Cryptocurrency

What Is a Stablecoin?

June 1, 2022
A hand is putting a coin in a piggybank

Cryptocurrencies such as Bitcoin and Ethereum are the native currencies used to transact on their respective blockchains. But because of their volatile price history, a new class of coins called stablecoins have been created to maintain a stable peg with a traditional asset. The most popular stablecoins in circulation are US dollar stablecoins which attempt to maintain a 1:1 value with the U.S. dollar.

Unlike bitcoins which fluctuate wildly in value, stablecoins maintain their value through a variety of strategies. These include asset-backed “pegs” supported by precious metals, fiat currencies, other cryptocurrencies, or algorithmic functions that change the supply to reduce volatility. The stability of each coin can be affected by the mechanism maintaining the peg. 

Fiat-Backed Stablecoins

For example, fiat-backed stablecoins maintain a reserve of actual currency so that 1 stablecoin can be converted back to 1 unit of the original currency. The reserve is usually maintained by a company, group of companies, or a central authority. For example USD Coin (USDC) is maintained by Circle Financial, Inc. and the company holds 1 USD in its treasury for each USDC it issues.

Crypto-Backed Stablecoins

Crypto-backed stablecoins work in a similar way as a fiat-backed stablecoin with the exception that typically a reserve of cryptocurrencies worth more than 1 USD is used to back 1 USD stablecoin due to the volatility of the crypto reserve. When the price of the underlying crypto dips, the backers need to put more crypto into the reserve and vice versa. While it requires more value to maintain the stablecoin peg, the benefits of this strategy is that the crypto reserve can be administered by a smart contract on a blockchain and does not require any centralized entity.

Thus, if you have purchased crypto-backed stablecoins, be prepared to keep regular track of how the underlying crypto is operating to maintain its value. 

Precious Metal-Backed Stablecoins

Some stablecoins are not pegged to currencies but precious metals such as gold. PAX Gold (PAXG) is one example where each stablecoin represents a fine troy ounce of gold. The Paxos Trust Company maintains the reserve of gold. Investors can now capitalize through investments on stablecoins backed by gold without having to take the trouble of storing and transporting it. In this way, it functions similarly to the very popular gold-backed ETF GLD.

Algorithmic Stablecoins

These stablecoins have a variety of strategies, but in general attempt to stabilize the price by adjusting the total supply of coins in each individual holder’s wallet. This is possible since the stablecoin is controlled by a smart contract, but it takes a bit of getting used to since you own a randomly fluctuating amount of coins at any point in time.

Why Should People Use Stablecoins?

It is true that stablecoins do not offer price appreciation in the way bitcoins or any other crypto for that matter can, but it is still great in terms of offering flexibility and user-friendliness for people that are looking to pay for goods and services internationally. This decentralized system improves the process of money transfers by making it a lot faster and also makes obtaining financial services a lot easier.

Not to mention, stablecoins also safeguard financial data by keeping transactions pseudonymous and typically cost less to use than regular financial services!

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