What is a Stablecoin?

Many of us didn’t even know when we first started to buy crypto that we were using stablecoins beforehand, so what is stablecoin then?

A stablecoin is a type of cryptocurrency that is designed to minimize price volatility by being pegged to a stable asset such as gold or the US dollar. These coins use various mechanisms to maintain their stability, such as being backed by a reserve of the stable asset or being algorithmically stabilized. They are intended to be used as a store of value and a medium of exchange, similar to traditional fiat currencies.

But if you have little knowledge about stablecoins, this article is something you can’t afford to miss.

How do stablecoins work?

Stablecoins are a form of cryptocurrency with a value that is guaranteed to remain constant relative to an external factor, such as a fiat currency or a commodity like gold. 

Stablecoins aim to give a cryptocurrency with lower price fluctuations than others, such as Bitcoin and Ethereum. This increases the desirability of stable coinage for use in everyday commerce and as a long-term investment.

The value of stablecoins is maintained by a number of different processes. Methods that are typically used are:

Fiat-collateralized stablecoins

Stablecoins backed by a reserve of fiat currency, such as the US dollar, are known as fiat-collateralized stablecoins. Stablecoins are digital currencies whose value is tied to that of a reserve currency that is kept in a bank or similar entity.

Crypto-collateralized stablecoins

Stablecoins backed by a reserve of another cryptocurrency, such as Bitcoin or Ethereum, are known as crypto-collateralized stablecoins. 

Stablecoins have a value tied to the value of a reserve of the underlying cryptocurrency, which is stored in a smart contract on the blockchain.

Non-collateralized stablecoins

These stablecoins are not collateralized, meaning they are not backed by a central bank or another institutional fund. They depend instead on sophisticated algorithms to preserve their worth. 

The algorithms used to maintain the stable coin’s value can be based on supply and demand or on the decisions of a decentralized autonomous organization (DAO).

Every one of these techniques comes with its own set of pros and cons. Fiat-backed stablecoins are the simplest, but their success depends on the credibility of the issuing bank that holds the reserve.

 Decentralized crypto-collateralized stablecoins are backed by the value of a cryptocurrency index. Stablecoins that do not rely on collateral are the most difficult to implement but are also the most decentralized.

Some stablecoins employ a mix of processes, such as those listed above, to maintain a constant value. A stablecoin may, for instance, use both collateralization and non-collateralization, or it may be backed by both fiat currency and cryptocurrency.

Challenges and limitations of stablecoins

Pegging a stable coin means anchoring its value to that of another asset, usually a fiat currency like the US dollar or a commodity like gold. 

This is done to reduce its volatility to make the stable currency more useful as a means of exchange and a store of value. 

Fully backed, algorithmic, and hybrid stablecoin pegs are all possible variations.

As the name implies, with a fully backed stable coin peg, the stablecoin is backed one-to-one by the underlying asset.

The algorithm’s design guarantees the stability of a cryptocurrency linked to an algorithm rather than a physical object.

These hybrid pegged stable coins include the advantages of both fully backed and algorithmically pegged stable coins.

Stablecoins are ideally suited for use as a medium of trade and a store of value because of the stability of stablecoin pegging.

Can a stablecoin collapse?

Stablecoins can fail if they lose confidence in the procedures utilized to maintain their value.

This could happen if it becomes evident that the stable coin’s value stabilization mechanisms (the underlying assets or algorithms) are flawed.

When a supporting asset, such as a fiat currency or a commodity, drops in value, the stablecoin’s value also declines, and investors may begin to question its stability.

A stablecoin may also collapse if its demand decreases, which may occur if investors lose faith in the currency’s stability mechanisms, lose interest in it, or if the market moves its attention to alternative stable coins or cryptocurrencies.

As a result, confidence in the stablecoin may decrease, and the entire system may fail.

Moreover, if the stablecoin is not offered on enough exchanges or if its market volume is insufficient, the value of the stablecoin may collapse.

This can make purchasing and trading the stablecoin difficult for individuals and businesses, resulting in a decrease in value or perhaps collapse.

In the end, regulatory constraints and legal concerns can also cause a stablecoin to fail. 

As the laws and regulations surrounding stablecoins continue to evolve, a stablecoin project may face regulatory obstacles that make it impossible to operate, resulting in a loss of trust in the stable currency and its eventual extinction.

What is the most traded stablecoin?

One of the earliest stablecoins ever created was called Tether (USDT). It was first introduced to the public in 2014. According to the total market cap as of 2023, it is the stablecoin with the most trading volume. 

For several years now, Tether has consistently been among the top five most valuable cryptocurrencies in market valuation. The value of one Tether is equivalent to one US Dollar.

 This relationship is known as “pegging.” It is said that the firm behind Tether backs each unit with funds from the United States. Despite this, law enforcement agencies are sceptical of these assertions. 

The price has remained relatively unchanged for the most part, with the exception of a few brief periods in which it fell.

Final Thoughts

If you are a beginner in crypto, it is crucial to understand how stablecoins work. It is an excellent tool to keep your capital safe whenever there is high market volatility.

If you made it this far, you might consider giving a shot to our website’s blog and resource pages, where we have a handful of helpful content and tools.