What Are Stablecoins? | Definition, How They Work, Types

by Mar 3, 2024Technical Terms0 comments

In the ever-evolving landscape of cryptocurrencies, a new class of digital assets has emerged to address the issue of price volatility: stablecoins. These unique cryptocurrencies offer a more stable and predictable value compared to their volatile counterparts like Bitcoin and Ethereum. But what exactly are stablecoins, and how do they work?

This article aims to provide a comprehensive understanding of stablecoins, exploring their definition, underlying mechanisms, and different types. We will delve into the fundamental concepts behind stablecoins, examine their working principles, and shed light on the various forms they can take. Whether you’re a cryptocurrency enthusiast, investor, or simply curious about the evolving financial landscape, this article will equip you with the knowledge to navigate the world of stablecoins with confidence. So, let’s dive in and unravel the fascinating realm of stablecoins, their functions, and the diverse types that exist in today’s digital economy.

What Are Stablecoins?

A stablecoin is a type of cryptocurrency that is designed to have a stable value, unlike other cryptocurrencies that can have big price changes. It is called “stable” because its value is meant to stay relatively the same over time.

Stablecoins

The reason stablecoins are created is to provide a digital currency that can be used for buying things, investing, or saving money, without worrying about its value suddenly going up or down a lot. This stability makes stablecoins more similar to traditional money like the US dollar or euro.

Stablecoins achieve this stability by being “pegged” to something else, like a real-world currency or a commodity. For example, some stablecoins are pegged to the US dollar, which means that 1 stablecoin is supposed to be equal to 1 US dollar.

To make sure that the value stays stable, the people who create stablecoins usually keep reserves of the thing they are pegged to. So, for every stablecoin that exists, there is a reserve of the underlying asset (like US dollars) held in a bank account or other secure storage.

This reserve is there to give people confidence that they can always exchange their stablecoins for the underlying asset whenever they want, ensuring the stability of the value. Some stablecoins even get regular audits to make sure that the reserves are there and the value is being maintained.

Why Are Stablecoins So Important?

Bitcoin, undoubtedly the most renowned cryptocurrency, has gained widespread popularity. However, its inherent volatility poses challenges for routine transactions. The price of Bitcoin can experience significant fluctuations within short periods, making it a risky endeavor for both buyers and sellers. While such volatility may benefit traders, it hampers the potential for cryptocurrencies to serve as a stable medium of exchange.

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The need for stability in a non-fiat currency arises from the requirement for assurance that its value will retain purchasing power over the short term. Traditional fiat currencies rarely exhibit daily movements exceeding 1% in forex trading. To address this issue, stablecoins have emerged as a solution, aiming to maintain a consistent value for cryptocurrencies through various mechanisms.

This article explores the impact of Bitcoin’s volatility on transactions and the motivation behind stablecoins. By examining the challenges faced by cryptocurrency users and the importance of stability in non-fiat currencies, we will delve into how stablecoins strive to address these concerns by offering a reliable and steady value.

What Kinds of Stablecoins Are There?

There are differing perspectives on the necessity of stablecoins, with some arguing that they are a solution without a specific problem, considering the widespread availability and acceptance of the U.S. dollar. However, within the cryptocurrency community, there is a belief that the future belongs to digital currencies independent of central bank control. In the realm of stablecoins, there are three distinct types, each employing a different mechanism to maintain a stable value.

Fiat-Collateralized Stablecoins

Fiat-collateralized stablecoins operate by securing a reserve of a specific fiat currency, such as the U.S. dollar, to ensure the stablecoin’s value. These stablecoins may also utilize alternative collateral, including precious metals like gold or silver, as well as commodities such as crude oil. However, the majority of fiat-collateralized stablecoins maintain reserves in U.S. dollars.

These reserves are held by independent custodians and undergo regular audits to ensure transparency and accountability. Notable examples of stablecoins backed by U.S. dollar reserves and pegged to the dollar include Tether (USDT) and TrueUSD (TUSD). As of late July 2023, Tether (USDT) held the position of the third-largest cryptocurrency by market capitalization, with a value exceeding $83 billion.

Crypto-Collateralized Stablecoins

Crypto-collateralized stablecoins derive their backing from other cryptocurrencies. Since the reserve cryptocurrency is also susceptible to market volatility, these stablecoins are designed to be overcollateralized. This means that the value of the cryptocurrency held as reserves exceeds the value of the stablecoins issued.

To mitigate the risk of price fluctuations, an example of overcollateralization could involve holding a cryptocurrency worth $2 million as reserves to issue $1 million in a crypto-backed stablecoin. This ensures protection against a 50% decline in the price of the reserve cryptocurrency. One prominent example of a crypto-collateralized stablecoin is MakerDAO’s Dai (DAI). Dai is pegged to the U.S. dollar but backed by Ethereum (ETH) and other cryptocurrencies, with a total value of 150% of the circulating supply of DAI stablecoins.

Algorithmic Stablecoins

Algorithmic stablecoins differentiate themselves by their approach to maintaining stable value, which may or may not involve holding reserve assets. Instead, these stablecoins rely on algorithms, computer programs running predetermined formulas, to regulate their supply and stabilize their value.

