What are stablecoins – How They Work & Types Explained

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Stablecoins are a type of cryptocurrency that are designed to minimize the volatility of the price of the coin, relative to some “stable” asset or basket of assets. This stability is typically achieved by pegging the value of the stablecoin to the value of an asset such as the US dollar or gold. Some popular examples of stablecoins include Tether (USDT), USDC, and DAI.

How Are Stable Coins Used?

Stablecoins are used for a variety of purposes, including as a store of value, a medium of exchange, and a unit of account. They are often used to facilitate transactions on blockchain platforms, such as trading cryptocurrencies on decentralized exchanges, and can also be used to make purchases or pay for services in the real world. Additionally, they can be used as a hedge against volatility in the value of other cryptocurrencies.

One way stablecoins are used in crypto trading is as a means to move funds between different exchanges without incurring large price fluctuations. For example, let’s say you have some Bitcoin on an exchange that does not have the trading pair that you want to trade into. You can first convert your Bitcoin into a stablecoin such as USDT, transfer it to the other exchange that does have the desired trading pair, and then convert it back into the desired cryptocurrency. Since USDT is pegged to the value of the US dollar, the value of your funds should remain relatively stable during this process. This allows you to avoid any significant losses due to price volatility while moving your funds.

stablecoins

Additionally, stablecoins can also be used to trade with leverage. Leveraged trading allows you to trade with more money than you have in your account, which means you can make larger trades and potentially greater profits. However, it also means that you can lose more money if the trade goes against you. By using stablecoins in leveraged trading, you can limit the amount of risk you take on as the value of the stablecoin should remain relatively stable.

When the price of a cryptocurrency is dropping, using stablecoins can be a way to protect your assets from losing value. By converting your cryptocurrency into a stablecoin that is pegged to a stable value such as the US dollar, you can avoid the potential loss in value that would occur if you held onto your cryptocurrency during a price drop.

For example, let’s say you have $10,000 worth of Bitcoin and you see that the price is starting to drop. By converting your Bitcoin into a stablecoin such as USDT, you can ensure that your $10,000 investment is preserved. Once the price of Bitcoin stabilizes or starts to rise again, you can then convert your USDT back into Bitcoin and potentially make a profit.

Additionally, stablecoins can also be used to short-sell in the crypto market. Short-selling is a trading strategy where an investor sells an asset they do not own with the hope of buying it back at a lower price. When the price of a crypto is dropping, an investor can short-sell it by borrowing the crypto and then selling it for a stablecoin, with the expectation of buying it back at a lower price in the future and returning the borrowed crypto to the lender and keep the difference as profit.

Algorithmic Stablecoins

Algorithmic stablecoins are a type of cryptocurrency that use algorithms to maintain a stable value, often pegged to a fiat currency such as the US dollar. The stability is achieved by automatically adjusting the supply of the coin based on market demand. This is in contrast to traditional stablecoins, which are backed by reserves of fiat currency or other assets. Algorithmic stablecoins are a relatively new development in the cryptocurrency space and are seen by some as a potential solution to the volatility issues that have plagued many cryptocurrencies.

What are the dangers associated with Algorithmic Stable Coins?

There are several potential dangers associated with algorithmic stablecoins. One of the main concerns is the risk of the algorithm malfunctioning or being manipulated. If the algorithm that controls the supply of the coin is not functioning properly, it could lead to a significant deviation from the target peg, resulting in a loss of value for holders of the coin. Additionally, if the algorithm is not transparent or open-source, it may be vulnerable to manipulation by bad actors, who could exploit loopholes in the code to profit at the expense of other users.

Another concern is the potential for a lack of decentralization. Some algorithmic stablecoin projects rely on a central authority or group of validators to oversee the functioning of the algorithm, which can introduce counterparty risk and make the system more susceptible to censorship.

Additionally, if the underlying assets that the stablecoin algorithm is trying to track the value of is not stable, it will cause the stablecoin value to be unstable too.

Regulatory risks are also a concern for algorithmic stablecoins. As the regulatory landscape for cryptocurrencies is still developing, it is unclear how governments will treat these types of coins. This uncertainty could make it more difficult for algorithmic stablecoin projects to operate and attract investment.

Algorithmic Stable Coins losing their pegs

There are several reasons why an algorithmic stablecoin may lose its peg to the underlying asset, such as a fiat currency or commodity.

It can also be manipulated by bad actors.

Case In Point – Terra Luna.

Luna, also known as Terra or UST, was an algorithmic stablecoin that used a complex system of collateralized debt positions (CDPs) and an autonomous market maker (AMM) algorithm to maintain its peg to the value of a fiat currency such as the US dollar.

The basic idea behind Luna was to use a system of collateralized debt positions (CDPs) to control the supply of the coin. CDPs were smart contracts that allowed users to borrow stablecoins by putting up collateral in the form of other cryptocurrencies. The collateral was then used to mint new Luna tokens, which were then sold on the open market.

The autonomous market maker (AMM) algorithm, which was called the “Keeper” algorithm, was responsible for maintaining the peg of Luna to the US dollar by automatically adjusting the supply of the coin based on market demand. The Keeper algorithm used a variety of strategies to buy and sell Luna, including market making, liquidity provision, and price stabilization.

The Luna token was also used as a collateral for other tokens and it was also used to pay for transaction fees on the Terra Station blockchain.

The Luna network also had a governance mechanism, where holders of the token could vote on changes to the network’s parameters and upgrades to the Keeper algorithm.

However, it’s worth mentioning that, the Luna token experienced a significant drop in value, referred as “Luna crash”, and it is no longer actively traded or used in the market.

In summary, stablecoins can be used as a hedging tool during a price drop in the crypto market, they provide a way to preserve the value of your investment and can also be used to potentially profit from the price drop.

Gerald
Geraldhttps://news.safaritravelplus.com
As a writer, I have a passion for exploring a variety of topics. When I'm not putting pen to paper, I enjoy traveling and spending time with my family. As a husband and father, I understand the importance of balance and finding time for the things I love. Whether I'm delving into new subjects or spending quality time with my loved ones.

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