What Is a Stablecoin?
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 has been created to maintain a stable peg with a traditional asset. The most popular stablecoins in circulation are U.S. dollar stablecoins, which attempt to maintain a 1:1 value with the U.S. dollar.
Unlike Bitcoin, which fluctuates 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.
Different types of stablecoins
Section titled “Different types of stablecoins”Fiat-backed stablecoins
Section titled “Fiat-backed stablecoins”Fiat-backed stablecoins maintain a reserve of actual currency so that one stablecoin can be converted back to one unit of the original currency. The reserve is usually maintained by a company, a group of companies, or another central authority.
For example, USD Coin (USDC) is maintained by Circle Financial, Inc., and the company holds one U.S. dollar in its treasury for each USDC it issues.
Crypto-backed stablecoins
Section titled “Crypto-backed stablecoins”Crypto-backed stablecoins work similarly to fiat-backed stablecoins, except that a reserve of cryptocurrencies worth more than one U.S. dollar is typically used to back each one-dollar stablecoin due to the volatility of the crypto reserve.
When the price of the underlying cryptocurrency falls, the backers need to add more crypto to the reserve, and vice versa. While this approach requires more value to maintain the stablecoin peg, the benefit is that the crypto reserve can be administered by a smart contract on a blockchain without requiring any centralized entity.
If you purchase crypto-backed stablecoins, be prepared to keep track of how the underlying cryptocurrency is performing, as it directly affects the mechanism that maintains the peg.
Precious metal-backed stablecoins
Section titled “Precious metal-backed stablecoins”Some stablecoins are not pegged to currencies but instead to precious metals such as gold.
PAX Gold (PAXG) is one example, where each stablecoin represents one fine troy ounce of gold. The Paxos Trust Company maintains the reserve of gold.
This allows investors to gain exposure to gold without the hassle of storing or transporting the physical metal. In this way, it functions similarly to popular gold-backed ETFs such as GLD.
Algorithmic stablecoins
Section titled “Algorithmic stablecoins”Algorithmic stablecoins use a variety of mechanisms, but in general, they attempt to stabilize the price by adjusting the total supply of coins.
Because these stablecoins are controlled by smart contracts, the protocol can automatically increase or decrease supply to maintain the target price. As a result, holders may see the number of coins in their wallets fluctuate over time, which can take some getting used to.
Why should people use stablecoins?
Section titled “Why should people use stablecoins?”While stablecoins do not offer price appreciation in the way Bitcoin or many other cryptocurrencies can, they provide flexibility and convenience for people looking to pay for goods and services internationally.
This decentralized system makes transferring money much faster while also making financial services more accessible.
Stablecoins also help safeguard financial data by keeping transactions pseudonymous and typically cost less to use than traditional financial services.
What is one way you can take advantage of stablecoins?
Section titled “What is one way you can take advantage of stablecoins?”Introducing PennyWorks!
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