What are Stablecoins & How Do They Work?

Cryptocurrencies are known for their volatility. The price of a crypto asset can swing wildly over a short period of time, leading to huge losses and a destabilization of the market. And while Bitcoin may be relatively stable due to its popularity and investor trust, this doesn’t prevent the Bitcoin price from quick upward or downward shifts.

Stablecoins were created to bring calmness to the crypto space by providing an asset that can hold its value over time, similar to fiat currency. But what exactly are they, and how do they work?

What are Stablecoins?

Stablecoins are cryptocurrencies whose value is pegged, or tied, to another more stable asset. This asset can be another currency, commodity, or financial instrument. 

The aim of stablecoins is to provide a cryptocurrency that can avoid the frequent price swings synonymous with crypto assets such as Bitcoin and Ethereum. They can therefore be used as a medium of exchange, whether you want to acquire another cryptocurrency or simply pay for goods and services using cryptocurrency. 

The fact that you can predict the price of stablecoins inspires trust in these assets and also boosts the entire cryptocurrency market. They also help make crypto more mainstream, as users can hold these digital assets without fear of a price crash.

How Stablecoins Work

The whole idea behind stablecoins is collateralization. This means that these coins are insured, such that their positive and negative price movements can be corrected, helping maintain stability.

Ideally, the collateralization of stablecoins is 1:1. For example, if a stablecoin is pegged against the US dollar, the company issuing the stablecoin should have USD reserves equal to the amount of stablecoins issued. This will ensure that the price of the stablecoin does not fluctuate, and the company can intervene to correct it when necessary.

However, the pegging of stablecoins can differ from one coin to the other.

Fiat-collateralized Stablecoins

Stablecoins backed by fiat currency are the most common, and they were also the first in the market. Most of these coins are backed against the USD, but there are also others pegged on the euro (EUR) and Japanese yen (JPY).

In these types of stablecoins, the fiat currency acts as the collateral, and the stablecoin-issuing company needs to store an equivalent amount of fiat currency in traditional banks. If a stablecoin holder cashes out their tokens, an equal amount of the fiat is then released from the reserve. 

Tether USD (USDT) is the most popular fiat-collateralized stablecoin, and it’s widely used to trade other cryptocurrencies.

Crypto-collateralized Stablecoins

A more complex version of stablecoins is one that is backed by other cryptocurrencies. In these types of stablecoins, the user has to provide their own cryptocurrency to get newly minted stablecoins. However, since cryptocurrencies are volatile, a higher value of cryptocurrency is required, so there’s over-collateralization. This is important as the higher value can be used as a buffer against market volatility and price fluctuations.

To make this kind of collateralization work, crypto-collateralized stablecoins use smart contracts or decentralized autonomous organizations (DAO) to manage the collateralization process and ensure everything is transparent and secure. MakerDAO is the most famous stablecoin issuer that uses this mechanism.

Commodity-collateralized stablecoins

Besides fiat currency, there are also stablecoins that are pegged against physical commodities, more specifically, precious metals such as gold and silver. These stablecoins use tangible assets unit-for-unit, and the collateral is held in secure storage facilities. A good example is Tether Gold (XAUT), which uses a unit of XAUT to represent one unit of physical gold.

Note that since these commodities can change in price, the stablecoin will also change with it. While it will not deviate from the pricing of the commodity, a rise in the price of gold would mean more value for a stablecoin based on gold.

Algorithmic Stability

Besides regular collateralization, there’s a novel way of achieving stability that is not based on fiat currency, commodities, or other cryptocurrencies. This method uses complicated algorithms to manipulate the prices of a stablecoin to maintain it at a particular level. The stablecoins can therefore be set to mimic the USD price with no reserve backing.

To make this possible, stablecoins based on algorithmic stability use smart contracts or decentralized algorithms to govern the issuance and redemption of stablecoins. These mechanisms monitor market conditions such as supply and demand dynamics, trading volume, and price fluctuations. They then adjust the token supply to either increase or decrease the price of the stablecoin.

While this method may not be as reliable as backing against actual reserves, these coins help avoid the centralization of stablecoins. 

Do stablecoins have any Drawbacks?

While stablecoins offer stability and borderless payments, they are not perfect. This is because fiat and commodity-backed stablecoins rely on tech firms for regulation, which eliminates transparency. You will need to trust that a company has the number of reserves it advertises, something that has been proven questionable for several of them (including USDT). 

The companies that develop these stablecoins can also have way more control than is expected in crypto. For example, USD Coin (USDC) openly has a back door to stop payments if coins are used in an illicit manner. 

Algorithm-based stablecoins help restore transparency and decentralization, but their code is not perfect yet.

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