What Are Stablecoins and How Do They Work?

What Are Stablecoins and How Do They Work?

In this article, you will learn the 101 of this crypto token class, how they work, how to buy them, and their pros and cons.

Stablecoins are cryptocurrencies whose value is pegged to a fiat currency like the US dollar, other cryptocurrencies, or a commodity like oil or gold, resulting in a relatively stable price.

Key takeaways:

• Designed to maintain price stability, stablecoins bridge the gap between fiat currencies and cryptocurrencies
• They are pegged to traditional assets such as fiat currencies or gold, making them a less volatile alternative than typical cryptocurrencies 
• Promising faster transactions and lower costs, stablecoins are an attractive alternative to traditional banking
• They allow traders to keep their money in the crypto ecosystem while storing them in a stable asset between trades or during volatile periods

Stablecoins are cryptocurrencies that have their price pegged to a specific asset – which is most often, but not always, the United States dollar. 

But what makes this type of cryptocurrency so special compared to classic crypto tokens?

You are probably aware of the drastic ups and downs of valuation of some traditional cryptocurrencies within a short period of time. Recalling the historical price of Bitcoin in February of 2021, it nearly doubled in price from around USD 32,000 to USD 58,000, but then dropped dramatically in May back to around USD 34,000. 

Such fluctuations, or so-called ‘short-term volatility’, make these cryptocurrencies unfavourable for everyday use by the public. 

Serving the purpose of maintaining the value and purchasing power, pegging with assets can make stablecoins more resilient from market fluctuations in cryptocurrency space. For instance, one of the most popular stablecoins – Tether (USDT) – is equal to USD 1 at nearly all times. Other popular stablecoins include USD Coin (USDC) and TerraUSD (UST).

Unlike other cryptocurrencies, not only does a stablecoin have significantly lower volatility due to its asset-backed nature, it also plays a bridging role in the world of cryptocurrencies and fiat currencies to facilitate daily commercial transactions and exchange. 

Benefits of stablecoins include:

• Lower volatility 
• Lower-cost transactions
• Safe option to keep assets in the crypto ecosystem
• Real-time payments

These benefits make stablecoins more competitive than other crypto tokens as they touch on consumer and business painpoints of Bitcoin and other tokens that offer neither stability nor scalability to real-time transactions.

Today, the total market capitalisation of all the stablecoins in the world has reached more than USD 150 billion. They command more than half of the global crypto trade volume, making them an important asset in the DeFi ecosystem.

There are four types of stablecoins:

• Fiat collateralised stablecoins (the most popular)
• Crypto-backed stablecoins
• Commodity-backed stablecoins
• Non-collateralised stablecoins

The primary use for a stablecoin is facilitating trades on crypto exchanges. Instead of buying Bitcoin directly with fiat currency, like the US dollar, traders often exchange fiat for a stablecoin – and then execute a trade with the stablecoin for another cryptocurrency like bitcoin or ether. 

Stablecoins can also act as payment alternatives. By utilising stablecoins, businesses can accept payments at a very low cost and governments could run conditional cash transfer programs easier than before. Due to its fast as thunder transaction, stablecoins can also be used to distribute monetary aid to beneficiaries worldwide. 

Another use for stablecoins is to send funds across international borders. Sol Digital, a stablecoin that’s pegged to the sol, Peru’s national currency, launched on the Stellar blockchain in September. It can be exchanged between individuals in different countries without third-party fees for cross-border money transfers.

The pegging of stablecoins is near-perfectly one-to-one through various methods including:

Reserving of pegged assets (e.g. USDC, USDT)

It refers to a fully collateralised system backed by the pegged asset, where arbitrageurs are incentivised by helping to stabilise the price. When the price of the stablecoin is lower than the pegged asset, the arbitrageurs can buy cheaper stablecoin, which can then be redeemed for USD 1 each. Similarly, when the price is higher than the pegged asset, they can sell the coins to gain profits.

Dual coins

Two coins exist in these kinds of systems, where one is the pegged coin while a secondary coin is used to absorb the volatility of the pegged coin.

