What is a stablecoin?
If you’ve watched the news, or you’ve been monitoring crypto markets you’ve probably seen the price of almost all cryptocurrencies vary significantly. Stablecoins serve as a robust solution to this volatility problem.
Stablecoins are cryptocurrencies backed by more traditionally stable assets like fiat currencies, precious metals like gold and silver or larger pools of cryptocurrency. This collateral support makes them more ‘stable’ like the traditional assets that back them while offering the advantage of both holding value and being quickly tradable back into other cryptocoins
Cryptocurrencies aren’t currently deemed fit for daily usage by the mainstream for the exchange of goods, as their value could increase or decrease by 10-20% within a few hours making pricing of simple goods in a grocery shop for example very difficult
Stablecoins solve this volatility issue very effectively. They also offer a safe place to store value when trading between different cryptocurrencies.
Stablecoins are stable, scalable, private and remain decentralised; effectively bridging the gap between the standard expected from a fiat currency and the crypto world.
Let’s dive into different types of stablecoins.
Fiat-based stablecoin
As the name suggests, these stablecoins are intrinsically linked, or ‘tethered’, to fiat currencies like GBP or USD. The stablecoin provider holds a certain amount of the fiat currency in collateral against the crypto tokens.
Stablecoins follow a 1:1 ratio, meaning for every one stablecoin issued there is one dollar or pound in collateral to back it. It’s essential the stablecoin issuers are transparent with their fiat holdings to ensure people maintain trust in their stablecoins as a safe store of value.
Crypto-backed stablecoin
Crypto-backed stablecoins are tied to cryptocurrencies using smart contracts. They are issued by the smart contracts themselves, as opposed to a central issuer in fiat-backed stablecoins. This more decentralised approach means trust is placed with the majority consensus of the platform to ensure stability rather than a centralised offering.
You have to lock a certain amount of cryptocurrency in a smart contract to get your stablecoins issued. As cryptocurrency can be highly volatile, a crypto-backed stablecoin is always over collateralised. For instance, for every 1000 tokens issued there would be a reserve of 1500 crypto coins. This extra collateral is intended to balance any fluctuations in the crypto markets and maintain greater stability.
Algorithmic stablecoins
Algorithmic stablecoins aren’t backed by fiat or crypto assets. Instead, algorithms and smart contracts maintain the stability of tokens by actively controlling the token supply. In vague terms, algorithmic stablecoins are loosely tied to fiat currency as they trace a particular fiat currency.
If a token price falls below the price of the fiat currency it is linked to the algorithm will reduce the token supply. Similarly, the algorithm will increase more stablecoins if its price exceeds that of the fiat currency. This active management provides stability to the algorithmic stablecoins.
However, they are still collateralised assets. They also have a substantial reserve to manage and volatile swings in the markets.
Summary
Stablecoins are cryptocurrencies tied to fiat currencies, other traditional physical assets like gold, silver or other cryptocurrencies. This collateral is the principle at the heart of a stablecoin as it provides security and stability within the crypto space.
To put it simply, stablecoins is the bridge between the crypto world and the traditional financial systems.
