A stablecoin is a digital asset whose value remains stable in relation to a pegged external traditional asset class, such as fiat currencies, bonds, or precious metals. Designed to offer a stable price, stablecoins minimize volatility risks often found in the crypto market by anchoring their value to conventional assets. These digital assets aim to promote cryptocurrency adoption and offset the speculative nature of digital assets by combining the security and decentralization of cryptocurrencies with the stability of fiat currencies.
Due to price fluctuations, Bitcoin is too volatile for everyday use. A digital asset that maintains a stable value over time is required for entering and exiting decentralized finance ecosystems and as a medium of exchange. Ideally, this digital asset should experience low inflation to preserve its purchasing power.
Previously, crypto investors and traders could not secure profits or avoid volatility without converting crypto back to fiat. Stablecoins have provided a straightforward solution to these challenges.
There are three main types of stablecoins:
1. Fiat-backed stablecoins hold reserves in fiat currencies like USD or GBP. Examples include USDT and BUSD, which are backed by real US dollars as collateral. Users can exchange between fiat and stablecoin at the pegged rate, and arbitrageurs help maintain the fixed rate if the token’s price deviates from the underlying fiat.
2. Cryptocurrency asset-backed stablecoins are backed by other cryptocurrencies, such as Bitcoin or Ether, generated on the Ethereum platform. These stablecoins, held in smart contracts, are less centralized and not vulnerable to the same risks as traditional asset-backed collateral.
3. Non-collateralized stablecoins do not have asset backing. Instead, they employ algorithms to balance the stablecoin’s supply and demand, ensuring its value remains stable. An algorithmic stablecoin system reduces token supply when the price falls below the tracked fiat currency through locked staking, burning, or buy-backs. When the price exceeds the fiat currency’s value, new tokens circulate to decrease the stablecoin’s value.
It is important to note that stablecoins are not guaranteed to maintain their peg. While some large projects have had success, others have failed. A stablecoin that consistently struggles to maintain its peg can lose value significantly.
Lastly, not all stablecoins undergo full public audits; many only provide regular attestations conducted by private accountants on behalf of the stablecoin issuers.