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In some respects, this is reminiscent of central banks, which also maintain stable currency values without relying on reserve assets. However, there is a key distinction. Central banks like the U.S. Federal Reserve establish monetary policies transparently, based on well-defined parameters. Furthermore, their status as issuers of legal tender bolsters the credibility of their policies.

In contrast, algorithmic stablecoin issuers lack these advantages during times of crisis. For instance, on May 11, 2022, the price of TerraUSD (UST), an algorithmic stablecoin, experienced a significant drop of over 60%, causing it to lose its peg to the U.S. dollar. This decline coincided with an overnight slump of more than 80% in the price of the associated Luna token used for Terra’s pegging mechanism.

Stablecoin Regulation

Stablecoin

Stablecoins have attracted increased attention from regulators due to the rapid expansion of the approximately $130 billion market and its potential impact on the broader financial system. In October 2021, the International Organization of Securities Commissions (IOSCO) recommended that stablecoins be subject to regulatory oversight as financial market infrastructure, alongside payment systems and clearinghouses. The proposed regulations primarily target stablecoins that are considered systemically significant by regulators, as they have the potential to disrupt payment and settlement transactions.

Furthermore, there has been growing political pressure to tighten regulations surrounding stablecoins. For example, Senator Cynthia Lummis (R-Wyoming) called for regular audits of stablecoin issuers in November 2021, while others advocated for implementing bank-like regulations for the sector. These calls reflect the increasing scrutiny of stablecoins and the push for greater transparency and accountability within the industry.

What Is the Purpose of Stablecoin?

The purpose of stablecoins is to provide stability and reliability in the world of cryptocurrencies. Here are some key purposes and use cases for stablecoins:

  • Stable Value: The primary purpose of stablecoins is to maintain a stable value over time. They aim to minimize the price volatility that is often associated with other cryptocurrencies like Bitcoin or Ethereum. This stability makes stablecoins more suitable for everyday transactions, store of value, and financial contracts.
  • Medium of Exchange: Stablecoins can be used as a digital medium of exchange, just like traditional fiat currencies. They enable quick and low-cost transactions, both domestically and internationally. Stablecoins offer the benefits of digital currencies, such as speed, security, and borderless transferability, while minimizing the risks of price fluctuations.
  • Store of Value: Stablecoins provide a way to store value digitally, similar to how people use traditional bank accounts or savings. By holding stablecoins, individuals can protect their funds from the volatility of other cryptocurrencies. Stablecoins offer stability and can serve as a reliable means of preserving wealth over time.
  • Remittances: Stablecoins can facilitate cross-border payments and remittances. They offer a faster and cheaper alternative to traditional money transfer methods, such as wire transfers or international bank transfers. Stablecoins enable individuals to send and receive money globally, bypassing intermediaries and reducing transaction costs.
  • Access to Financial Services: Stablecoins can provide financial services to individuals who are unbanked or underbanked. In regions with limited access to traditional banking systems, stablecoins offer an opportunity to participate in the global financial ecosystem. They can provide a secure and accessible means of storing and transferring value, opening up opportunities for savings and investments.
  • Decentralized Finance (DeFi): Stablecoins play a crucial role in decentralized finance, or DeFi, ecosystems. DeFi platforms utilize stablecoins as a stable unit of account for lending, borrowing, and trading. Stablecoins enable users to access various decentralized financial services while minimizing exposure to the volatility of other cryptocurrencies. Also read What is Decentralized Finance (DeFi) and How Does it Work?
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How Does Stablecoin Work?

Stablecoins strive to establish a fixed market value by pegging themselves to an external reference, typically a fiat currency. In comparison to highly volatile cryptocurrencies, stablecoins offer greater utility as a means of exchange. These stablecoins can be tied to a specific currency like the U.S. dollar, linked to the value of commodities such as gold, or employ algorithms to regulate their supply. Additionally, stablecoins may maintain reserve assets as collateral or rely on algorithmic formulas to control their supply.

Which Is the Best Stablecoin?

Tether (USDT) holds the distinction of being the most widely adopted stablecoin, both in terms of popularity and market capitalization. With a pegged value of 1:1 to the U.S. dollar, Tether is backed by reserves of gold. This stablecoin consistently maintains its position among the top five cryptocurrencies based on market capitalization. Tether is readily available for trading on major cryptocurrency exchanges, including Kraken, Binance, and Coinbase.

Conclusion

In conclusion, stablecoins have emerged as a crucial component of the cryptocurrency ecosystem, addressing the inherent volatility that plagues popular cryptocurrencies like Bitcoin. By aiming to maintain a stable value, stablecoins offer a more reliable medium of exchange for everyday transactions. These stablecoins utilize various mechanisms such as fiat collateralization, crypto collateralization, or algorithmic control to achieve price stability. While fiat-collateralized stablecoins rely on reserves of fiat currencies, crypto-collateralized stablecoins utilize other cryptocurrencies as backing. Algorithmic stablecoins, on the other hand, employ algorithms to regulate their supply and stabilize their value. The rise of stablecoins has attracted attention from regulators and policymakers, leading to calls for tighter regulation and oversight. Despite challenges and scrutiny, stablecoins continue to play a significant role in shaping the future of digital currencies as they strive to provide stability and utility in an otherwise volatile market.

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