Stablecoins have emerged as an important part of the web3 world, playing a crucial role in providing financial stability to a typically volatile cryptocurrency market. For those new to blockchain and crypto, stablecoins might seem like a complex concept, but they’re actually quite simple.
Think of them as a “digital version of the dollar” or other traditional currencies, designed to maintain a steady value rather than fluctuating like Bitcoin or Ethereum. In this blog, we’ll break down the concept of stablecoins, why they exist, how they work and their importance in the growing web3 world.
What Are Stablecoins?
A stablecoin is a type of cryptocurrency that is pegged to the value of a stable asset, typically fiat currencies like the US dollar or Euro. Unlike Bitcoin, which can experience dramatic price swings, stablecoins aim to stay steady. It should be noted however that no financial asset is perfectly stable, but stablecoins are comparatively stable to most cryptocurrencies.
Imagine you’re traveling to a foreign country and you exchange your money for local currency. When you return home, you expect your leftover foreign currency to hold roughly the same value. This is the idea behind stablecoins—they are designed to ensure your digital assets don’t lose value overnight, especially in the often volatile cryptocurrency world.
Why Do Stablecoins Exist?
Cryptocurrency is known for its wild price swings. Bitcoin, for example, can rise or fall by thousands of dollars in just a day. While this can be exciting for traders, it’s risky for businesses and individuals looking for stability. Enter stablecoins—designed to minimize this volatility by pegging their value to more stable assets.
Here’s why stablecoins are essential:
1. Price Stability for Transactions:
In a world where cryptocurrencies are becoming more common as payment methods, having a stable unit of currency is vital. Imagine buying a coffee for $5 worth of Bitcoin in the morning, only for that Bitcoin to lose value by the time your payment processes. With stablecoins, the value of your purchase remains consistent, making them ideal for everyday transactions. Depending on many variables (complexity, blockchain, amount), web3 transactions can take time. Vendors must rely on knowing that the price paid for a product or service is consistent with their asking price, even if the purchase takes a variable amount of time to fulfill.
2. Cross-border Transactions:
Traditional banking systems often charge high fees for international transfers and can take days to process. Stablecoins make cross-border payments faster, cheaper and easier. Since stablecoins are based on blockchain technology, you can send money across the world in minutes without worrying about the value changing dramatically during the process.
3. DeFi (Decentralized Finance) Applications:
Stablecoins have become an integral part of the decentralized finance (DeFi) ecosystem, where people can lend, borrow and trade assets without relying on traditional banks. In these systems, having a stable currency to work with makes it easier to manage risks and avoid the extreme price swings common in other cryptocurrencies.
How Do Stablecoins Work?
There are a few different types of stablecoins, each using different methods to maintain their stable value. Here are the three main types:
1. Fiat-collateralized Stablecoins:
These stablecoins are backed by actual reserves of fiat currency (like US dollars) held in a bank. For every stablecoin issued, there’s an equivalent amount of fiat currency sitting in reserve. One of the most popular examples is Tether (USDT), which is pegged 1:1 to the US dollar. So, for every USDT in circulation, there should be a dollar in reserve.
Example: If you have 100 USDT, theoretically, the company behind it holds $100 in a bank somewhere to back up your digital assets and allow your tokens to maintain their precise value.
2. Crypto-collateralized Stablecoins:
Instead of being backed by fiat money, these stablecoins are backed by other cryptocurrencies, often over-collateralized to account for the volatility of crypto. This means for every $1 of stablecoin, there might be $2 worth of cryptocurrency backing it. DAI, created by the MakerDAO platform, is a well-known example of a crypto-collateralized stablecoin.
Example: If you want to create $100 worth of DAI, you might have to lock up $200 worth of Ethereum. If the price of Ethereum falls, the system will liquidate your assets in order to keep the value stable.
LEARN MORE:
“What are crypto-backed stablecoins and how do they work?” – Nuant, July 2024
3. Algorithmic Stablecoins:
These stablecoins are not backed by any collateral. Instead, they use algorithms to control their supply, automatically increasing or decreasing the number of tokens in circulation to maintain a stable value. When the demand for the stablecoin rises, the algorithm issues more coins to bring the price down. If demand falls, the supply is reduced to increase the price back to its pegged value.
Example: TerraUSD (UST) was one of the more well-known algorithmic stablecoins before it collapsed in 2022 due to its inability to maintain its peg to the US dollar, highlighting one of the most important risks associated with this type of stablecoin.
LEARN MORE:
“A beginner’s guide on algorithmic stablecoins” – CoinTelegraph, 2023
Why Are Stablecoins Important in Web3?
Stablecoins have become indispensable in the broader Web3 ecosystem because they serve as the bedrock for many financial activities on the blockchain. Here’s why:
Liquidity and Trading
Stablecoins are often used as a medium of exchange on decentralized exchanges (DEXs). Traders use stablecoins to quickly move in and out of more volatile cryptocurrencies like Bitcoin or Ethereum without needing to cash out into traditional fiat currencies.
Decentralized Finance (DeFi)
DeFi platforms rely heavily on stablecoins. Lenders and borrowers use stablecoins as collateral, ensuring that their loans or savings won’t lose value overnight due to market volatility.
Onboarding to Crypto
Stablecoins offer a familiar value system for people new to crypto. Instead of having to understand complex pricing of volatile assets, newcomers can start by using a digital currency that mirrors traditional money.
Safety from Market Crashes
During significant market downturns, investors often convert their holdings into stablecoins to protect their portfolios. This acts like a “safe haven” during turbulent times.
Popular Examples of Stablecoins
Let’s take a look at some of the most widely used stablecoins in the cryptocurrency space:
- Tether (USDT): The largest and most popular stablecoin, pegged to the US dollar.
- USD Coin (USDC): A highly regulated stablecoin backed by US dollar reserves, known for its transparency.
- DAI: A decentralized stablecoin backed by crypto assets, primarily used in DeFi applications.
Because of their proven stability, both USDT and USDC are accepted as payment methods for many products sold in the Gala ecosystems. Additionally, payments are also accepted in both GUSDT and GUSDC, the GalaChain-bridged versions of these Ethereum-based stablecoins.
Each of these stablecoins offers unique benefits depending on the use case—whether it’s transparency, decentralization, or regulatory compliance.
Stablecoins are the unsung heroes of the cryptocurrency world, bringing much-needed stability to a notoriously volatile market. They are an essential bridge between the traditional financial system and the world of Web3, facilitating everything from day-to-day transactions to more complex decentralized financial activities. Whether you’re new to blockchain or a seasoned crypto trader, stablecoins play a pivotal role in making digital assets more accessible and usable.
