What Are Stablecoins And How Do They Work?

what are stablecoins

The crypto space is looking to address the issue of volatility through an instrument called stablecoins. Stablecoins offer users a way to minimize volatility by pegging their value to a stable asset such as fiat currency (USD). This article will look closely at stablecoins, their types, and how they work. 

Key Points 

  • Stablecoins are a type of cryptocurrency that peg their value to stable fiat currencies or any other stable asset.
  • They can be pegged to fiat currencies such as the USD or even a commodity such as gold. 
  • Stablecoins ensure stability by maintaining assets in reserve, which serve as collateral. A new type of stablecoin, called algorithmic stablecoins, utilizes algorithms to maintain their value.
  • The assets have come under significant regulatory scrutiny, given their potential to impact the larger financial system. 

What Are Stablecoins And How Do They Work?

A stablecoin is a cryptocurrency pegged 1:1 to an external asset class, such as fiat or gold, to maintain a stable price. They were created as an alternative to popular cryptocurrencies such as Bitcoin due to the latter’s extreme volatility, which limits its utility as a mode of payment. Entities that issue stablecoins maintain a reserve holding the assets backing the stablecoin. For example, if an entity has issued 1 billion stablecoins, it will maintain a reserve of $1 billion in fiat to back the stablecoin. Prominent stablecoins include USD Coin (USDC), managed by a consortium called Centre. 

The idea behind stablecoins is simple. Unlike Bitcoin, stablecoins are supposed to maintain a stable price, depending on the asset’s fiat currency. These assets can be used in several use cases where volatility is not desirable. They are a novel solution to the volatility of cryptocurrencies, with price stability built into the assets themselves. There are four types of stablecoins, each identified by their underlying collateral. We shall discuss them later in the article. 

Why Are Stablecoins Important? 

Let’s understand the importance of stablecoins with an example. In March 2020, the value of Bitcoin was just under $5000. However, by April 2021, this value had risen to a staggering $63,000 before losing nearly half its value over the next couple of months. While this volatility is good for traders, it can turn routine transactions into risky speculation for buyers and sellers. This is a significant hindrance to the utility of cryptocurrencies in day-to-day transactions. If an asset that is not legal tender has to act as a medium of exchange, its value must remain stable to assure those that accept it as a mode of payment that it can retain its value. 

The Three Types Of Stablecoins

As mentioned earlier, there are several stablecoins, each depending on their underlying collateral. Let’s briefly look at each of them. 

Fiat-Collateralized Stablecoins 

As the name suggests, fiat-collateralized stablecoins maintain their value by maintaining a reserve of fiat currency, such as the USD or Euro, which acts as collateral. Fiat-backed stablecoins can also be pegged against other stable assets such as gold, silver, and even crude oil. However, most fiat-collateralized stablecoins have their value pegged to the US dollar. Reserves backing these stablecoins are held by independent custodians and are often audited by external agencies to ensure their integrity. USD Coin (USDC) is a prominent example of a fiat-collateralized stablecoin. 

Crypto-Collateralized Stablecoins 

These stablecoins have their value backed by baskets of other crypto assets. Because the reserve assets are cryptocurrencies and could themselves face extreme volatility, crypto-collateralized stablecoins are often overcollateralized. Overcollateralization means that the value of the cryptocurrency held in reserve is greater than the value of the stablecoins issued. For example, if an entity has issued $1 billion worth of a crypto-backed stablecoin, it will hold crypto-assets worth $2 billion in reserve to counteract any volatility. 

Algorithmic Stablecoins 

Algorithmic stablecoins are very different from the ones discussed above. This is because these stablecoins do not use assets held in reserve to back their value. Instead, algorithmic stablecoins utilize algorithms to keep their value stable, determining their supply based on the demand. The infamous Terra UST is an algorithmic stablecoin.

How Are Stablecoins Used? 

Like their counterparts, the primary use of stablecoins is as a store of value and a medium of exchange. Traders can use them as a safe haven when the market experiences volatility. However, lately, stablecoins have become critical to the decentralized finance (DeFi) ecosystem, especially regarding lending, yield farming, and providing liquidity. Investors and traders can gain exposure to stablecoins by purchasing them directly from exchanges and can also mint new stablecoins by depositing collateral with the issuing entity. 

Let’s look at some of the use cases of stablecoins. 

  • Minimizing Risk – Stablecoins help holders shield their holdings from the extreme volatility of the crypto space. 
  • Trading – Stablecoins are extremely easy to transfer. Holders can seamlessly transfer them across the world. They are instrumental in areas where the local currency is unstable. 
  • Interest – Stablecoin holders can also use their assets to earn interest. 
  • Cheap Transfers – Stablecoins also facilitate extremely cheap transfers directly between users. 

In Closing 

Stablecoins are set to play a critical role in the crypto ecosystem, especially after the most recent crypto market crash. Investors are looking to stablecoins as a safer avenue to enter the crypto space, which has been reflected in the numbers. Regulators, too, have realized the importance of these assets and recently permitted banks and savings associations to hold reserves for stablecoin issuers.