A cryptocurrency is a digital currency that can be exchanged online using blockchain technology. While there are many different kinds of cryptocurrencies like Bitcoin, Ethereum and Altcoins, in this article we’ll be learning all about stablecoins –– including what they are and how they work.
A Brief History of Stablecoins
The first cryptocurrencies to see the light of day weren’t stablecoins. For example, Bitcoin and Ethereum are non-stablecoin cryptocurrencies. When they started gaining in popularity, we saw their value fluctuate wildly, sometimes overnight. Stablecoins were created as an answer to the unpredictability of these cryptocurrencies.
The fact was that many people wanted to start using cryptocurrencies but many were discouraged by the risks associated with the volatility of their value. Today, there are dozens of stablecoins in existence—and their combined worth reaches several billion dollars. The most popular ones include the USD Coin and Binance USD.
How Stablecoins Work
A stablecoin is a type of cryptocurrency whose value is directly tied to the value of a real-world asset. That means that if the value of the real-world asset changes, so does the value of the stablecoin. Many stablecoins such as the Diem Dollar are tied to government-issued currencies like the US Dollar. They can also be tied to physical assets like real estate or gold.
This is done by first selecting an asset that will determine its value, such as a fiat currency, or in rarer cases real-life commodities such as gold or platinum. Next, the creators of a stablecoin are responsible for ensuring its value’s stability over time. This is done through a ‘reserve’ which can take on different forms depending on the chosen asset. The reserves work by ensuring the cryptocurrency holds its own wealth equivalent to the number of its coins in existence.
For example, if you want to redeem 100 Diem Dollars, the Diem Association will give you 100 USD that it has in its reserve. Of course, it’s important to remember that a stablecoin backed by the US Dollar is only ever as stable as the US Dollar itself and its value isn’t completely static.
See also: Why Diem is Better Than Bitcoin
Types of Stablecoins
While fiat-backed currencies are the most well-known type of stablecoin, many other types of stablecoins exist to date. While they all function a little differently, they all share common characteristics such as a reserve that ensures and stabilizes its value. Below are some of the different kinds of stablecoin models including their key differences and how they work.
1. Fiat-backed Stablecoins
Fiat-backed cryptocurrencies are the most common kind of stablecoins, as well as the first to be introduced to the market. Fiat-backed stablecoins are centralized, which means they are managed by a specific entity. Centralized stablecoins rely on public trust that the entity managing them is actually backing their coins with real cash or cash equivalents.
- Their value is pegged to one or more currencies in a fixed ratio.
- Their tether is realized off-chain through regulated financial institutions which serve as depositaries of the currency used to back the stablecoin.
- The amount of the currency used to back the stablecoin has to match the amount of stablecoin in circulation.
Examples of fiat-backed stablecoins include Diem, USD Tether (USDT), and USD Coin.
2. Commodity-backed Stablecoins
Commodity-backed stablecoins are guaranteed by physical assets such as oil, precious metals, and even real estate. It’s important to keep in mind however that these real-world commodities can often fluctuate in price and have the potential to fluctuate or drop in value.
- Their value is fixed to one or more real-world commodities.
- They can be redeemed by agorist firms or regulated financial institutions.
- The amount of the commodity used to back the stablecoin has to match the amount of stablecoin in circulation.
Examples of commodity-backed stablecoins include Digix Gold Tokens (DGX).
3. Crypto-backed Stablecoins
Cryptocurrency-backed stablecoins are backed by cryptocurrencies as collateral. While they work similarly in theory to fiat-backed stablecoins, there are key differences between the two. Fiat collateralization typically happens off-chain and is run using a centralized payment system, while crypto-backed stablecoins are typically done on-chain in a decentralized manner.
- The value of the stablecoin is pegged to another cryptocurrency.
- The peg is executed on-chain using smart contracts.
- The supply is regulated on-chain.
- Prices are stabilized through the use of supplementary instruments and incentives.
Examples of crypto-backed stablecoins include Haven and DAI.
See also: What is Diem and Why You Should Use It
The Benefits of Stablecoins
Stablecoins offer a number of benefits compared to more traditional forms of cryptocurrency, including:
- Low Volatility –– These cryptocurrencies don’t double in value or lose all their value overnight.
- Long-term Stability –– Stablecoins can be stored in a digital wallet as a long-term asset and maintain their value over extended periods.
- Accessibility –– The concept of a stablecoin is mucheasier to understand than other cryptocurrencies making them accessible to many more people.
- Ease of Use –– Compared to the US Dollar, cryptocurrencies are easier to exchange and offer faster transfer times as well as better fraud protection.
Stablecoin - Conclusion
When it comes to cryptocurrencies, stablecoins offer the best of both worlds. Like non-stable cryptocurrencies, they make digital payments easier by removing the middle-man such as banks and other traditional financial institutions. However, unlike other types of cryptocurrencies, stablecoins maintain their value over time making them a reliable and affordable method for financial transactions.