What are Stablecoins: How they work, History, Types

Introduction 

Holding stable value in the volatile world of cryptocurrencies is made possible by stablecoins, which have become common in the ecosystem. Recent changes and updates highlight their increasing role and significance. For instance, Circle recently got the green light to issue stablecoins in the EU under the stringent MiCA law, becoming the first global stablecoin issuer. Such regulatory clarity is likely to further support the stablecoin market, which already comprises over 160 stablecoins valued at more than $151 billion in total market capitalization by April 2024.

So, this article provides the reader with information about stablecoins' origins, markets, and participants.

What are Stablecoins?

Stablecoins are currencies backed by another asset type, including fiat currencies, which are hard currencies such as the US dollar, precious metals, or other cryptocurrencies. This pegging mechanism helps eliminate strong fluctuations in cryptocurrencies and makes stablecoins a stable means of exchange and value storage.

How Do Stablecoins Work?

Stablecoins are designed to maintain a stable value by being pegged to an underlying asset, such as a fiat currency, commodity, or basket of assets. A different company might execute each stage. Here’s a detailed explanation of their working mechanism:

1. Creation: A company or organization issues a stablecoin by creating tokens that are backed by a specific asset. Each issued stablecoin is typically pegged to a fiat currency like the US dollar (e.g., 1 stablecoin = 1 USD), ensuring its value remains stable.
2. Ledger: The stablecoin is issued to the public through a blockchain ledger. This ledger tracks all transactions and ownership of the stablecoin, ensuring transparency and facilitating the exchange of stablecoins between users. Blockchain technology ensures that all transactions are recorded immutably and can be audited. 
3. Redemption: Stablecoin holders can redeem their stablecoins for the equivalent value in fiat currency. This process ensures that users can convert their stablecoins back to fiat currency without incurring a loss, maintaining the stable value of the stablecoin. The redemption process usually involves the issuer holding a reserve of the fiat currency or asset to back the stablecoins in circulation.
4. Digital Wallet: Digital wallets provided by different companies allow users to store, send, and receive stablecoins. These wallets can be accessed on smartphones, computers, or other devices, making it easy for users to manage their stablecoins. 

Types of Stablecoins 

1. Fiat-Collateralized Stablecoins: 

• Backed by fiat currencies such as the U.S. dollar, euro, yen, etc., held in reserves by central banks or financial institutions.
• Examples: Tether (USDT), USD Coin (USDC).

2. Crypto-Collateralized Stablecoins: 

• Supported by other cryptocurrencies used as collateral. These stablecoins are often over-collateralized to account for cryptocurrency volatility.
• Example: DAI by MakerDAO.

3. Algorithmic Stablecoins: 

• Use algorithmic techniques to maintain their value without relying on collateral. They adjust the supply based on demand to stabilize their price.
• Example: Frax (FRAX).

4. Commodity-Backed Stablecoins: 

• Supported by physical assets like gold or other commodities.
• Examples: Tether Gold (XAUT), Pax Gold (PAXG).

List of the top 5 Stablecoins

Several stablecoins are popular in the market, each with its strengths and weaknesses:

• Tether (USDT): Tether is one of the oldest and most traded stablecoins. Tether is linked to the U. S. dollar and has the highest market capitalization. However, the company has recently felt the heat over the honesty of its reserve numbers. The pioneer with the highest market capitalization above $100 billion.
• USD Coin (USDC): USDC, created by Circle and Coinbase, is famous for its traces and compliance with American legislation. It is also fixed to the U.S. dollar at the latest reported exchange rate. Managed by the Centre Consortium with $32.4 billion in circulation.
• Dai (DAI): Dai is an Over-Collateralized Stablecoin operated by MakerDAO organization and backed by other Cryptocurrencies. Its primary purpose is to uphold a fixed exchange rate with the U.S. dollar without support from a central bank. 
• Binance USD (BUSD): This stablecoin is released by Binance, which is also backed by the U.S. dollar and has a very strict compliance level. 
• PayPal USD (PYUSD): Although quite recent, PayPal's stablecoin is ensured by the company's financial reliability and utilization of the most liquid, safe, and secure assets.

History of Stablecoins

Stablecoins were created to address the volatility seen in regular cryptocurrencies like Bitcoin (BTC) and Ethereum (ETH). The goal was to develop a digital currency that could maintain a stable value, making it more suitable for everyday use and a reliable store of value.

