
- What is Dash? (DASH)
- What is Ethereum Classic? (ETC)
- What is Zcash? (ZEC)
- What is Basic Attention Token? (BAT)
- What is Algorand? (ALGO)
- What is Icon? (ICX)
- What is Waves? (WAVES)
- What is OmiseGo? (OMG)
- What is Gnosis? (GNO)
- What is Melon? (MLN)
- What is Nano? (NANO)
- What is Dogecoin? (DOGE)
- What is Tether? (USDT)
- What is Dai? (DAI)
- What is Siacoin? (SC)
- What is Lisk? (LSK)
- What is Tezos? (XTZ)
- What is Cosmos? (ATOM)
- What is Augur? (REP)
Why Use Stablecoins?
Users may be interested in purchasing stablecoins as they offer all the benefits of traditional cryptocurrencies, such efficiency and transparency, while protecting from price volatility.
Further, like other cryptocurrencies, they are borderless, programmable and easy to transfer at low cost, offering a valuable alternative to traditional banking institutions.
If you are interested in learning more about the different types of cryptocurrency, you can visit Kraken’s “Types of Cryptocurrency” page.
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