How do stablecoins work?

Stablecoins are digital currencies linked to the market price of another asset. Common stablecoins are tied to the US dollar, gold prices, and other digital currencies like Bitcoin and Ethereum. In this article, you will learn how stablecoins work, the risks associated with them, and their uses.

How do stablecoins work?

Stablecoins are digital currencies that are pegged to another price through algorithms or massive reserves. The peg is the price the stablecoin aims to maintain relative to the asset it is tied to. In the case of a stablecoin linked to the US dollar, the price is 1 dollar.

It is assumed that stablecoins can easily be exchanged or traded at the value of the asset they are linked to. While some stablecoins are backed by tangible assets – for example, PAX Gold is supported by gold bars stored in vaults – other digital currencies support more volatile stablecoins.

Digital currencies can experience significant price volatility over a short period, meaning that the stablecoin linked to a digital currency can face strong fluctuations in value.

Types of stablecoins

Based on the type of assets they are linked to, stablecoins can be classified into several categories.

Fiat-backed stablecoins

Fiat-backed stablecoins are digital currencies supported by a significant cash reserve or its equivalent. Fiat currencies are standard currencies issued by a central bank, such as the US dollar, British pound, and euro. As of May 2022, the largest three fiat-backed stablecoins by market capitalization are Tether, Binance USD Coin (BUSD), and USD Coin (USDC).

Crypto-backed stablecoins

Crypto-backed stablecoins are stablecoins backed by other digital currencies. The most well-known crypto-backed stablecoin by market capitalization is Wrapped Bitcoin (WBTC), which is a token that reflects the value of Bitcoin but is issued on the Ethereum network. The supply of Wrapped Bitcoin is held in vaults managed by custodians. Other crypto-backed stablecoins, such as renBTC, are held in vaults managed by smart contracts – pieces of digital currency tokens.

Asset-backed stablecoins

Asset-backed stablecoins are not just fiat currencies represented by stablecoins on the tradable chain. Other assets represented by stablecoins include commodities like gold (such as Tether Gold and Paxos Gold) or tokenized stocks.

Algorithmic stablecoins

Algorithmic stablecoins are backed by other digital currencies, but this support is not exactly a reserve of that digital currency. Simply put, the peg is determined by rules or software associated with another digital currency rather than by holding the underlying digital currency in a reserve. Dai maintains its peg to the US dollar through collateralized loans linked to currencies like Ethereum, Bitcoin, and fiat-backed stablecoins like USDC.

Uses of stablecoins

Stablecoins also allow for the representation of off-chain tradable assets (like gold) and other on-chain tradable assets. The goal is to use the value of the original asset within the digital currency ecosystem. As the name suggests, the greatest advantage of stablecoins is stability. The stability of stablecoins linked to the US dollar has made them the most common pair in cryptocurrency exchanges and a popular currency for staking within DeFi protocols like Yearn Finance, which allows you to lend your digital currencies and generate yields on them.

How many stablecoins are there?

There are many stablecoins, but only five have a market capitalization exceeding $1 billion as of May 2022: Tether, USDC, Binance USD, Dai, and TrueUSD.

What are the best stablecoins?

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It’s difficult to answer this question, and stablecoins that are stable during times of strong market confidence can crash when things get tough. Historically, dollar-pegged stablecoins like USDC and Dai have demonstrated their ability to withstand market collapses, maintaining their peg or only temporarily deviating by a few cents.

Before investing, it’s advisable to research the stablecoin before purchasing. “Adequate insurance and sustainable returns are essential,” he said. “The focus should be on high-quality collateral that is on-chain but not native to the protocol (like Luna), which provides strong support in times of stress.”

Investors should review audit reports and certifications, understand what backs the coin, and read white papers. But above all, he advised clearly: “Check the performance of the coin under market stress. Did it manage to maintain its peg?”

Source: https://www.thebalancemoney.com/how-do-stablecoins-work-5295901