What Is Stablecoin?
A stablecoin is a state of digital currency pegged to a “stable” reserve asset like the US Dollar, gold, or other cryptocurrencies. By tying their value to a stable asset, stablecoins aim to reduce the risk of price fluctuations, making them a more reliable investment option.
Imagine a roller coaster ride that goes from the highest peaks to the lowest valleys within seconds. That’s how volatile the crypto market can be, especially for unpegged cryptocurrencies like Bitcoin. But what if there was a smooth, stable ride that always kept you at a steady pace? That’s what stablecoins is and aims to provide – a reliable and predictable journey for investors looking for stability in the wild earth of crypto. So, stablecoins are like anchors that keep investors steady in the sea of crypto volatility.
Tether (USDT) is an excellent benchmark, a stablecoin pegged to the US Dollar’s value. This means that for every USDT token in circulation, a corresponding US Dollar is held in reserve, providing investors with a sense of security and predictability.
How Does Stabelcoin Work?
The volatile nature of the cryptocurrency market has led many to view it as speculative at best. To address this, stablecoins were created to provide some level of security to the market.
These digital currencies are pegged to a real-world asset, giving them the same value as actual money. By reducing price volatility, stablecoins create a dependable environment for the adoption of cryptocurrencies.
Stablecoins are supported by reserves, with the assets used to back the coin securely stored and serving as collateral. They are primarily used as a reliable means of exchange, functioning just like any other coin and serving as an intermediary between transactions. This feature benefits both institutional and retail crypto users as they can trust that prices will remain stable during transactions.
As stablecoins bridge traditional finance and digital assets, they have become vital to the cryptocurrency ecosystem.
Case in point, merchants are wary of potential losses if crypto prices drop following a payment. Stablecoin fixes these worries. More, institutions see stablecoins as a universal solution for settling international payments, reducing costs, and increasing cross-border transactions’ speed and efficiency.
Still Don’t Get It. How Is a Stablecoin Launched?
If you still don’t get the hang of stablecoins, we’ll explain how a stablecoin gets launched so maybe you’ll understand the process better.
So to launch a stablecoin, the following steps are required:
- Asset Selection and Reserve Management;
- Token Creation;
- Maintaining Stability;
- Regulatory Compliance.
To create a stablecoin, the first step is to select the asset to peg it to. Typically, fiat currencies like the US Dollar or commodities like gold are the most common choices. The asset is then held in a reserve to back the stablecoin’s value.
Maintaining the stablecoin’s value requires crucial reserve management. It is essential to manage the reserve transparently and auditable to ensure the promised asset backs the stablecoin. This requires rigorous record-keeping and reporting to regulatory bodies.
Once the reserve is established, the stablecoin can be created as a digital token using a blockchain platform such as Ethereum or Binance Smart Chain. The stablecoin token is then issued to investors who can purchase it using cryptocurrency or fiat currency. These tokens are also listed on cryptocurrency exchanges for trading purposes.
Several mechanisms are put in place to maintain the stability of a stablecoin. One common mechanism is an algorithmic stabilizing mechanism, where a smart contract is created to adjust the supply of stablecoins automatically based on demand, keeping the price stable.
Another mechanism involves a network of trusted validators who monitor the reserve and report any issues. In case of discrepancies or fraud, the validators can trigger a redemption process where investors can exchange their stablecoins for the underlying asset.
Stablecoins are also subject to regulatory compliance in many jurisdictions, which means adhering to strict reporting and record-keeping requirements as well as anti-money laundering and know-your-customer rules. Regulatory compliance can be complex and expensive, but it is essential to maintaining the stablecoin’s legitimacy and value.
The Most Common Types of Stablecoins
Stablecoins come in different types with varying mechanisms for maintaining their value:
Fiat-Backed Stablecoins
These are the most common type of stablecoins and are backed by fiat currency, such as the US Dollar, the Euro, or the Yen. They are collateralized by fiat-equivalent reserves equivalent to the coin’s market cap. The reserves are held in bank accounts or other types of traditional financial institutions, and independent entities regularly audit and maintain these reserves to ensure legitimacy. The value of these stablecoins is maintained at a 1:1 ratio with the fiat currency they are backed by.
Commodity-Backed Stablecoins
These stablecoins derive their value from a tangible asset, such as a precious metal like gold or silver, or another commodity like crude oil. Reserves of the commodity in question collateralize the stablecoin, and customers receive fractional ownership of the physical asset. This type of stablecoin provides exposure to the commodity’s price movements, making it an attractive option for investors looking to diversify their portfolios.
Crypto-Backed Stablecoins
These stablecoins are backed by other cryptocurrencies, such as Bitcoin or Ethereum. The stablecoin is issued to launch the underlying crypto asset on different blockchains. The crypto held in reserve for backing purposes is often over-collateralized, meaning that the value of the cryptocurrencies significantly exceeds the value of the stablecoins issued. This is due to the extreme volatility of the cryptocurrency market, which causes the reserve to be prone to volatility as well.
Algorithmic Stablecoins
These stablecoins use a computer program running a preset formula to stabilize the coin’s value. They may or may not be backed by reserves, and the value of the stablecoin is maintained through smart contracts that dictate its demand and supply. The algorithmic stablecoin is dubbed decentralized since no centralized reserve exists for these coins. These stablecoins are considered more volatile than the other stablecoins, and their value can fluctuate significantly over time.
What Can You Do with Stablecoins?
- Minimizing Volatility – By being pegged to a more stable currency or asset, stablecoins can offer buyers and sellers certainty that the value of their tokens won’t rise or crash unpredictably in the near future.
- Trading or Saving Assets – Stablecoins are easy to transfer and hold without needing a bank account. Their value can be sent easily around the globe, including to places where the US Dollar may be hard to obtain or where the local currency is unstable.
- Earning Rewards – Some stablecoins offer easy ways to earn rewards (typically higher than what a bank would offer) on an investment.
- Cheap Money Transfers – People have sent as much as a million dollars worth of stablecoins with transfer fees of less than a dollar.
- International Money Transfers – Stablecoins like USDC offers fast processing and low transaction fees, making them a good choice for sending money anywhere in the world.
