What is a stablecoin?

Stablecoins are digital currencies that are designed to maintain a stable value relative to an external reference, such as a fiat currency like the U.S. Dollar, or another cryptocurrency, and to maintain reserve assets as collateral. This reserve or collateral used for the issuance of the stablecoin is what backs the value of the asset.

They are built on blockchain technology and don't rely on a central bank like the Federal Reserve, just like cryptocurrencies, but they offer a level of stability that other crypto assets lack. Indeed, despite the attention that cryptocurrencies such as Bitcoin (BTC), Ethereum (ETH) and Solana (SOL) have gained over the years, their volatility isn't attractive to financial stability seekers.

From concepts like NFTs to DeFi and decentralized identity, the crypto market is ever evolving, innovation is happening rapidly, and more and more stablecoins are surfacing and bringing change to the traditional financial system. Stablecoins have a number of advantages over traditional fiat currency, like faster transaction speeds, lower transaction fees and increased transparency. Let's take a look at how they work and the most popular ones.

Types of stablecoins

There are several types of stablecoins, including fiat-backed, crypto-backed, commodity-backed and algorithmic stablecoins.

Crypto-backed stablecoins, such as Dai and TerraUSD (UST), are backed by other digital assets like Ethereum (ETH). These stablecoins use smart contracts to maintain price stability, making them ideal for use in decentralized finance (DeFi) ecosystems. However, in the event of a crisis, thinks can shift dramatically. As an example, UST was pegged to Luna, which slumped over 80% overnight in May 2022, leading TerraUSD to also plunge by over 60%.

Algorithmic stablecoins use complex algorithms to maintain their stability. These stablecoins are designed to automatically adjust their supply based on market demand, ensuring that their value remains stable.

Collateralized stablecoins maintain a reserve of a fiat currency or physical assets as collateral, assuring the token's value. Forms of collateralized stablecoins include fiat-backed stablecoins such as Tether (USDT), USD Coin (USDC), and Binance USD (BUSD), which are pegged to a fiat currency. These stablecoins are backed by actual U.S. dollars held in reserve by stablecoin issuers, providing a level of transparency and regulatory compliance that is attractive to regulators and financial institutions. Commodity backed stablecoins are backed by physical assets such as precious metals, oil and real estate.

Non-collateralized stablecoins (also called seigniorage-style stablecoins) work similarly to algorithmic stablecoins but don't have any reserves in smart contracts. They rely on complex processes that adjust the supply of the coins depending on supply and demand, destroying and inflating supply on-chain to maintain their peg. They are essentially self-collateralized, meaning no collateral is used to mint them.

Stablecoins can be purchased on crypto exchanges such as Coinbase, Binance and others. Like other cryptocurrencies, they are kept in digital wallets.

The market capitalization of stablecoins has grown tremendously in recent years. Tether (USDT), one of the most popular stablecoins, is leading with a market cap of over $80 billion at the time of writing. Its primary use is moving money between exchanges quickly, to take advantage of arbitrage opportunities. When the price between cryptocurrencies differs on two exchanges, traders can make money on these discrepancies.

Another very popular stablecoin is the USD Coin, which pegged to the US dollar. USDC is an open-source protocol, meaning anyone can use it to develop their own products, and suggest improvements or changes.

Other stablecoins like Dai and TrueUSD (TUSD) have also gained significant market share. Dai is is a stablecoin on the Ethereum blockchain, pegged to the U.S. dollar and backed by ether, the token behind Ethereum.

Scrutiny over stablecoins by regulators and politicians continues to increase, with tighter regulations developing. The Gemini Dollar (GUSD) and the Paxos Standard (PAX) are two examples of coins that got the regulatory approval of the New York State Department of Financial Services.

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