Stablecoins Explained for BYDFi: What They Are and How They Work

Stablecoins are less volatile than other cryptocurrencies and are growing in popularity. Learn how to use stablecoins and whether they're right for you.

Due to the inherent instability of crypto assets, stablecoins are growing in popularity with both crypto and traditional markets. Stablecoins are a type of crypto asset that offers a way to bridge the gap between fiat currencies like the U.S. dollar and cryptocurrencies.

Because they are price-stable digital assets that behave like fiat but maintain the mobility and utility of cryptocurrency, stablecoins offer a novel solution to crypto volatility: price stability is built directly into the assets themselves. There are four primary stablecoin types, identifiable by their underlying collateral structure: fiat-backed, crypto-backed, commodity-backed, and algorithmic stablecoins.

How Do Stablecoins Work?

As with any emerging asset class, cryptocurrencies are susceptible to market forces. Accordingly, many crypto projects actively explore ways to reduce risk and bolster participation in the broader crypto ecosystem.

Current solutions go well beyond the buy, sell, and stop orders of conventional markets. Instead, price stability is being built directly into the assets themselves. The result is an entirely new subset of the cryptocurrency market known as stablecoins. These tokens are meant to function as their name suggests — with stability.

The concept of the stablecoin was created to lessen volatility, and its popularity is growing among both crypto and more traditional market investors. The growing popularity of stablecoins can be attributed to several factors, particularly their ability to combat inflation and facilitate fast, efficient transactions — especially within international exchanges.

What Are the Benefits of Stablecoins?

Stablecoins have several key advantages. Keeping these in mind can help you make more informed decisions.

Transaction Speed

When you consider the amount of time it takes for traditional banking transactions to settle compared to the lightning speed of stablecoins, it's easy to see the appeal. Stablecoin transactions can be completed in a matter of seconds, rather than the several days that can occur with traditional banking transactions.

Global User Access

Stablecoins offer a solution for sending and receiving money across borders. Because of their decentralized nature, stablecoins aren't confined to any one country. Additionally, stablecoins appeal to people across many social classes in less developed countries. Due to their digital nature, stablecoins are accessible to nearly everyone with a few taps on a mobile device — they have global appeal.

Platform Flexibility

Stablecoins can be used on a wide variety of platforms and exchanged quickly. Simply connect your wallet to an exchange and purchase stablecoins. There's a lot of flexibility with stablecoins, and they can be bought in several ways, including by making a bank transfer or using a crypto credit card.

Security

Stablecoins offer higher security than other types of payments, along with more privacy. For peace of mind, stablecoins are typically backed by a fiat currency or other tangible assets.

Low Transaction Fees

Have you ever sent money overseas through traditional banks? The cost can be very high. Stablecoins offer an affordable option for money transfers to other countries because they remove "the middleman." Using blockchain technology, stablecoins use a direct transaction approach, resulting in low transaction fees.

What Are the Risks of Stablecoins?

It's also important to stay mindful of some potential drawbacks.

Reserve Management

Stablecoins are only as stable as the management of their reserves. Although stablecoins are less risky than many other cryptocurrencies, look out for a lack of transparency and be wary of any history of fraudulent behavior by the issuer, as this can affect the stability — which is the main attribute of stablecoins.

Centralization Concerns

Due to the nature of stablecoins, control is often centralized, which has its pros and cons. The risk lies in making sure the issuer is trustworthy and has enough reserves on an ongoing basis.

De-Pegging

One or more events, including price fluctuations, could cause stablecoins to drop below their target value — otherwise known as de-pegging. De-pegging can cause a domino effect and impact values at a systematic level, or it can be isolated to an individual stablecoin.

Any investment has both benefits and risks. The key is to do your research and understand your objectives and how you will use the investment.

Why Do Stablecoins Exist?

To understand why you would use stablecoins, let's talk about why other cryptocurrencies, like Bitcoin, became so popular.

Looking at the history of cryptocurrency starting with Bitcoin, part of the rising popularity stemmed from a lack of trust in central banks and the desire for efficiency. These factors, among others, have put Bitcoin on the investment map, appealing to both new and seasoned investors.

The downside of Bitcoin is its inherent volatility and unpredictability. This is the main reason stablecoins emerged. Their stable value has made them a viable alternative to other cryptocurrencies for certain use cases.

Main Stablecoin Use Cases

Two main use cases generally stand out for stablecoins.

