You’ve probably heard of stablecoins: they get a lot of media attention. But more than a fad, stablecoins are a crucial part of the DeFi ecosystem. See, they let you earn a yield in a cryptocurrency that matches the price of a traditional currency. So your payouts will be more, er, stable – and that’s appealing. But what exactly are stablecoins? And why are they so important to DeFi? Read on to find out.
1. What are stablecoins?
Like bitcoin and ether, stablecoins are digital assets that you can send from point A to point B over the blockchain. But unlike bitcoin and ether, stablecoins are designed to match the value of a fiat currency – like, say, the US dollar.
In the DeFi-verse, you can choose to earn your yield in stablecoins. And seeing as lots of regular coins and tokens can be quite volatile, many people prefer to do it that way.
Stablecoins can have the benefits of blockchain technology without the associated volatility in price. You can ping them across the blockchain quickly and cheaply – and you don’t need a bank’s permission to do it. Plus, the blockchain won’t charge you extra (not to mention make the process more cumbersome) when you send stablecoins across international waters.
There are two kinds of stablecoins you should be aware of: centralized and decentralized.
2. Centralized stablecoins
You can think of centralized stablecoins like the gold standard in the early 1900s, where countries backed their currencies with equal amounts of gold.
Centralized stablecoins require a project to be responsible for keeping the coin’s price in line with the dollar (or any other fiat currency). To do that, the project holds cash reserves and other assets on its balance sheet. Each time it mints new stablecoins, it must also increase its reserves by the same amount. That way, when traders want to swap stablecoins for actual dollars, the project has those funds on hand to pay them out.
The biggest centralized stablecoins right now, by market size, are Tether (USDT), USD Coin (USDC), and Binance USD (BUSD).
Your biggest risk with centralized stablecoins is “counterparty risk.” That’s the risk that the project backing the stablecoin doesn’t have the assets to do so, and it’s why regulators are calling for more auditing.
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4. Decentralized stablecoins
Decentralized stablecoins – unlike their centralized counterparts – have no central organization that keeps the token’s price in line with the dollar (or other fiat currency). Rather, they run off of some kind of algorithm that incentivizes certain people in the crypto market to do certain things to maintain price stability. They’re also known as algorithmic stablecoins for that reason.
Different stablecoin projects have different algorithms. MakerDao, for example, has a decentralized stablecoin called DAI, which maintains its peg with the US dollar through a borrowing mechanism built into its protocol. You can read more about that here.
DAI has been stable since 2019, but not all decentralized stablecoins have had the same success. Terra USD, for example, crashed 99.9% against the US dollar in May 2022 after a series of events that effectively led to a bank run on the token.
- Stablecoins are a crucial part of the DeFi ecosystem: they let you earn a yield in a cryptocurrency that matches the price of a traditional currency.
- Centralized stablecoins require a project to be responsible for maintaining the token’s price, by way of holding cash reserves.
- Decentralized stablecoins rely on algorithms to stay pegged – but those algorithms don’t always work as intended.
This guide was produced in partnership with Ledger.