What Are Stablecoins? A Complete Beginner’s Guide
Stablecoins were designed to remain steady by linking the coin’s value to a traditional asset, such as the U.S. Dollar, the Euro, or a commodity. The purpose of crypto stablecoins is to eliminate the volatility inherent in cryptocurrencies, like Bitcoin and Ethereum, and provide users with consistency in their exchanges within the crypto world. Therefore, users can trade, transact, and use stablecoins with confidence as they don’t experience wild swings in prices.
The most commonly used stablecoins in crypto include Tether (USDT), USD Coin (USDC), and DAI. USDT and USDC have been primarily used by many as centralized stablecoins for both trading and payment. DAI was built on Ethereum and is a decentralized stablecoin that does not rely on any single organization or entity for stability.
Since they’re used for a variety of purposes, like crypto trading, cross-border remittance, and decentralized finance (DeFi), stablecoin technology is useful in a digital economy.
What Are Stablecoins? Definition and Meaning
Stablecoins typically maintain price stability using a reserve asset or assets. The most common reserve assets for stablecoins are fiat currencies, such as U.S. dollars and euros, and even commodities like gold.
There are several ways that stablecoins can maintain a stable price. One method is to use fiat currency as collateral for a stablecoin. This means a stablecoin will always be backed by an exact amount of fiat currency that exists in a designated bank account. Another method is to create a crypto-collateralized stablecoin. This is done by taking existing cryptocurrencies and utilizing them as collateral.
The majority of crypto-collateralized stablecoins are backed 100% or more by other cryptocurrencies to prevent potential price fluctuations. Finally, algorithmic stablecoins are created using smart contracts to autonomously adjust the supply of stablecoins based on fluctuations in demand for stablecoins. Algorithmic stablecoins can provide a stablecoin option, but do not require any tangible collateral to back the stablecoin’s value.
The predictability of stablecoins has made them an integral component of the cryptocurrency ecosystem, allowing traders, investors, and users to easily transact and store value while being involved in various decentralized financial applications that do not expose them to the extreme volatility common in other cryptocurrencies.
Why Stablecoins Were Created
Stablecoins are designed to provide users with an alternative to the volatility of traditional cryptocurrencies, which can fluctuate wildly in price. Users get enough stability with stablecoins to transact and store value in a digital format. By allowing for a value that is stable (typically tied to assets such as fiat currency), Stablecoins work as an intermediary between traditional financial systems and blockchain-based financial systems.
As such, Stablecoins remove the need for users to experience volatility while transitioning between traditional fiat currency and blockchain-based assets or cryptocurrencies. By providing users with stability in price for both trading, remittances, cross-border payments, DeFi, and payments, stablecoins help fuel the growth of the blockchain ecosystem while providing users a better sense of financial security than crypto assets.
How Stablecoins Work
Stablecoins are usually pegged to different assets through various methods. The most popular method for pegging a stablecoin is to back each coin with a reserve of an underlying asset, such as cash, government bonds, or other assets that have a stable market price.
In addition, many crypto stablecoins utilize a method known as collateralization, which requires an additional amount of cryptocurrency to be held in reserve to ensure the price of the stablecoin stays near its pegged value. Furthermore, some stablecoins use automated systems to control the supply of their coins. Automated systems can artificially inflate or deflate the circulating supply of stablecoins with the rise or fall in their demand.
All these methods provide stablecoins with a stable price, allowing for widespread use in commerce and even in trading and digital payments.
Types of Stablecoins
Stablecoins are divided into four categories based on the various mechanisms used to support their value. The types of stablecoins are:
- Fiat-Backed Stablecoins
Fiat-backed stablecoins are the most commonly accepted stablecoins, backed by government-issued currencies like the US dollar and the euro. They have a reserve backing it, like a centralized entity issuing USDC maintains a cash reserve that corresponds to each USD Coin issued. Such stablecoins are commonly used in online trading, remitting money, and other transactions as they are simple to use and have a stable value.
- Crypto Backed Stablecoins
Crypto-backed stablecoins are issued against the value of other cryptocurrencies. Since cryptocurrencies have wild price swings, most crypto-backed stablecoins are over-collateralized to avoid losing too much value when there is a significant price decline. An example of a crypto-backed stablecoin is DAI, created and maintained using smart contracts on the Ethereum blockchain. Crypto-backed stablecoins provide more decentralization and transparency.
- Algorithmic Stablecoins
Algorithmic stablecoins maintain their stability through an automatically controlled supply of tokens. If demand for the token is high, more tokens are created and issued, and if demand decreases, the total token supply decreases. Algorithmic stablecoins don’t have a direct collateral source, making them more innovative but also subject to greater risk.
- Commodity Backed Stablecoins
Commodity-backed stablecoins, which are pegged to a physical commodity such as gold or silver, have values that are based on the market prices of the commodities.
Are Stablecoins Important for Crypto Adoption?
One of the key reasons stablecoins help in increasing crypto adoption is that they fill the gap of a lack of price stability in an otherwise highly volatile crypto market. For new users and investors who are just learning about cryptocurrencies, stablecoins offer a familiar method of entry as the value does not fluctuate drastically every day, unlike many of the other coins on the market.
Many traders and day traders also use stablecoins as a way to hold liquidity, execute fast transactions, and protect their portfolios from market fluctuations. In the real estate markets, stablecoins can streamline payments, remittance services, and enable participation in DeFi. Therefore, with the blend of reliability of traditional currencies and the efficiencies of blockchain technology, stablecoins in crypto can offer a practical, accessible digital currency to transact digitally, thereby promoting wider adoption of these assets globally.
