Why do Stablecoins Stay Stable? Everything You Need to Know about Stablecoins
Today, it’s difficult to find someone who wouldn’t be aware of what a cryptocurrency is. But still, some terms might be a bit confusing for people. There is a cryptocurrency, Bitcoin, but there are also altcoins. And now people are talking about stablecoins. So, what is a stablecoin? Check out the article to learn more about stablecoins and how they stay stable.
Explaining the Stablecoin
The very first thing you need to understand is that stablecoin is a type of cryptocurrency. Unlike the original crypto coins like Bitcoin, Litecoin, Ethereum, etc., stablecoins are backed by some value.
Originally, the idea was to connect these tokens to strong fiat currencies like the dollar or euro. But today, stablecoins are of different types and even offer to solve some tasks. For example, a stable crypto token is used to minimize the volatility of cryptocurrencies when trading.
As you know, traditional crypto tokens aren't backed by anything except for the belief of investors. The prices go higher and lower because of minor events, for example, certain posts on Twitter.
Stablecoins maintain the stability of fiat money they are backed by. At the same time, stablecoins offer the speed and safety of transactions while offering low fees. These features of stable tokens explain why today they are used in crypto banking. But since the launch of the very first stablecoin, other stable tokens have emerged. Today, they form a whole mainstream branch with various types of stablecoins.
Types of Stablecoins
The idea of a stable coin is to be backed by some value to make sure the cryptocurrency stays stable. The cryptocurrency basically gets the stability of the item it is backed by. There could be different types of value - fiat currency, another cryptocurrency, an asset, or by using an algorithm.
A fiat-backed stablecoin is a cryptocurrency backed by fiat currency on a 1 to 1 basis. Usually, fiat currencies are chosen based on their stability. For example, the most popular options are the dollar, euro, yen, and other types of fiat money that are stable and backed by strong economies.
The idea is simple - as long as the fiat currency stays stable, the stablecoin also stays stable and can be used in transactions. Basically, these stablecoins are defended by the central bank of the country of fiat currency. The largest stablecoins backed by fiat currencies are Tether, USD Coin, TrueUSD, and others.
Crypto-backed stablecoins use cryptocurrencies as collateral. Usually, one or several (a basket) cryptocurrencies are used to back the stablecoin. Crypto-backed stablecoins are similar to fiat-backed ones, but with several differences.
For example, collateralization of fiat-backed stable tokens happens outside of the blockchain, while crypto-backed coins are collateralized within the chain. The cryptocurrency backing a stablecoin is locked by a smart contract. A user can take out the loan against a smart contract by locking up its collateral. Consequently, it makes it more worthy to pay off the debt in case the stablecoin starts dropping in price.
There is also a system that prevents crashes. For example, if the user's loan gets closer to their withdrawal, the smart contract might liquidate the user within the system.
As you have probably already figured out, an asset-backed stablecoin is backed by a valuable asset, for example, gold. In simple words, an asset-backed stablecoin is supported by a store of value. It can be gold, other precious metals, precious stones, there are even coins backed by Swiss real estate.
A store of value in this case can be anything that has value and is subject to regular audits. That way experts can prove that the stablecoin is backed or not backed by something valuable.
This is one of the most interesting and complex stablecoins out there. An algorithmic stablecoin isn’t backed by anything, instead, it is regulated by smart contracts or complex algorithms that control the stability of the coin. These algorithms or smart contracts can decrease or increase the market supply of the coin they control depending on the situation on the market.
To control the stability of the stablecoin, smart contracts or algorithms automatically increase or decrease the price of the stable token depending on the fiat currency they track. If the price of the fiat currency they track decreases, risking to decrease the price of the stablecoin, the system automatically removes stable tokens from the market to keep the price.
If the stablecoin’s price increases above the fiat currency the algorithm tracks, then the system will drop more stable tokens to not let it drastically increase in price. The system works as a decentralized central bank that uses available tools to keep the price of a stablecoin on the same level.