What are stablecoins? This is an explanation and its type and how it works

What are stablecoins – Stablecoins are digital assets designed to mimic the value of fiat currencies such as dollars or euros. They allow users to transfer value cheaply and quickly around the world while maintaining price stability.

Cryptocurrencies like Bitcoin and Ethereum are notorious for their volatility when priced against fiat. This is to be expected, as blockchain technology is still very new, and the cryptocurrency market is relatively small.

The fact that the value of cryptocurrencies is not tied to any asset is interesting from a free market point of view, but can be tricky when it comes to usability.

As a medium of exchange, cryptocurrencies are excellent from a technological point of view. However, fluctuations in their value ultimately make them a very risky investment, and not ideal for making payments. By the time the transaction is completed, the coins can be worth significantly more or less than when they were sent.

But stablecoins have no such problem. These assets see negligible price movements and closely track the value of the underlying asset or fiat currency they are copying. As such, they serve as reliable safe haven assets in volatile markets.

There are several ways in which stablecoins can maintain their stability. In this article, we will discuss some of the mechanisms used, their advantages, and limitations.

Types and How Stablecoins Work

There are several categories of stablecoins, each of which pegs their unit in a different way. Below are some of the most common types of stablecoins.

Fiat-backed stablecoins

The most popular types of stablecoins are those that are directly backed by fiat currency at a 1:1 ratio. We also call fiat-collateralized stablecoins. The central issuer (or bank) has a reserve amount of fiat currency and issues a proportionate number of tokens.

For example, an issuer can keep a million dollars, and distribute one million tokens worth one dollar each. Users can freely trade these as they would with tokens or cryptocurrencies, and at any time, holders can redeem them for the equivalent value in USD.

There is clearly a high degree of counterparty risk here that cannot be mitigated: in the end, the issuer must be trusted. There is no way for users to determine with confidence whether the issuer is keeping funds in reserve.

At best, issuing companies can try to be as transparent as possible when it comes to audit publishing, but this system is far from trustless.

Crypto-backed stablecoins

Crypto-backed stablecoins mirror their fiat-backed counterparts, with the main difference being that cryptocurrencies are used as collateral. But because cryptocurrencies are digital, smart contracts take care of issuing units.

Crypto-backed stablecoins are minimized by trust, but it should be noted that monetary policy is determined by voters as part of their governance system. This means that you don’t trust a single publisher, but you trust that all network participants will always act in the best interests of users.

To obtain this kind of stablecoin, users lock their cryptocurrency into a contract, which issues the token. Then, to get their guarantee back, they pay the stablecoin back into the same contract (along with any interest).

The specific mechanisms that enforce the stakes vary based on the design of each system. Suffice to say, the mix of game theory and on-chain algorithms incentivizes participants to keep prices stable.

Read: 6 Cryptocurrency Risks and Threats

Stablecoin Algorithm

The stablecoin algorithm is not supported by fiat or cryptocurrencies. Instead, their stake is achieved entirely by algorithms and smart contracts that manage the supply of issued tokens. Functionally, their monetary policy is very similar to that used by central banks to manage national currencies.

Basically, the algorithmic stablecoin system will reduce the supply of tokens if the price falls below the price of the fiat currency it tracks. If the price exceeds the value of the fiat currency, new tokens go into circulation to reduce the value of the stablecoin.

You may hear this category of tokens referred to as unsecured stablecoins. This is technically wrong, as they are guaranteed – though not in the same way as the previous two entries. In terms of black swan event, algorithmic stochastics may have some kind of collateral pool to handle highly volatile market movements.

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