What Is a Stablecoin?
Stablecoins are digital assets that track the value of fiat currencies or other assets. For example, you can purchase tokens pegged to the dollar, euro, yen, and even gold and oil. A stablecoin allows the holder to lock in profits and losses and transfer value at a stable price on peer-to-peer blockchain networks.
In simple terms, a stablecoin is a type of cryptocurrency that is designed to maintain a stable value, unlike most cryptocurrencies, which can experience significant fluctuations in value. The goal of a stablecoin is to maintain a relatively stable price so that users can avoid the volatility risks common in the crypto markets. The most well-known stablecoin is Tether, whose price is tied to the US dollar. With Tether, users can transact or hold their assets in a cryptocurrency that has its value tied to a stable asset, that is, the US dollar.
There are different methods used to maintain the stability of stablecoins, but the most common method is to peg the value of the stablecoin to a fiat currency, such as the US dollar. For example, if a stablecoin is pegged to the US dollar, it may be designed such that each coin is backed by a corresponding amount of US dollars held in reserve. This helps to ensure that the value of the stablecoin remains stable, as fluctuations in the value of the US dollar will be reflected in the value of the stablecoin.
There are three types of stablecoin: fiat-backed, crypto-backed, and algorithmic. Fiat-backed stablecoins, like Tether (USDT), are pegged to traditional fiat currencies. They maintain a peg by keeping fiat reserves that can be exchanged for the stablecoin. Crypto-backed stablecoins (such as DAI) over-collateralize their tokens to factor in crypto price volatility, and algorithmic stablecoins control supply without the need for reserves.
Stablecoins in Crypto
Cryptocurrencies aren’t all about volatility. In fact, some of them are specifically designed to maintain a fixed price: stablecoins. In an industry where coins and tokens can crash overnight, there is a massive demand for currencies that mix blockchain benefits with the ability to track a more stable commodity. If you haven’t started using stablecoins while trading or investing, it’s worth learning more about them as well as the benefits and drawbacks they bring.
Bitcoin (BTC), Ether (ETH), and other altcoins have always historically been volatile. While this provides many opportunities for speculation, it does have drawbacks. Volatility makes it challenging to use cryptocurrencies for day-to-day payments. For example, merchants may take $5 in BTC for a coffee one day but find their BTC worth 50% less the next. This makes it challenging to plan and operate a business around.
Before, crypto investors and traders had no way to lock in a profit or avoid volatility without converting crypto back into fiat. The creation of stablecoins provided a simple solution to these two issues. Today, you can easily get in and out of crypto volatility using stablecoins like USDT or USDC.
How Do Stablecoins Work?
Creating a coin that tracks another commodity’s price or value requires a pegging mechanism. There are multiple ways to do this, and most rely on another asset acting as collateral. Some methods have proved more successful than others, but there is still no such thing as a guaranteed peg.
A fiat-backed stablecoin keeps a fiat currency, such as USD or GBP, in reserves. For example, each USDT is backed up by a real US dollar held as collateral. Users can then convert from fiat into a stablecoin and vice versa at the pegged rate. If the price of the token drifts from the underlying fiat, arbitrageurs will quickly bring the price back to the fixed rate.
Let’s say USDT is trading above one dollar. Arbitrageurs turn US dollars into USDT and sell it for more on the market. This increases the supply of USDT for sale and lowers the price to one dollar again. If USDT trades below one dollar, traders purchase USDT and convert it to USD. This increases demand for USDT, raising its price back to one.
Crypto-backed stablecoins work in a similar way as fiat-backed stablecoins. But instead of using dollars or another currency as reserves, we have cryptocurrencies acting as collateral. As the crypto market is highly volatile, crypto-backed stablecoins usually over-collateralize the reserves as a measure against price swings.
Crypto-backed stablecoins use smart contracts to manage minting and burning. This makes the process more reliable as users can independently audit the contracts. However, some crypto-backed stablecoins are run by Decentralized Autonomous Organizations (DAOs), where the community can vote for changes in the project. In this case, you will have to get involved or just trust the DAO to make the best decisions.
Algorithmic stablecoins take a different approach by removing the need for reserves. Instead, algorithms and smart contracts manage the supply of the tokens issued. This model is much rarer than crypto or fiat-backed stablecoins and more challenging to run successfully.
Essentially, an algorithmic stablecoin system will reduce the token supply if the price falls below the fiat currency it tracks. This could be done via locked staking, burning, or buy-backs. If the price surpasses the value of the fiat currency, new tokens enter into circulation to reduce the stablecoin’s value.
Are Stablecoins Regulated?
Stablecoins have caught regulators’ interest worldwide due to their unique mix of fiat and crypto. As they are designed to maintain a stable price, they are useful for reasons other than speculation. They also can be transferred internationally cheaply and quickly. Some countries are even experimenting with creating their own stablecoins. As a stablecoin is a type of cryptocurrency, it will likely fall under the same regulations as crypto in your local jurisdiction. Issuing stablecoins with fiat reserves may also need regulatory approval.