how does a stablecoin work

How Does A Stablecoin Work? Everything You Should Know

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Last Updated on October 14, 2021 by Calvin C.

Stablecoins bridge the gap between fiat currencies and volatile cryptocurrencies, giving risk-averse users an opportunity to step into the world of crypto…but what the heck is a stablecoin? How does a stablecoin work? To learn all about this type of crypto asset, keep reading.

What is a stablecoin?

A stablecoin is a cryptocurrency that is linked to an non-volatile asset, like a USD, or other means, to achieve stability.

The first stablecoin, Tether, was launched in 2014 by Tether Limited and it is the oldest stablecoin.

Stablecoins attempt to give the best of both worlds, that is:

  1. Instant processing, privacy and security of cryptocurrencies
  2. Stability of fiat currencies like the USD
  • Interested in buying or selling stablecoins? Use the most popular exchange:

How does a stablecoin work?

The stability of stablecoins is achieved by 4 main ways.

The most popular way has already been highlighted above and this is by backing a stablecoin with a reserve of fiat currency like USD.

Since fiat currencies are tightly controlled by reserve banks, they are less likely to make wild changes in value like what we get with decentralized cryptocurrencies.

Scammers can take advantage of the volatility of other cryptocurrencies like Bitcoin to steal from unsuspecting investors and this is what stablecoins attempt to solve.

Make sure you read about various types of Bitcoin and Altcoin scams in the article linked.

The second way is even better as it backs the stablecoins with precious metals e.g. gold or silver, commodities like oil etc.

In the third method, the stablecoins are backed by reserves of other cryptocurrencies. To counter the volatility that comes with these other cryptocurrencies, a large number of cryptocurrencies backs a smaller number of stablecoins.

This scenario is called over-collateralization and this is done to give investors confidence that they can recover their funds should tokens be stolen.

Lastly, there are algorithmic stablecoins that don’t use any collateral to maintain a stable value.

Instead, the supply and demand of the coins is maintained by an algorithm that ensures that the stablecoin maintains its value.

Pros and cons of stablecoins

Pros

  • Easily retrievable when you want to use them
  • No regulatory authority to get your funds
  • Great interest rates
  • Less fees compared to transacting with credit cards
  • Anonymous transactions

Cons

  • If you lose the keys, you risk losing your coins forever
  • No warrants on your funds, unlike banks that are regulated
  • Exchanges may fail to give investors an honest value of stablecoins that are truly backed
  • Don’t expect major gains like in other digital currencies
  • A third party controls your crypto assets
  • No clear standards in auditing issuers of stablecoins
  • Regulators of fiat currencies also involved

Cryptocurrencies rely purely on supply and demand in the market, without any influence from any socioeconomic or political indicators.

This makes digital currencies very volatile, hence investors who want a stable currency shy away from regular digital currencies.

With that background, stablecoins are used to store value without leaving the cryptocurrency ecosystem.

Popular examples of stablecoins

To make it easier to know the various stablecoins that are out there, let’s split them into 3 groups:

  1. Fiat-collaterized
  2. Crypto-collaterized
  3. Non-collaterized

1. Fiat-collaterized

For this to be effective, the issuer must be audited regularly and be transparent.

Popular fiat-collaterized stablecoins are:

  • Tether-USDT
  • TrustToken
  • GUSD Paxos
  • USDC
  • PAX Circle
  • TUSD Gemini
  • Binance USD

2. Crypto-collaterized

Here, other cryptocurrencies are used as a reserve.

Examples of crypto-collaterized stablecoins are:

  • MakerDAO
  • Havven

3. Non-collaterized stablecoins

These stablecoins use an algorithm to regulate supply and demand.

  • Basis
  • Carbon

Conclusions

Stablecoins are good for long-term investment as they are free from wild, unexpected market swings, provided the issuer is reputable.

Make sure you store your stablecoins on a hardware wallet instead of keeping them on the exchange.

In addition, you should buy or sell your stablecoins on a reputable cryptocurrency exchange to avoid falling victim to scammers.

Are you interested in stablecoins? Leave comments below and share the article on social media.

Tech writer and VPN expert. DIY enthusiast and loves anything to do with space science.

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