Algorithmic coins

Instead of using any reserve or being backed by assets, these kinds of stablecoins use a fully algorithmic approach to adjust the supply of the stablecoin in response to price fluctuations. However, a stable algorithmic coin only exists in theory. None currently exist in the market.

Leveraged loans (e.g. DAI)

This kind of stablecoin is backed by an over-collateralised system. The most successful example is DAI, in which the stablecoin is backed by PETH, and its value is correlated to Ethereum. Since the collaterals are more volatile in terms of price, users need to have more than USD $1.5 worth of PETH to borrow USD $1 of DAI. If the collateral price falls sharply, the debt position will be liquidated, and the remaining amount of collateral will be returned to the user.

A common concern over stablecoins is whether they are less secure than US regulated bank accounts or money market funds. Investors can mitigate this in two ways: the first is the classic crypto advice of DYOR – do your own research – before investing. Check the issuing entity, their history and past projects, in detail before trusting them with your funds. Further, investors can easily move into other stablecoins or even other cryptocurrencies if investors lose confidence in a coin as volatility is not an issue. However, based on its nature and mechanism, the risk of failure or volatility is near zero for established stable coins if they are sufficiently pegged by the issuers.

Currently, stablecoins regulations are still up to discussion in most jurisdictions. For example in the US, the President’s Working Group on Financial Markets, composed of the heads of the US Treasury Department, Federal Reserve, SEC, and CFTC, has released a report in Nov 2021. It raises the risks related to lack of transparency, market integrity, and investor protection. Legislation to regulate stablecoin issuers is proposed but yet to be enacted.

With the growing acceptance of cryptocurrencies and the steadiness that stablecoins bring to the DeFi, their integral role in the ecosystem, providing ease of trading crypto, staking, and lending is cemented. While legislation of some countries may place additional restrictions and requirements on stablecoins issuers, it is also anticipated that financial regulatory agencies and related stakeholders will continue to work closely on ways to foster financial innovation while minimising associated risks. 

What is a Crypto Wallet? A Beginner’s Guide

 

What is a Crypto Wallet? A Beginner’s Guide

Hot wallets vs cold wallets. Custodial or non-custodial. If you are confused by the different types of crypto wallets on the market, you have come to the right place.

Key Takeaways

• Contrary to popular belief, crypto wallets do not physically hold cryptocurrencies like the wallet in your pocket
• Instead, they store the public and private keys required to buy cryptocurrencies and provide digital signatures that authorise each transaction
• There are several types of crypto wallets including physical devices, software, and even paper
• Determining which crypto wallet is best for you depends entirely on your individual trading needs 

What is a Crypto Wallet?

Cryptocurrency wallets store users’ public and private keys while providing an easy-to-use interface to manage crypto balances. They also support cryptocurrency transfers through the blockchain. Some wallets even allow users to perform certain actions with their crypto assets such as buying and selling or interacting with decentralised applications (DApps).

It is important to remember that cryptocurrency transactions do not represent a ‘sending’ of crypto tokens from your mobile phone to someone else’s mobile phone. When you are sending tokens, you are actually using your private key to sign the transaction and broadcast it to the blockchain network. The network will then include your transaction to reflect the updated balance in your address and the recipient’s.

So, the term ‘wallet’ is actually somewhat of a misnomer as crypto wallets don’t really store cryptocurrency in the same way physical wallets hold cash. Instead, they read the public ledger to show you the balances in your addresses and also hold the private keys that enable you to make transactions.

Not sure what a public or private key is? 
A key is a long string of random, unpredictable characters. While a public key is like your bank account number and can be shared widely, your private key is like your bank account password or PIN and should be kept secret. In public-key cryptography, every public key is paired with one corresponding private key. Together, they are used to encrypt and decrypt data.

Why You Need a Crypto Wallet

Your cryptocurrency is only as safe as the method you use to store it. While you can technically store crypto directly on the exchange, it is not advisable to do so unless in small amounts or if you plan to trade them frequently. 

For larger amounts, it’s recommended that you withdraw the majority to a crypto wallet, whether that be a hot wallet or a cold one. This way, you retain ownership of your private keys and have full power and control over your own finances. 

How do Cryptocurrency Wallets Work?

