Stablecoins are tokens designed to have stable prices by being pegged to a “stable” asset like the US dollar.
Globally, stablecoins have a $160B+ market cap (~12% of the $1.3T cryptocurrency market). As of May 2022, the top 5 stablecoins are Tether, USDC, Binance USD, Dai, and Frax.
How do stablecoins stay stable?
Stablecoins keep prices stable in different ways:
Fiat-backed stablecoins: Backed by fiat currency (e.g., US dollar) and held in a regulated financial entity. Examples include Tether and USDC.
Crypto-backed stablecoins: Backed by cryptocurrencies and work like a collateralized loan. For example, to get a loan for $50 in DAI (a crypto-backed coin pegged to the US dollar), you might have to park $100 ETH. If ETH goes up in value, then your borrowing power will increase. If ETH goes down in value, then you might have to park more ETH or risk getting liquidated. You get your ETH back when you return the DAI.
Algorithmic stablecoins: Rely on algorithms to control the money supply, similar to how a central bank prints and destroys fiat currency. This group of stablecoins is the most capital efficient, but the riskiest as they are not fully backed, which can lead to a bank run if users lose faith. Be cautious with algorithmic stablecoins. Some have failed to maintain their $1 peg including Terra USD, Basis Cash, and Iron Finance.
Inflation is still a problem for stablecoins pegged to the US dollar or another fiat currency. Some protocols are exploring inflation-adjusted stablecoins. Stablecoins also have yield opportunities, which can combat inflation.
Why hold stablecoins?
People hold stablecoins to:
Earn yield: Stablecoins offer yields opportunities without massive price swings. Yield opportunities exist in DeFi. Please explore our Yield Farming guide to learn more. There are yield opportunities on centralized platforms, but we recommend caution. Some centralized platforms have undertaken risks and have been unable to return customer funds in full.
Reduce volatility: Crypto assets are volatile, by converting volatile assets into stablecoins you can reduce price swings without having to convert assets back to fiat currency.
Make payments and money transfers: It’s often cheaper and faster to pay someone in a stablecoin than fiat currency, especially if you’re sending money internationally. Volatile currencies don’t work well for payments, so stablecoins are great for paying DAO contributors or vendors.
Let's continue on with DeFi, exploring a popular use case, swapping tokens for one another.