• 2014: The first major stablecoin, Tether (USDT), was launched. It was pegged to the U.S. dollar, with each USDT token backed by one U.S. dollar held in reserve. This peg helped maintain its stable value, reducing the price swings common in other cryptocurrencies.
• 2015 - 2018: The stablecoin market began to expand. New stablecoins such as USD Coin (USDC) and TrueUSD (TUSD) were introduced, also pegged to the U.S. dollar and backed by fiat reserves. These stablecoins offered greater transparency and regular audits to assure users of their reserves.
• 2017: MakerDAO launched DAI, a decentralized stablecoin backed by cryptocurrencies like Ethereum (ETH). DAI uses smart contracts and collateralization to maintain its peg to the U.S. dollar, providing a decentralized alternative to fiat-backed stablecoins.
• 2019 - 2020: Algorithmic stablecoins like Ampleforth (AMPL) and Frax (FRAX) emerged. These stablecoins use algorithms to adjust their supply based on demand, aiming to maintain price stability without direct collateral backing.
• 2020 - 2023: Commodity-backed stablecoins like Tether Gold (XAUT) and Paxos Gold (PAXG) were introduced. These stablecoins are backed by physical assets such as gold, providing an additional layer of stability and value preservation.
• 2024: The stablecoin market has continued to evolve, with over 160 different stablecoins in circulation and a total market capitalization exceeding $151 billion. Regulatory clarity, such as the EU's MiCA law, has further supported the market's growth and adoption.

Market Dynamics 

1. Growth and Adoption 

The stablecoin market continues to increase more than three times larger, reaching approximately $27. 5 million active users by mid-2024. This growth is attributed to the need for a stablecoin to invest in through the unpredictable crypto market, the emergence of DeFi, and its reliance on stablecoins. The market capitalization of stablecoins now stands at over $150 billion, and the total daily volume of trade is $122 billion. 

2. Regulatory Developments 

A stable impact on species adoption and trading in the market is regulatory certainty. The regulations the EU intends to use in its theatre through MiCA law that defines how the cryptocurrency companies should conduct themselves have provided a benchmark worldwide. How Circle obtains MiCA approval to launch USDC and Euro Coin in the EU demonstrates the need for regulatory approval in stablecoins. 

3. Technological Innovations 

In the case of stablecoins, technology has also been influential in the development of it throughout the years. Some trends currently defining this market include the relationship between stablecoins and Central Bank Digital Currencies (CBDCs) and implementing Layer 2 for better functionality. Also, ecological considerations and energy consumption are still more relevant.

4. Purpose of Stablecoins and its use

Stablecoins have several applications due to their specific features:

• Stability: Provide market stability by anchoring value to tangible assets like fiat money or commodities, making them a good store of value.
• Medium of Exchange: Used for payments, internet purchases, money transactions, and cross-border payments due to their stability.
• Decentralized Finance (DeFi): Serve as collateral in lending/borrowing transactions within DeFi platforms, enhancing financial dealings without intermediaries.
• Risk Mitigation: Help traders hedge value during volatile periods or reduce investment risks.

Potential Developments

The stablecoin market is poised for significant advancements driven by technological innovations and evolving regulatory landscapes. One key development area is the rise of algorithmic stablecoins, which promise capital-efficient, decentralized, and price-stable assets without intermediaries, thus reducing counterparty risk. 

Additionally, integrating stablecoins with Central Bank Digital Currencies (CBDCs) and adopting Layer 2 solutions are expected to enhance scalability and efficiency. Emerging markets suffering from high inflation may increasingly turn to stablecoins as a hedge against currency devaluation, further expanding their use cases beyond cryptocurrency trading. 

Finally, the ongoing competition among new stablecoins, such as Aave's GHO and Curve's crvUSD, exemplifies the dynamic evolution within the DeFi sector.

Conclusion

Stablecoins have revolutionized the cryptocurrency landscape by offering the stability of traditional currencies while leveraging the benefits of blockchain technology. As the market continues to grow and evolve, driven by regulatory clarity, technological advancements, and increasing adoption, stablecoins are set to play an even more significant role in the global financial system. With key players like Tether, USDC, and emerging stablecoins like PYUSD and USDD, the future of stablecoins looks promising, offering a stable and efficient medium of exchange in the digital economy.

Disclaimer: Please note that the information provided on this website is intended for informational purposes only. CoinEx assumes no liability for any financial losses resulting from cryptocurrency trading. It is advised that you conduct your own research.

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