An Introduction to Stablecoins – What Are They and What Exactly Makes Them “Stable”

The currency peg system is adopted by roughly half the population, allowing countries to control inflation by tying their domestic currencies to foreign bank-issued money. However, a currency peg isn’t inherently the staple of traditional financial systems, which operate on fiat money only.
Once crypto struck the trading scene, the need to keep this strange and unpredictable market relatively stable grew overnight. And what other way to keep a currency – whether it be fiat or digital – steady, than pegging it to bank-issued money or any other reference asset?
Only five years after the first Bitcoin was minted, the first token was pegged to the US dollar. As a result, we’ve got our first of many stablecoins.

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Illustration: Milica Mijajlovic

What Is a Pegged Cryptocurrency?

Pegged cryptocurrency describes digital assets whose value is tied to a predetermined fiat currency or a commodity type. Cryptocurrency pegging is initiated to control the value of a cryptocurrency through external factors such as the value of a fiat currency. When a digital asset is too volatile for safe trading, and price fluctuations can’t be tamed through supply and demand, crypto pegging can protect it from extreme volatility.

However, that’s not always a predisposition for crypto pegging. We need stable currency circulating the market to power decentralized systems, and it’s in everyone’s favor to have as many of these digital assets under some control, and that’s one of the reasons we are creating them.

Pegged crypto

Photo illustration: Freepik

Pegged cryptocurrencies are part of the stablecoin family. Most stablecoins are pegged to some of the major and widely accepted fiat money, such as the euro, US dollar, or GBP. When a cryptocurrency gets pegged to fiat money, authorized parties must establish the exchange rate between the two assets.

Once established, the fixed exchange rate keeps the value of a pegged currency in check. The value of that cryptocurrency now moves in the same way the value of the currency to which it is pegged fluctuates. More importantly, the predetermined ratio dictates the volatility’s magnitude.

Fiat-Pegged Cryptocurrency Is a Stablecoin Type

Stablecoins don’t have to be pegged to fiat money. Instead, we could tie them to other reference assets like gold and silver. For example, Tether Gold is one of the most popular gold-backed stablecoins, while Kinesis Silver (KAG) is a stablecoin pegged to the value of silver.

That said, here’s how we categorize stablecoins:

  • Fiat-pegged stablecoins: Fiat-pegged or fiat-collateralized crypto is a type of stablecoin backed by bank-issued currencies such as the euro or US dollar. This is the most popular stablecoin category, and similarly to fiat currencies, some can be used to pay for goods and services online. Stablecoins pegged by fiat money are coins with fiat currency reserves, meaning the bank-issued money is collateral for these assets.
  • Algorithmic stablecoins: Algorithmic stablecoins don’t need collateral in fiat currencies or securities. Instead, a computer algorithm keeps them in check by controlling supply, making them less prone to volatility. Still, they could be backed by fiat. TerraUSD, for example, was one of the most popular algorithmic stablecoins pegged to the US dollar.
  • Crypto-collateralized stablecoins: Some stablecoins are pegged to other cryptocurrencies instead of bank-issued money. But, as the collateral that backs stablecoins could also suffer extreme volatility due to the market’s nature, crypto-collateralized stablecoins are overcollateralized. In other words, the value of collateral surpasses the value of stablecoins backed by the crypto in question.

The First Stablecoins

The first stablecoin entered the market back in 2014, and it was a result of a joined effort of Charles Hoskinson, the Cardano founder, and the creator of EOS, Dan Larimer. BitUSD was issued as a token on the BitShares network, and it was a crypto-backed stablecoin. This stablecoin was backed by BTS, a cryptocurrency that powers the BitShares blockchain. 

Stablecoin example

Source: NuBits, BitUSD

NuBits is another early example of a crypto-backed stablecoin. However, NuBits stablecoin used Bitcoin as collateral. This stablecoin suffered two major crashes – one in 2016, followed by another crash that happened in 2018. NuBits’ peg to Bitcoin disintegrated due to Bitcoin’s volatility during its second significant market crash

Despite the first two pioneering stablecoins failing miserably, stablecoins prevailed and are considered stable investments due to their lack of price volatility. Tether, for example, which was launched only a year after the first stablecoins appeared on the trading scene, has had a bright future since its inception and is now the third-largest cryptocurrency by market cap. Tether is the first fiat-backed stablecoin and a haven for investors.

Advantages and Disadvantages of Stablecoins

Stablecoins have several use cases and are a popular option for businesses dabbling in the Web 3.0 space for the first time. But despite being a reliable asset in most cases, these cryptocurrencies have a few disadvantages that shouldn’t be overlooked.

Stablecoin pros:

  • The staple of blockchain startups: Stablecoins act like any other cryptocurrency, meaning they can circulate the market faster than fiat. And because of this efficiency, they’re a popular choice for businesses and investors entering the Web 3.0 space for the first time.
  • A good choice for peer-to-peer payments: Peer-to-peer payments in stablecoins require short processing time and are relatively anonymous. Additionally, transaction fees for stablecoins could be drastically lower than fiat transaction fees.
  • Versatile investment: Those who invested in stablecoins could borrow, trade, lend, or hold them in non-custodial wallets. More importantly, crypto holders can stake stablecoins by adding them to liquidity pools, generating a yield on their investments.
  • A potential choice for countries wanting to accept crypto as legal tender.
crypto centralization

Photo illustration: Freepik

Stablecoin cons:

  • Centralization: As stablecoins have the potential to be used in countries as legal tender, and a collateral of equal value must support every coin classified as a stablecoin, this structure leans more toward a centralized approach to finance. That isn’t inherently bad, but since decentralization is the backbone of crypto, many would see this wide adoption and “misuse” of stablecoins as a disadvantage.
  • Transparency issues: Despite being the third strongest cryptocurrency and the most popular stablecoin, Tether regularly receives backlash from the public due to concerns regarding Tether’s collateral. The lack of transparency makes it impossible to determine whether the company has the exact amount of collateral to match every Tether stablecoin in circulation.

As you can see, stablecoins offer various benefits and are widely adopted by crypto holders who don’t want to participate in risky trading practices. However, depending on where you stand on specific issues in the crypto world, the ongoing attempts at centralizing stablecoins could deter you from investing. Regardless of what you plan to do, though, it’s critical to familiarize yourself with your potential investments before putting money and faith into them.

Jelena is a content writer dedicated to learning about all things crypto. Her hobbies are playing chess, drawing, baking, and going on long walks. During winter, she usually spends her leisure time reading books.