A stablecoin is a type of cryptocurrency that is backed by a reserve asset and aims to provide price stability. Stablecoins have gained popularity since they try to combine the best of both worlds: the rapid processing and security or privacy of cryptocurrency payments, as well as the volatility-free and stable prices of fiat currencies.
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Though Bitcoin (BTCUSD) remains the most popular cryptocurrency, its prices are notoriously volatile. For example, it climbed from under $5,000 during the peak of the coronavirus pandemic sell-off in March 2020 to over $65,000 in April 2021 before plummeting by more than half to around $30,000 in June 2021. Even intraday price fluctuations may be extreme, with the cryptocurrency sometimes jumping more than 10% in each direction in a matter of hours.
Bitcoin and other prominent cryptocurrencies are unsuitable for everyday usage due to their short-term volatility. A currency should essentially serve as a medium of monetary exchange and a means of storing monetary value, with its value being relatively steady over extended time periods. Users will be hesitant to accept it if they are unsure about its purchasing power in the future.
In an ideal world, a cryptocurrency would preserve its purchasing value while having the lowest possible inflation, which would encourage people to use their tokens rather than save them. Stablecoins offer a way to accomplish this desirable behavior.
Types of Stablecoins
Fiat currencies (such as the US dollar) have some appeal since they are backed by the complete confidence and credit of the government that issued them. For fiat currencies, this provides some price stability. However, many fiats are intrinsically controlled by their central banks as a result of this. Stablecoins are a type of cryptocurrency that attempts to bridge the gap between fiat and digital currencies. Stablecoins are divided into three groups based on their operating mechanics.
Fiat-collateralized stablecoins use a fiat currency reserve, such as the US dollar to issue a sufficient amount of crypto coins. Other types of collateral include precious metals like gold and silver and commodities such as oil. However, the majority of today’s fiat-collateralized stablecoins employ dollar reserves.
Independent custodians manage such reserves, which are audited on a regular basis to ensure that the essential compliance is met. Tether (USDTUSD) and TrueUSD (TUSDUSD) are popular cryptocurrencies that are backed by dollar deposits and have the same value as a single US dollar.
Stablecoins that are crypto-collateralized are backed by other cryptocurrencies. Because the reserve cryptocurrency may be volatile, such stablecoins are over-collateralized, which means that a higher number of cryptocurrency tokens are kept as a reserve for releasing a smaller number of stablecoins.
For example, $2,000 in ether might be retained as reserves for releasing $1,000 in crypto-backed stablecoins, which would account for up to 50% of reserve currency movements (ether). Price stability is improved through more regular audits and monitoring. MakerDAO’s DAI (DAIUSD) is backed by Ethereum (ETHUSD) and is tied to the US dollar, allowing for the use of a basket of crypto assets as a reserve.
Non-Collateralized (Algorithmic) Stablecoins
Non-collateralized stablecoins don’t have any reserves, but they have a functional mechanism to keep the price stable, similar to that of a central bank. The dollar-pegged base coin, for example, employs a consensus method to increase or reduce token production based on demand.