A stablecoin is a new class of cryptocurrencies that attempts to offer price stability and are backed by a reserve asset.Stablecoins are much more fixed than normal cryptocurrencies. This is because their values are pegged to other assets such as the US dollar or gold.
Today, there are 180 currencies across the world that are recognized by the United Nations, from the US dollar to the European Euro to the Japanese Yen, and more.
Across global economies, these currencies are often used to buy goods and services. Despite inflation, fluctuating exchange rates, and other factors, the value of most of these currencies is subject to very little change on a day-to-day basis.
This allows several economies to rely on the use of these government-issued currencies to operate. In other words, you can buy a loaf of bread from your favorite baker and pay $3.50 for it today knowing that it’s highly unlikely that it would drastically drop to 99 cents tomorrow.
Stablecoins — in the form of digital money — aim to mimic traditional, stable currencies.
In general, a stablecoin is a cryptocurrency that is collateralized by the value of an underlying asset. What that underlying asset may vary from coin to coin, which we’ll dive into later in this piece.
Many stablecoins are pegged at a 1:1 ratio with certain fiat currencies, such as the US dollar or the Euro, which can be traded on exchanges.
Two primary reasons for the price stability of fiat currencies are the reserves that back them and the timely market actions by the controlling authorities, like central banks. Since fiat currencies are pegged to an underlying asset, such as gold or forex reserves which act as collateral, their valuations remain free from wild swings.
Even in certain extreme cases when a fiat currency’s valuations may move drastically, the controlling authorities jump in and manage the demand and supply of currency to maintain price stability. The bulk of cryptocurrencies lacks both these key features—they don’t have a reserve backing their valuations and they don’t have a central authority to control prices when required.
Stablecoins attempt to bridge this gap between fiat currencies and cryptocurrencies. There are three categories of stablecoins, all based on their working mechanism.
Fiat-collateralized stablecoins maintain a fiat currency reserve, like the U.S. dollar, as collateral to issue a suitable number of crypto coins. Other forms of collateral can include precious metals like gold or silver, as well as commodities like oil, but most of the present-day fiat-collateralized stablecoins use dollar reserves.
Such reserves are maintained by independent custodians and are regularly audited for adherence to the necessary compliance. Tether (USDT) and TrueUSD are popular crypto coins that have a value equivalent to that of a single U.S. dollar and are backed by dollar deposits.
Crypto-collateralized stablecoins are backed by other cryptocurrencies. Since the reserve cryptocurrency may also be prone to high volatility, such stablecoins are “over-collateralized”—that is, a larger number of cryptocurrency tokens is maintained as a reserve for issuing a lower number of stablecoins.
For example, $2,000 worth of ether may be held as reserves for issuing $1,000 worth of crypto-backed stablecoins which accommodates for up to 50% of swings in reserve currency (ether). More frequent audits and monitoring add to price stability. Backed by ethereum, MakerDAO’s DAI is pegged against the U.S. dollar and allows for using a basket of crypto-assets as a reserve.
Non-collateralized stablecoins don’t use any reserve but include a working mechanism, like that of a central bank, to retain a stable price. For instance, the dollar-pegged basecoin uses a consensus mechanism to increase or decrease the supply of tokens on a need basis. Such actions are similar to a central bank printing banknote to maintain valuations of the fiat currency. It can be achieved by implementing a smart contract on a decentralized platform that can run in an autonomous manner.