The first is buying and selling crypto assets — because stablecoins are pegged to another currency or commodity, they serve as a great alternative to holding volatile cryptocurrencies as a trading base.

The second is cross-border payments. Stablecoins allow efficient, low-cost international transfers with the reassurance of less volatility than other cryptocurrencies. Due to the nature of blockchain technology, these payments can be sent at any time, day or night.

Given their stability, stablecoins could become more widely utilized in other use cases as the market matures.

The Four Types of Stablecoins

Stablecoins are digital currencies minted on blockchain networks, typically identifiable by one of four underlying collateral structures. While these structures vary, all stablecoins aim for the same goal: stability.

1. Fiat-Backed Stablecoins (Off-Chain)

The most popular stablecoins are backed 1:1 by fiat currency (like the U.S. dollar). Because the underlying collateral isn't another cryptocurrency, this type is considered an off-chain asset. Fiat collateral remains in reserve with a central issuer or financial institution and must remain proportionate to the number of stablecoin tokens in circulation.

For example, if an issuer has $10 million in fiat currency, it can only distribute $10 million in stablecoins, each worth one dollar.

Examples: USDC, USDT (Tether)

2. Crypto-Backed Stablecoins (On-Chain)

Crypto-backed stablecoins are backed by another cryptocurrency as collateral. This process occurs on-chain and employs smart contracts instead of relying on a central stablecoin issuer.

When purchasing crypto-backed stablecoins, you lock your cryptocurrency into a smart contract to obtain tokens of equal representative value. You can then put your stablecoin back into the same smart contract to withdraw your original collateral amount.

These stablecoins are typically over-collateralized to buffer against price fluctuations. For example, to buy $1,000 worth of DAI, you might need to deposit $2,000 worth of Ethereum (ETH) — a 200% collateralization ratio. If the price of ETH drops, the excess collateral buffers DAI's price to maintain stability.

Example: DAI (via MakerDAO)

3. Algorithmic Stablecoins

Algorithmic stablecoins do not use fiat or cryptocurrency as collateral. Instead, their price stability results from using specialized algorithms and smart contracts that manage the supply of tokens in circulation.

If the market price falls below the target price, the system reduces the number of tokens in circulation. If the token price rises above the target, new tokens enter circulation to adjust the value downward.

Risk note: Algorithmic stablecoins have historically been more vulnerable to losing their peg (e.g., UST in 2022).

4. Commodity-Backed Stablecoins

Commodity-backed stablecoins are collateralized using physical assets like precious metals, oil, or real estate. The most popular commodity for collateralization is gold.

Examples: Tether Gold (XAUT), Paxos Gold (PAXG)

These stablecoins facilitate investments in assets that may otherwise be out of reach locally. Obtaining a gold bar and finding secure storage is complex and expensive in many regions. Commodity-backed stablecoins solve this problem.

Some gold-backed stablecoins can even be redeemed for physical gold. For example, holders of PAXG can redeem their tokens for physical gold bars stored in vaults (though minimums apply, typically one standard 400 oz gold bar).

Stablecoins as a Medium of Exchange and Store of Value

The most immediately apparent advantage of stablecoin technology is its utility as a medium of exchange, effectively bridging the gap between fiat and cryptocurrency. By minimizing price volatility, stablecoins achieve a utility separate from the ownership of legacy cryptocurrencies.

As their name suggests, stablecoins are inherently stable assets. This makes them suitable stores of value and encourages their use in everyday transactions. Further, stablecoins improve the mobility of crypto assets throughout the ecosystem.

Stablecoins point toward the integration of traditional financial systems with the quickly evolving decentralized finance (DeFi) industry. As a force for market stability, stablecoins present a primary vehicle for cryptocurrency adoption in loan and credit markets while inheriting much of the utility previously reserved for fiat currency alone.

Quick Summary: Types of Stablecoins

The Bottom Line

Stablecoins are gaining popularity due to their low costs, ease of use, global access, and flexibility. This type of cryptocurrency is tied to another asset class, making it less vulnerable to market volatility than traditional cryptocurrencies like Bitcoin or Ethereum.

Whether you're looking for a stable trading pair, a way to send money across borders, or a store of value without the wild price swings, stablecoins offer a practical solution at the intersection of traditional finance and blockchain technology.

Disclaimer: This article is for informational and educational purposes only and does not constitute financial or investment advice. Stablecoins carry risks including de-pegging, lack of transparency, and counterparty risk. Always do your own research before investing.