What is a stablecoin in simple terms?
By definition, a stablecoin is a type of cryptocurrency designed to maintain a stable value by being tied, or pegged, to another asset, such as a fiat currency like the US dollar or a commodity like gold. This link is referred to as a peg.
This peg is what sets them apart from other cryptocurrencies like Bitcoin (BTC) that can experience huge price swings in short spaces of time. Because their price is intended to stay relatively stable, stablecoins are often used for trading, payments, and moving money in and out of the crypto market without being exposed to that volatility.
How do stablecoins work?
Stablecoins use different mechanisms to keep their price close to the value of the asset they track. Broadly speaking, there are two main methods.
Some issuers hold reserves of the asset that backs each token in circulation. Depending on the stablecoin type, the reserves could be cash, government bonds, or commodities. Others rely on automated smart contracts, which adjust the supply of tokens in response to market demand, expanding or contracting it to keep the price stable.
Stablecoins fall into four main categories based on how they aim to maintain this stability.
Fiat-backed stablecoins
The most common type, fiat-backed stablecoins are backed by reserves of traditional fiat currency and cash-equivalent assets such as short-term government bonds. These reserves are intended to match the value of the tokens in circulation.
One unit of the stablecoin generally aims to equal one unit of the underlying currency. For example, a stablecoin pegged to the US dollar, such as USD Coin (USDC), aims for a value of 1 USDC = 1 USD. Holders may be able to redeem their tokens for the underlying fiat value, depending on the issuer’s rules.
Stablecoins such as USD Coin (USDC) are available on platforms like Bitpanda, where users can buy, sell, and hold them alongside other cryptocurrencies.
Crypto-collateralised stablecoins
Instead of being tied to traditional currencies, crypto-collateralised stablecoins are backed by other cryptocurrencies. So instead of holding cash in a bank, the system holds crypto assets such as Ether.
Because crypto prices can be highly volatile and fall in an instant, there is a risk that the stablecoin becomes underfunded. To reduce that risk, these stablecoins are typically over-collateralised, meaning the system requires users to deposit more value in crypto than the amount of stablecoins they create.
These systems operate through smart contracts, which manage collateral automatically according to predefined rules. If the collateral value falls too far, the smart contract can automatically liquidate part of it to keep the system solvent.
Algorithmic stablecoins
Algorithmic stablecoins are not backed by traditional reserves or fully collateralised assets. Instead, they use smart contracts and other programmed mechanisms to manage supply and demand. If the price rises above the target value, the system increases the supply of tokens to help bring it back down. If the price falls below the target, it reduces supply through mechanisms such as token burns or redemptions designed to restore the peg.
In practice, the stability of these tokens depends heavily on people trusting and using the system and, if trust weakens, the algorithm can struggle to maintain the peg. A well-known example is the 2022 collapse of TerraUSD (UST), which lost its peg to the US dollar and dropped sharply in value within days, illustrating how quickly algorithmic stablecoins can fail when confidence is lost.
Commodity-backed stablecoins
Stablecoins can be tied to the value of a real-world asset, most commonly gold, but sometimes silver, oil, or other raw materials. Each token typically represents a specific amount of that commodity, such as one gram of gold held by a regulated third party.
Rather than being physically held by the user, the underlying commodity is stored in secure vaults by the issuer or a custodian. Their value is primarily tied to the commodity’s market price.
Even though they’re backed by physical assets, they’re not without risk. The price of the underlying commodity can still fluctuate, and there are practical concerns around storage and whether the issuer actually holds the assets they claim to.
Paxos Gold (PAXG) and Tether Gold (XAUT) are two examples, both backed by physical gold stored in professional vaults.
