The drastic price movements of most cryptocurrencies are a concern for investors, but especially for anyone starting in crypto. The rapid changes in value make it difficult to get acclimated to the crypto space. It can make decisions on when to make purchases even harder when we see large price drops without understanding why.
Stablecoins were created to provide crypto investors price stability in a decentralized world.
Often, stablecoins serve as the fiat onramp. Investors will convert their US dollars into crypto to be exchanged later for another crypto.
Stablecoins are very comparable to money-market funds in traditional investing and serve as a vehicle for investors to park their cash while waiting to figure out which crypto to buy next. The key difference is that we have the ability to send our stablecoin from a CEX to our own wallets to access DEXs.
Assets that back stablecoins
Let's dive into how stablecoins work and what they use to hold value.
These stablecoins tie their value to a commodity, often precious metals like gold and silver.
The coins are redeemable (more or less) for the underlying asset. There is some comfort knowing we can convert a cryptocurrency into something real/tangible.
The price of this type of stablecoin fixes its value to the underlying fiat currency. It's the most popular form of stablecoin, and the US dollar is the most common fiat currency used to back stablecoins.
A third party holds onto the fiat currency in this system, redeemable at a fixed rate for the stablecoin. Most importantly, the amount of fiat currency used for backing has to reflect the circulating supply of the stablecoin.
These stablecoins use other cryptocurrencies as collateral. It's similar to fiat-backed stablecoins, but the mechanics are different. Instead of a third-party bank to hold the opposite currency, we lock up our crypto collateral using smart contracts on the blockchain - effectively loaning us the stablecoin in exchange for the other cryptocurrency.
There is a risk that the price of the underlying crypto could crash suddenly, dragging the stablecoin with it. As a result, smart contracts manage this risk by automatically paying back the loan if the value of our collateral drops too close to the value of the stablecoin we borrowed.
Seigniorage supply stablecoins
While not as popular, some stablecoins aren't backed by any assets. Instead, an algorithm stabilizes the price by adjusting the supply. The algorithm will lower the price by creating coins or destroying coins if the price falls too much.
Due to the stablecoins' ability to store value, people have turned to them as an alternative to their national currencies in uncertain economic and political conditions, times of high inflation, or as means to avoid internet censorship. Despite their price stability, stablecoins still carry many of the same risks as other cryptocurrencies. They are also subject to the same volatility and risks as the underlying asset.
As an investor getting our feet wet for the first time in the crypto space, a US dollar stablecoin would be a great place for us to start. By buying stablecoins we can learn how exchanges work without any timing risk for us. The last thing we want to happen is our crypto quickly losing value because we bought it when the price was at a peak.