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Stablecoins combine the world of cryptocurrencies with the stability of traditional currencies. They bridge traditional and digital finance, offering a more stable option for transacting within volatile crypto markets. In this guide, we explain what a stablecoin is, how stablecoins work, and their role within the crypto ecosystem.
Stablecoins are digital currencies whose value is tied to stable assets like the dollar.
They allow for less volatile trading on crypto platforms.
Well-known stablecoins include Tether (USDT) and USD Coin (USDC), which can be traded on crypto platforms.
Stablecoins are backed by fiat reserves, crypto assets or algorithmic processes.
By definition, stablecoins are digital currencies that are tied to traditional assets such as the US dollar. Their primary aim is to maintain price stability, which sets them apart from other cryptocurrencies. By being pegged to more stable assets, they minimise the risk of price fluctuations, are intended to support more stable transactions in the crypto market and can be used as a means of payment. Different types of stablecoins use various methods of value backing to maximise their stability, making them a crucial link between the digital and traditional financial worlds.
Stablecoins function by pegging their value to a stable asset such as a fiat currency or gold. To maintain this peg, different mechanisms are used. Some stablecoins hold direct reserves in the pegged currency, while others use algorithms to stabilise their price.
These mechanisms aim to ensure that the price of a stablecoin remains steady and closely aligned with the value of the underlying asset, despite the volatility of the crypto market. As a result, stablecoins are often used in trading and may offer a more predictable digital payment method, depending on the context.
Crypto-collateralised stablecoins represent an innovative form of decentralised backing. Instead of being supported by fiat currencies or physical assets, these stablecoins are backed by other crypto tokens or coins. The term “decentralised backing” refers to the fact that the value of these stablecoins is secured and regulated by a distributed network of crypto assets rather than a central authority.
“Collateralised” describes the process of securing value by depositing assets as collateral. In this case, cryptocurrencies are used as collateral to support the stablecoin’s value and shield it from the volatility commonly associated with digital currencies. This method offers increased transparency and security, as all transactions are recorded on a blockchain and can be verified by anyone. For example, when generating DAI, a well-known crypto-collateralised stablecoin, users must deposit Ether (the native cryptocurrency of the Ethereum blockchain) at a higher value than the amount of DAI issued. This ensures that the stablecoin remains stable even if the value of the deposited Ether declines.
Fiat-collateralised stablecoins follow a centralised backing model, using traditional, non-digital assets such as fiat currencies like the euro or US dollar for security. Unlike decentralised backing, which relies on crypto assets, this method is rooted in conventional financial systems. The value of these stablecoins directly reflects that of the underlying fiat currency on a one-to-one basis, supported by corresponding reserves held in the issuing entity’s bank accounts. This structure typically ensures high liquidity and allows for the direct exchange of digital and traditional currencies.
Centralised fiat backing requires a high level of trust in the issuing company, which must guarantee the redemption of digital currency into traditional money. Transparency through regular audits is crucial in maintaining this trust.
Algorithmic stablecoins do not rely on physical collateral. Instead, their value is regulated through algorithms and automated systems. The concept is that smart contracts automatically increase or decrease the supply based on demand to maintain a stable price. This approach remains experimental, with concerns regarding its effectiveness and responsiveness in extreme market conditions. Additionally, regulatory challenges may arise, as the legal framework for algorithmic stablecoins is still under development.
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Stablecoins have gained recognition for their stability and potential for fast transactions. Let’s take a look at some of the most prominent ones:
Tether is the most well-known and widely used stablecoin, pegged 1:1 to the US dollar. USDT operates on multiple blockchains, including Ethereum, Tron, and Solana. It is centrally issued by Tether Limited, which claims that every USDT is fully backed by reserves, though this claim has faced scrutiny in the past. Its centralised management has raised concerns about transparency and the verifiability of its reported fiat reserves.
BUSD is a stablecoin issued by Binance, one of the world's largest cryptocurrency exchanges, in partnership with Paxos, a US-based financial institution and technology company. BUSD is also pegged 1:1 to the US dollar and aims to provide users with a secure and stable way to trade cryptocurrencies.
USD Coin is a stablecoin supported by Circle and Coinbase. It is known for being fully backed by US dollar reserves and offers an alternative to USDT with similar functionalities. USDC is often praised for its more transparent reserve reports and adherence to compliance standards.
DAI stands out from other stablecoins as a decentralised stablecoin governed by MakerDAO, a decentralised autonomous organisation (DAO). MakerDAO serves as the backbone of the system, enabling a transparent and efficient management structure. DAI maintains its peg to the US dollar through a mechanism controlled by smart contracts, making it an interesting example of how stability and decentralisation can be combined.
Stablecoins can serve an important role in the broader crypto ecosystem. They act as a bridge between the volatility of the crypto market and the stability of traditional currencies.By aiming to reduce volatility, stablecoins offer a more predictable option for transactions and portfolio management. Their peg to established assets such as the US dollar, euro, or even gold makes them an useful option for those seeking stability.
Overall, stablecoins significantly contribute to the adoption and use of cryptocurrencies by offering a reliable and predictable alternative to traditional currencies. Their importance in the digital economy will continue to grow, as they serve as a connection between traditional and modern financial systems.
We address the most important questions about stablecoins to give you a clear overview.