As mentioned earlier, a wallet doesn’t actually hold your coins. Instead, it holds the key to your coins which are actually stored on public blockchain networks. 

In order to perform various transactions, you’ll need to verify your address via a private key that comes in a set of specific codes. The speed and security often depend on the kind of wallet that you have.

Different Types of Crypto Wallets

There are two main types of crypto wallets: software-based hot wallets and physical cold wallets. Read on to learn about the different types of cryptocurrency wallets, and which is best for you and your needs. 

Hot and Cold Wallets – What’s the Difference?

Hot Wallets

The main difference between hot and cold wallets is whether they are connected to the Internet. Hot wallets are connected to the Internet, while cold wallets are kept offline. This means that funds stored in hot wallets are more accessible, and are easier for hackers to gain access to.

Examples of hot wallets include:

• Web-based wallets
• Mobile wallets
• Desktop wallets

In hot wallets, private keys are stored and encrypted on the app itself, which is kept online. Using a hot wallet can be risky because computer networks have hidden vulnerabilities that can be targeted by hackers or malware programs to break into the system. Keeping large amounts of cryptocurrency in a hot wallet is a fundamentally poor security practice, but the risks can be mitigated by using a hot wallet with stronger encryption, or by using devices that store private keys in a secure enclave.

There are different reasons why an investor might want their cryptocurrency holdings to be either connected or disconnected from the Internet. Because of this, it’s not uncommon for cryptocurrency holders to have multiple cryptocurrency wallets, including both hot and cold wallets.

Cold Wallets

As introduced at the beginning of this section, a cold wallet is entirely offline. While they’re certainly not as convenient as hot wallets, they are far more secure. An example of a physical medium used for cold storage is a piece of paper or an engraved piece of metal.

Examples of cold wallets include:

• Paper wallets
• Hardware wallets

What is a Paper Wallet?

A paper wallet is a physical location where the private and public keys are written down or printed. In many ways, this is safer than keeping funds in a hot wallet, since remote hackers have no way of accessing these keys which are kept safe from phishing attacks. On the other hand, it opens up the potential risk of the piece of paper getting destroyed or lost, which may result in irrecoverable funds.

What is a Hardware Wallet?

A hardware wallet is an external device (usually a USB or Bluetooth device) that stores your keys. You can only sign a transaction by pushing a physical button on the device, which malicious actors cannot control.

For any cryptocurrency assets that you do not need instant access to, the best practice is to store them offline in a cold wallet. However, users should note that this also means that securing your assets is entirely your own responsibility. So it’s up to you to make sure that you don’t lose it or have it stolen!

Tip: For increased security, separate your public and private keys, keep them offline, and store your physical wallet in a safe deposit box. 

Hot Wallets vs Cold Wallets: Which is Better?

While both methods of storage have benefits and drawbacks, the option you choose will depend on what you are looking for. For example:

• If you plan to trade day-to-day, then accessibility will be of paramount importance, meaning that a hot wallet is probably an apt choice.
• However, if you are considering storing a huge amount of crypto assets and value security over convenience, then it might be wise to invest in a cold wallet.

Custodial and Non-Custodial Wallets

In addition to the wallets mentioned above, wallets can be further separated into custodial and non-custodial types.

Custodial Wallets

Most web-based crypto wallets tend to be custodial wallets. Typically offered on cryptocurrency exchanges, these wallets are known for their convenience and ease of usage, and are especially popular with newcomers, as well as experienced day traders. 

The main difference between custodial wallets and the types mentioned above is that users are no longer in full control of their tokens, and the private keys needed to sign for transactions are held only by the exchange.

The implication here is that users must trust the service provider to securely store their tokens and implement strong security measures to prevent unauthorised access. These measures include two-factor authentication, email confirmation, and biometric authentication, such as facial recognition or fingerprint verification. Many exchanges will not allow you to make transactions until these security measures are properly set up by the user.

Exchanges and custodial wallet providers will usually also take further steps to ensure the safety of users’ tokens. For example, a portion of the funds is usually transferred to the company’s cold wallet, where they can be safe from online attackers.

