What Are Stablecoins and How Do They Work?
Stablecoins are often seen as a financial “cheat code” as they give you exposure to the lucrative opportunities of cryptocurrencies. But without having to make any uneducated bets or participate in the traditional “risky” games of crypto.
Stablecoins are tokens pegged to another currency, fiat, or financial instrument, and are often seen as the backbone of Decentralized Finance (DeFi).
These coins serve as the link between cryptocurrencies and real-world currencies. They’re referred to as “stable” simply because they don’t experience high volatility. They’re pegged to a fiat currency, usually the USD. In cavemen's terms, the price of one stablecoin = $1.
This article breaks down what stablecoins are, the use cases, the different types, the risks involved, and a few of our recommendations.
The 4 Unfair Advantage of Stablecoins
1) Safe Bet Against Market Volatility
Everybody knows how wildly crypto prices can swing. But stablecoins lower the volatility in your portfolio and help you preserve your assets from losing too much value.
2) Higher Returns Than A Savings Account
Stablecoin lending is one of the most high-yield opportunities for retail investors, often offering double-digit interest rates. This demand is fueled by massive institutional demand for stablecoin loans.
Compared to savings accounts offered by banks, which usually pay out less than one percent a year, stablecoin returns on decentralized crypto lending platforms can be as high as 20% to 30%.
3) Hedge Against Ridiculous Inflation
Unless you’ve been living under a rock, you know the current inflation rate is at an all-time high as the “official” number has soared up close to 10%.
When you participate in stablecoin farming, you can easily “cancel out” the inflation rate without making any uneducated bets or playing the traditional “risky” games of crypto.
4) Quickly Capitalize On Wild Market Swings
With stablecoins, you don’t have to wait several days to transfer from your bank to your Central Exchange (CEX). This can be crucial whenever there are huge swings in the market, and you want to quickly capitalize and “buy the dip.”
The Different Types of Stablecoins
As an investor, it’s essential to understand that no two stablecoins are created equal or are the same. This is why we have different types of stablecoins, which include:
● Fiat Backed Stablecoins
● Crypto Collateralized Stablecoins
● Algorithmic Stablecoins
● Semi Algorithmic Stablecoins
Let us take a look at each of them below.
Fiat Backed Stablecoins
Fiat-backed stablecoins are backed by a real-world currency, usually the U.S. dollars. A few examples are explained below.
- Tether (USDT)
Tether is one stablecoin that was claimed in the past to be entirely backed by fiat until the United States government found out that they weren’t.
However, this does not take away that it is the largest stablecoin by market cap, with over $70 billion, and the most popular one.
Tether has launched itself on the Ethereum scaling solution, Polygon, to cement itself as a top stablecoin in the crypto market.
- USD Coin (USDC)
The USD Coin is a stablecoin that has always been fully backed by the equivalent value of U.S. dollar-denominated assets.
The coin is the second-largest stablecoin and was formed as a partnership between Coinbase and Circle.
The coin is also an Ethereum token, which investors can store in an Ethereum-compatible wallet.
It was also designed to let dollars move globally from the crypto wallet of investors to other exchanges, businesses, and people.
- Binance USD (BUSD)
Binance USD is a USD-denominated stablecoin launched in 2019 in Partnership with Paxos and Binance.
Thanks to its stability with the U.S. dollars, BUSD empowers traders and crypto users with the ability to transact with other digital and blockchain-based assets while minimizing the risk of volatility.
Since its launch, BUSD has performed exceptionally well and established itself as a leader in the cryptocurrency space with a market cap of $10 billion.
The risks of fiat-backed stablecoins include centralization and counterparty risk.
Centralization risk is when the accounts of fiat-backed stablecoins can be embezzled, blocked, or accessed by unauthorized individuals. Stablecoins also face the same centralization problem that fiat currencies do as regards a central authority who could potentially print excess money, leading to hyperinflation.
Counterparty risk is when the platform where you hold your stablecoins go under or experiences a leak, a hack, or a classic “rug pull” where the platform founders abandon their project, and, in a nutshell, run away with all its users' money.
Crypto Collateralized Stablecoins
A crypto collateralized stablecoin is backed by a cryptocurrency. This type of stablecoin is quite important, particularly to the DeFi ecosystem, and they overcollateralize digital assets to maintain a consistent market price.
A list of crypto collateralized stablecoins are explained below.
- MakerDao (DAI)
MakerDao is a project behind the stablecoin DAI, a cryptocurrency that is soft pegged to the U.S. Dollars.
What makes it unique is each DAI is backed by Ether instead of a 3rd party claiming to have the required collateral.
The main criticism of this coin, however, is that it isn't truly decentralized due to the amount of USDC it holds.
- Abracadabra (MIM)
MIM is also known as Magic Internet Money, and it is a USD-pegged stablecoin that utilizes interest-bearing tokens.
The interest-bearing tokens accumulate interest and constantly go up in price as users hold them. In addition, they describe a portion in a lending pool that increases in volume as borrowers repay interest.
The risks of crypto-backed stablecoins are smart contract risks and asset collateral depreciation. And since these kinds of require over-collateralization, they are generally not the most capital efficient
Algorithmic stablecoins are coins that use an algorithm to maintain a consistent value.
These algorithms usually link two coins and then adjust their price depending on the supply and demand of investors. While an algorithmic stablecoin is pegged to the value of a real-world asset, it is not backed by one.
Semi Algorithmic Stablecoins
This type of stablecoin combines the best of both worlds, in that they are backed by collateral and have an algorithmic side as well with the most popular type of semi-algorithmic stablecoin being Frax.
How To Win In Crypto With Stablecoins
Stablecoins are seen more as a cryptocurrency hedge to preserve capital rather than a “get rich quick” type thing.
They are an excellent choice during vicious bear markets and a personal staple in our reliable “All Weather Portfolio.”
At the end of the day, most investors are involved in the crypto world because they want the value of their portfolio to increase over time. But you won’t experience the true benefits of stablecoins by just sitting on them like a “hodler.”
Instead, if you take it a step further with stablecoin yield farming, you essentially have what we refer to as a cryptocurrency “goldmine.”
A lower risk, reliable way to generate 20% to 30% yearly returns without playing the traditional “risky” games or crypto.
Additional Yield Farming Resources
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The information contained in this post is for educational purposes only. Any results or hypotheticals discussed are not typical and are not a guarantee of your success. Yield Farming employees are experienced cryptocurrency investors. Your results will vary depending on education, work experience, and background. All investments involve risk, and the past performance of a security, industry, sector, market, financial product, investment strategy, or individual’s investment does not guarantee future results or returns. Investors are fully responsible for any investment decisions they make. Such decisions should be based solely on an evaluation of their financial circumstances, investment objectives, risk tolerance, and liquidity needs.