Stablecoin is a fixed-price cryptocurrency whose market value is attached to another stable asset. Differing from normal cryptocurrencies, stablecoin can be pegged to assets such as certain fiat currencies that can be traded on exchanges, including the U.S. dollar or the Euro. Some stablecoins can be pegged to other types of assets, including precious metals, such as gold, and even other cryptocurrencies.
Stablecoins let users enjoy the benefits of digital currencies based on blockchain, including security, privacy, low fees and transparency, while helping to alleviate the problem of extreme price volatility faced by most traditional cryptocurrencies.
People who use stablecoins to make purchases don’t have to worry about the day-to-day fluctuations of traditional cryptocurrencies. Businesses looking for less expensive and more efficient ways to pay their overseas suppliers could also use stablecoins since they wouldn’t have to deal with the conversions of different fiat currencies.
A digital and decentralized currency that’s stable and widely available could also be used by people living in certain countries whose monetary systems are unstable and whose restrictive capital controls prevent those individuals from buying goods or services in foreign currencies. And to hedge their investments, traders who think that their cryptocurrencies are going to go down in value could transfer their crypto holdings to stablecoins.
Currently, there are three main types of stablecoins in the market:
- traditional asset-backed
- cryptocurrency asset-backed
- non-collateralized stablecoins
Traditional asset-backed stablecoins
The most popular type of stablecoins is called traditional asset-backed stablecoins, also known as pegged cryptocurrency. This type of stablecoin is backed by a traditional asset, such as a national currency or gold. Every stablecoin is pegged at a 1:1 ratio to an asset.
So if a stablecoin is pegged to the U.S. dollar, then $1 is held in a bank account for each stablecoin that’s issued. If a stablecoin is pegged to the price of gold, then a specific amount of gold is held in a vault for each stablecoin issued.
One of the downsides of this type of stablecoin has to do with trust and centralization. Unlike many cryptocurrencies, which are decentralized, traditional asset-backed stablecoins are centralized, meaning they’re run by one centralized entity, such as a bank. This requires trust that this entity is actually backing up its stablecoins with a real traditional asset.
The users of traditional asset-backed stablecoins have to trust that the issuing party is properly regulated as well as properly honoring its deposits and withdrawals. Some stablecoin issuers haven’t been able to demonstrate that they’re able to honor 1:1 redemptions fully.
Traditional asset-backed stablecoins rely heavily on the issuer of the coin; if the issuer’s company is mismanaged and/or its investments are mismanaged, the stablecoin can go down with them. To solve this trust problem, stablecoins could provide regular audits from third parties to ensure transparency. This would help ensure that they are trustworthy and help keep their reputation high.
Traditional asset-backed stablecoins are also constrained by all the regulations that come with these currencies, compromising the efficiency of the conversion process. This means that they have less liquidity than regular cryptocurrencies. One traditional asset-backed stablecoin is Tether’s USDT.
Cryptocurrency asset-backed stablecoins
Cryptocurrency asset-backed stablecoins are backed by other cryptocurrencies, such as Bitcoin or Ether, whose blockchain is generated by the Ethereum platform. Less centralized than traditional asset-backed stablecoins, these crypto assets are held in smart contracts and aren’t subject to the same vulnerabilities as traditional asset-backed collateral.
Since the amount of crypto that backs up these stablecoins is more than the value of the stablecoin itself, any price fluctuations of the underlying crypto don’t affect the value of the stablecoin. Cryptocurrency asset-backed stablecoins include stable.PHP, bitUSD and bitCNY.
Non-collateralized stablecoins are not backed by any assets. Rather, they use algorithms to adjust the supply and demand of the stablecoin to ensure the value of the coin remains stable. Consequently, there’s no need for collateral to back the value of the token.
Then tokens rely on a mechanically-generated algorithm that can change the supply volume if necessary to maintain the price of a token, which is pegged to an asset, such as a fiat currency like the U.S. dollar. These stablecoins rely on smart contracts to supply tokens to the market if the value increases and to sell tokens if the price falls below the peg -- thus ensuring the stability of the token and enabling it to hold its peg.
The asset to which the stablecoin is pegged could be a fiat currency, such as the U.S. dollar, or another asset, such as gold. Non-collateralized stablecoins include Carbon and Kowala.
Learn more about stablecoin in the following video: