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Lesson in Course: Crypto (advanced, 6min )
Not all cryptocurrencies are volatile. How can we invest in crypto without the price swings?
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 and can be hard to decide when to make purchases.
Stablecoins were created to address these issues.
Stablecoins limit price fluctuations by pegging their value to another underlying asset. This creates a relatively fixed exchange rate.
People have turned to stablecoins as an alternative to their national currencies in uncertain economic and political conditions, addressing inflation concerns or avoiding 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.
Stablecoins typically use commodities, fiat currencies, and other cryptocurrencies as underlying assets to peg their prices.
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.
For example, $1 million would be held at a bank to support 1 million units of stablecoin. If the network grows, adding more coins, the bank would need to add more dollars to keep the price fixed.
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.
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 destroy coins if the price falls too much.
Here's a list of widely used stablecoins.
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. We can learn how exchanges work alongside of taking away the timing risk for us -- lowering the chance of our money quickly losing value in case we bought it when the price was at a peak.
Cryptocurrency with limited price fluctuations by pegging their value to another underlying asset, usually to a fiat currency like the US dollar. They can also be backed by a commodity or other cryptocurrencies. Some aren't backed by anything but an algorithm that controls the supply.