The complete guide to stablecoins: What it is and how it works
Traditional crypto assets are often subject to wild price fluctuations. With stablecoins, crypto investors have a less risky option to make the most of their digital assets.
Stablecoins are pegged to a fiat currency, giving them a more steady value compared to other cryptocurrencies. To give you more idea of what is a stablecoin and how stablecoin works, here’s a guide you need to check out:
Background of stablecoins
Learning stablecoins basics will help you answer the question ‘What are stablecoins?’ right away. To do so, you need to delve into the early days of crypto and the challenges it faced. When Bitcoin (BTC), the first decentralised crypto, was introduced in 2009, it sparked a wave of innovation and excitement in the financial world.
However, one of the inherent features of Bitcoin and the other early assets is its high volatility. Their prices fluctuate wildly within a short period, making them less suitable for everyday transactions and stores of value.
As developers and entrepreneurs recognised the need for stability in the crypto space, they began exploring the concept of a stablecoin.
The idea was to create digital currencies that could maintain a stable value, mirroring the stability of traditional fiat currencies like the US dollar or euro. With this goal in mind, various stablecoins were created to offer users a reliable and stable medium of exchange.
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How do stablecoins work?
Stablecoins work by implementing various mechanisms to maintain a stable value. As mentioned, stablecoins are pegged to fiat currency like the US dollar or a commodity like gold. Stablecoins like Tether (USDT) depend on the currency it’s anchored to—in this case, it’s the US Dollar. This means that every 1 USDT is backed by 1 US Dollar. The same concept applies to other stablecoins in the market.
Characteristics of stablecoins
With stablecoins explained, you can now easily spot a virtual currency stablecoin, thanks to its unique features. Other characteristics of stablecoins include:
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Asset-backed → Many stablecoins are backed by assets to ensure a stable value. These backed assets provide collateral that assures the stablecoins have an underlying value and can be redeemed or exchanged.
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Transparency → The issuers of stablecoins often provide regular audits or verifications to ensure transparency. This includes the assets held as collateral, the supply of stablecoins, and the mechanisms employed to maintain stability.
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Regulatory compliance → Stablecoins are subject to increasing regulatory scrutiny. To maintain stability and build trust, stablecoin issuers often comply with relevant regulations such as anti-money laundering (AML) and know-your-customer (KYC) requirements. Compliance with regulatory standards helps protect users and ensures the stability and integrity of the stablecoin ecosystem.
Stablecoin benefits: What you need to know
Many crypto users do not pass up the chance to take advantage of the stablecoin mechanism as it comes with various perks. Here are the top benefits once you buy stablecoins:
Price stability
Stablecoins aim to maintain a stable value, making them a more reliable medium of exchange and store of value than other coins. Their price stability reduces uncertainty and allows you to transact or hold assets without worrying about major value fluctuations.
Reduced volatility risk
By design, stablecoins minimise the volatility risk often linked with coins like BTC or ETH. This stability can be beneficial for businesses and investors engaged in commerce, as it reduces the likelihood of sudden price swings affecting transaction values.
Fiat-like features
Coins like USDT often mimic the features of traditional fiat currencies such as the US dollar or euro. Stablecoins provide many perks that come with fiat currencies, including ease of use, widespread acceptance, and affinity with existing financial frameworks.
Types of stablecoins
There are several types of stablecoins, each employing different mechanisms to maintain price stability. Every stablecoin type is as follows:
Algorithmic stablecoin
Algorithmic stablecoins rely on smart contracts and algorithms to regulate supply and stabilise their value. They do not require collateral or external assets. Instead, the algorithms monitor the demand and supply dynamics of the stablecoin and adjust its quantity accordingly.
If the price of the stablecoin goes above the target value, the algorithm can increase the supply to bring it back down. Conversely, the supply may be reduced if the price falls below the target value. These adjustments aim to maintain the stablecoin's stability. Examples of algorithmic stablecoins include Ampleforth (AMPL) and Basis Cash (BAC).
Commodity collateral type stablecoin
These stablecoins are pegged to the value of physical assets like gold or other commodities. When it comes to commodity collateral type stablecoin, the issuer holds reserves of the underlying asset to back the stablecoin's value. Examples include PAX Gold (PAXG), which is backed by physical gold, and Digix Gold Token (DGX), which represents ownership of physical gold stored in vaults.
Crypto-collateralised stablecoin
Crypto-collateralised stablecoins are backed by digital currencies held as collateral. The stablecoin issuer holds a pool of coins often of higher value than the stablecoin itself. Smart contracts and algorithms monitor the collateral's value and ensure it remains above a certain threshold to maintain stability. A popular example of a crypto-collateralised stablecoin is DAI.
Fiat-collateralised stablecoin
These stablecoins are backed by reserves of fiat currency, such as the US Dollar or Euro, held in bank accounts. For each stablecoin issued, an equivalent amount of the fiat currency is kept in reserve. Examples of fiat-collateralised stablecoins include Tether (USDT), USD Coin (USDC), and TrueUSD (TUSD).
Frequently asked questions about stablecoins
Learn more about stablecoins with these frequently asked questions:
What can you do with stablecoins?
Stablecoins can be used as a medium of exchange for various transactions.
What is the purpose of stablecoins?
According to the stablecoin definition, the purpose of these coins is to address some of the limitations and challenges associated with traditional cryptocurrencies like BTC. Simply, stablecoins aim to provide stability and a predictable value.
What are stablecoins used for?
Stablecoins have a variety of uses. They can be used for stablecoin betting, paying for goods and services, and transferring funds quickly and securely.
Is stablecoin safe?
Stablecoins are considered safer compared to other coins due to their stable value.
How do stablecoins stay stable?
Stablecoins maintain a stable value by pegging to a fiat currency like the US dollar.
If you are looking for a stable option in the volatile crypto market, you should buy stablecoins. Not only are they asset-backed, but most stablecoins are also easily accessible and are supported by various exchanges.
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