Stablecoins: What are crypto stablecoins, and how do they work? (2023)

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In Brief

The volatility of well-known cryptocurrencies like Bitcoin (BTC) and Ether (ETH) is typically quite significant.

Stablecoins are widely utilized in the DeFi industry and on exchanges and have been created on a number of blockchain networks that allow smart contracts.


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A group of cryptocurrencies known as stablecoins offers price stability to investors as they are either backed by certain assets or use algorithms to change their supply in response to demand. 

Stablecoins are designed to overcome some of the volatility and risk associated with cryptocurrencies, which can often fluctuate in value dramatically over short periods of time.

What is a stablecoin?

Stablecoins are a type of cryptocurrency that is designed to be less volatile and more stable than other types of cryptocurrencies by pegging their value to an underlying asset or algorithmically increasing or decreasing the supply of coins in circulation.

Knowledge of stablecoins

The volatility of well-known cryptocurrencies like Bitcoin (BTC) and Ether (ETH) is typically quite significant. Volatility is the measure of uncertainty surrounding fluctuations in an asset’s value. Stablecoins aims to provide investors with more stable and predictable price fluctuations, making them an attractive option for those looking to invest in cryptocurrencies.

One common approach used by stablecoins is asset backing, where the coins are backed by a certain physical asset or another financial instrument. For example, Tether (USDT), one of the most popular stablecoins, is backed by the U.S. dollar, with each tether equivalent to one dollar in value. This gives investors greater stability and confidence that their investment will not suddenly lose significant value.

Another approach used by stablecoins is algorithmic mechanisms that change supply levels in response to demand. For example, Dai (DAI) uses an algorithm that automatically increases or decreases the supply of coins in circulation, depending on the level of demand. This allows the price to remain relatively stable even when market conditions change.

Why do people use stablecoins?

Holders of stablecoins can benefit from a variety of opportunities thanks to the blockchain technology on which they are founded. Stablecoins are often used as a medium of exchange, allowing users to buy and sell goods or services on cryptocurrency exchanges.

Stablecoins can also be used for investment purposes, offering price stability that is not typically found in other types of cryptocurrencies. Additionally, stablecoins may present new opportunities for leveraging blockchain technology in the financial sector.

Stablecoins are widely utilized in the DeFi industry and on exchanges. They have been created on a number of blockchain networks that allow smart contracts. Blockchain-based stablecoins offer many potential benefits, including increased security, improved transparency and efficiency, greater scalability, and reduced transaction costs.

How to keep stablecoins stable

Stablecoin

Through the acts of regulating authorities like central banks, who ensure that their currencies’ prices stay largely stable, government-issued fiat currencies remain stable. Stablecoins, however, do not have the backing of a central bank and must instead employ mechanisms like asset backing or algorithmic supply changes to maintain their value.

In order to keep stablecoins stable, it is important to pay close attention to market conditions and make adjustments as needed. Stablecoin creators also need to be transparent about how the coins are managed and how they maintain their stability in order to build trust with investors and encourage continued adoption.

Fiat-backed stablecoins

Stablecoin is backed by a real, physical asset like fiat currency or precious metals. Stablecoin’s price is kept stable by issuing more tokens when the price of the coin falls below the value of backing assets and destroying them when their price rises above that level.

Fiat-backed stablecoins are one of the most popular and widely utilized forms of stablecoins. They are typically asset-backed by currencies like the U.S. dollar or Euro and can be exchanged with their corresponding fiat currency on cryptocurrency exchanges.

Cryptocurrency-backed stablecoins

Another type of stablecoin is backed by cryptocurrencies instead of a fiat currency. Cryptocurrency-backed stablecoins are designed to maintain price stability by maintaining an equivalent amount of their underlying cryptocurrency.

Cryptocurrency-backed stablecoins can be used for both investment and trading purposes. Providing investors with the benefits of using a traditional cryptocurrency while also mitigating some of the risks associated with price volatility.

One potential challenge facing cryptocurrency-backed stablecoins is ensuring that they remain sufficiently collateralized. Stablecoin creators must implement mechanisms that monitor and manage the underlying crypto assets in order to avoid situations where a coin’s value becomes severely inflated or devalued.

Commodity-backed stablecoins

Stablecoins backed by reserves maintained by a central authority are essentially blockchain-based representations of commodities. Stablecoins backed by commodities, like gold or oil, are designed to maintain their value by being redeemed for the underlying commodity at a fixed price.

Commodity-backed stablecoins allow users to gain exposure to physical assets without requiring them to interact directly with these assets. Stablecoin creators must undertake careful due diligence in order to ensure that the underlying commodities are appropriately valued and responsibly managed.

While stablecoin use cases vary widely, they present exciting opportunities for leveraging blockchain technology in financial markets and beyond. Stablecoins can help improve efficiency, security, transparency, and scalability for a range of applications, making them an increasingly popular choice for both investors and businesses alike.

Algorithmic or hybrid stablecoins

Stablecoins that use complex algorithms to maintain price stability are known as algorithmic or hybrid stablecoins. These stablecoins work by balancing funds stored on the blockchain via smart contracts. Supply and demand to preserve price stability.

Algorithmic or hybrid stablecoins offer the benefits of traditional stablecoins but with added flexibility and security. Stablecoin creators can easily adjust supply in response to changes in market activity, giving them more control over how their coins are managed.

Non-collateralized or seigniorage-style stablecoins

Finally, non-collateralized or seigniorage-style stablecoins are designed to maintain price stability without any underlying assets. These stablecoins rely on various mechanisms and market forces to keep the coins’ value stable over time.

Non-collateralized or seigniorage-style stablecoins are typically used for creating decentralized payment systems that are not limited by the restraints of traditional financial institutions. Stablecoin creators must carefully design these algorithms to ensure that they can effectively keep the value of their coins stable over time.

Can you lose money on stablecoin?

If the stablecoin’s price falls sharply, you could lose your entire investment. There is still risk associated with investing in stablecoins because their value is only as stable as the underlying asset that it’s pegged to. As such, if the price of the underlying asset drops rapidly or there are wide fluctuations in its value then this could have an impact on the stablecoin’s value and result in a loss for investors.

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Disclaimer

Any data, text, or other content on this page is provided as general market information and not as investment advice. Past performance is not necessarily an indicator of future results.

Ken Gitonga

Ken Gitonga is passionate about writing. His work involves writing crypto articles on SEO, TAs, News writing, Web3 articles, crypto price prediction, and white paper drafting. Ken is a content writer and marketer. He has worked in the SEO and content marketing industries for over 3 years and has helped businesses grow their online presence and traffic.

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