At Crypto.com, we have taken many measures to ensure the protection of customer funds. After rigorous security audits by a team of cybersecurity and compliance experts, Crypto.com is the first crypto company in the world to have obtained ISO/IEC 27701:2019, ISO22301:2019, ISO27001:2013 and PCI:DSS 3.2.1, Level 1 compliance, and independently assessed at Tier 4, the highest level for both NIST Cybersecurity and Privacy Frameworks, as well as Service Organization Control (SOC) 2 compliance.

Additionally, we have in place a total of US$360 million for insurance protection of customer funds.

Non-Custodial Wallets

Non-custodial wallets, on the other hand, allow you to retain full control of your funds since the private key is stored locally with the user.

When starting a non-custodial wallet, you will be asked to write down and safely store a list of 12 randomly generated words, known as a ‘recovery’, ‘seed’, or ‘mnemonic’ phrase. From this phrase, all of your public and private keys can be generated. This acts as a backup or a recovery mechanism in case you lose access to your device.

Anyone with the seed phrase will be able to gain full control of the funds held in your wallet. In a case scenario where the seed phrase is lost, you will lose access to your funds. So it is imperative to keep the mnemonic phrase in a secure location, and to not store a digital copy of it anywhere! Do not print it out at a public printer or take a picture of it with your phone.

Note that hardware wallets are inherently non-custodial since private keys are stored on the device itself. There are also software-based non-custodial wallets, such as the Crypto.com Wallet. The common theme here is that the private keys and the funds are fully in users’ control. As the popular saying within the crypto community goes, ‘not your keys, not your coins!’

On the flip side, however, this means that users must be in charge of their own security, with regard to the storage of passwords and seed phrases. If any of these are lost, recovery can be difficult or impossible since they are typically not stored in any third-party server.

Custodial vs Non-Custodial Wallets: Which is Better?

Custodial and non-custodial wallets have different pros and cons that make them suitable for different types of users:

• If you are prone to losing passwords and devices, then it makes more sense to use a custodial wallet, since an exchange or custodian is likely to have better security practices and backup options. That’s why it’s a popular option for beginners who have little to no experience trading crypto. Further, transaction fees with a custodial wallet tend to be cheaper or even free. 

• However, if you prefer to retain full control over your own funds, you might want to consider a non-custodial wallet.

Ultimately, it all comes down to your choice.

For Additional Security, Consider Multi-Signature Wallets

Multi-signature wallets – or multisig wallets – are wallets that require two or more private key signatures to authorise transactions. This solution is useful for a number of use cases:

• An individual using a multisig wallet can prevent losing access to the entire wallet in a case scenario where one key is lost. For example, if a user loses one key, there will still be two other keys that are able to sign transactions.

• Multisig wallets can prevent the misuse of funds and fraud, which makes them a good option for hedge funds, exchanges, and corporations. As each authorised person will have one key and a sign-off requires the majority of keys, it becomes impossible for any individual to unilaterally make unauthorised transactions.

Any of the wallet types described above have multisig versions. You can have multisig hot wallets, cold wallets, hardware wallets, and so on.

Which Crypto Wallet Should You Use?

When it comes to crypto wallets, there is no perfect solution. Each type of wallet has different strengths, purposes, and trade-offs. So it’s really up to you to weigh up what works best for you and your specific needs. 

• For those with a high risk tolerance who want to make regular, quick online payments, the convenience of a hot wallet would suit you best.
• But if you’re a little more gun-shy and intend to hold your coins long-term, then a secure offline device might make the most sense. 
• And if it’s the NFT market that you’re interested in, then you need to look for a wallet that is compatible with NFT marketplaces such as OpenSea, Solanart, and Crypto.com. 

When choosing a crypto wallet, there are certain factors you should take into consideration. These include:

• Software vs hardware
• Security features
• How user-friendly it is
• Fees
• Supported coins
• Platform compatibility
• Whether you need DApp and DEX integration
• Whether the wallet has backup options
• The wallet’s reputation and longevity on the market

As storing large quantities of coins in a single wallet is quite risky, a combination of cold and hot wallets is usually ideal, and can help you strike the right balance between convenience and security. 

The final choice remains yours, with the non-custodial Crypto.com Defi Wallet one of many secure options.