What is stablecoin and how does it work? A guide for beginners
Stablecoin is a cryptocurrency that binds its own market value to external “stable” reserve assets such as gold or fiat currency (e.g. the US dollar). How exactly does stablecoin work and why is it so popular among crypto investors?
Stablecoin is a bridge that connects cryptocurrencies with the classic fiat currencies we use every day. It was created as a type of cryptocurrency that will protect investors from major changes happening in the market.
Although the cryptocurrency market is developing rapidly, it is still subject to greater changes in value. Stablecoin uses a mechanism that makes it a less volatile asset than other cryptocurrencies.
This feature makes it a great tool for day-to-day cryptocurrency trading or transferring funds between different cryptocurrency exchanges.
The “stability” of fiat currencies and the flexibility of blockchain technology made stablecoin popular among crypto investors.
Recently the total value of stablecoin market was around 180 billion dollars.
What is Stablecoin and why it is important?
Stablecoin can be defined as a type of cryptocurrency that is pegged to the value of a commodity or fiat currency. Stablecoin ties its value to other real-world assets in order to maintain price stability.
Let’s take Tether for example. Tether is one of the most popular stablecoins in the cryptocurrency market. Tether is pegged to the value of the US dollar in a ratio of 1:1. Since it has coverage in US dollars, the price of Tether is always moving around 1 US dollar.
It may seem at first that stablecoin has the characteristics of traditional assets, but it is actually a type of asset that relies on blockchain technology.
We can see this from the following features:
- Stablecoins are global and available to everyone online, 24 hours a day.
- Every transaction made with stablecoin will be stored on the blockchain network.
- Stablecoins are fast, safe, and cheap when it comes to transaction fees.
How does stablecoin work?
In order to explain how stablecoin works we will use an example. Let’s say you have some Bitcoin and Ethereum in your portfolio. Now, you want to buy more Bitcoin with Ethereum.
First, you need to sell some Ethereum for stablecoin. After that, you can use that same stablecoin to buy Bitcoin.
This is just one use case for stablecoin. Stablecoin has many other functions. It can also be used as a means of preserving value, especially for traders who want to keep their money invested on a crypto exchange.
For example, if you have made a certain profit by trading cryptocurrencies and you want to protect it from the market dip.
The usual practice is to take your profits and turn them into stablecoin.
What can stablecoin be used for?
1. Protection against cryptocurrency market volatility
The value of cryptocurrencies is subject to great changes. Stablecoins are usually pegged to more stable assets, which is why investors use them in times of uncertainty in the market. By converting their crypto assets into stablecoin investors avoid the possibility of unpredictable rise or crash in the market.
2. Cryptocurrency trading
Stablecoin is based on blockchain technology, which means you don't have to have a bank account to have stablecoin. You can use Stablecoin anytime and anywhere, and even as a form of savings.
3. Earning interest
You can also stake your stablecoins on many platforms and earn interest that is higher than bank saving interest (they go around 0,01%).
4. Easy money transfer
Stablecoin is an asset that relies on blockchain technology. This is why stablecoins can be sent anywhere in the world at high speed with low fees.
Types of stablecoin
1. Fiat-backed stablecoin
As pointed out earlier in this text, this is the type of stablecoin that is pegged to the value of real-world assets like fiat curencies (or gold).
Most of today’s stablecoins are pegged to the value of the US dollar. Stablecoins pegged to the value of fiat currency must usually have reserves of that same fiat currency as collateral.
For example, if a certain amount of stablecoins enters circulation, the same value in fiat currency must be put in reserves to ensure that stablecoin coin has full coverage.
Most popular fiat-backed stablecoins:
- Tether USDT
- USD Coin USDC
- Binance USD BUSD
- Terra USD
2. Cryptocurrency-backed stablecoin
Cryptocurrency-backed stablecoins use the same principle as fiat-backed stablecoins. The only difference here is that cryptocurrencies are used as collateral.
Since cryptocurrencies tend to fluctuate in value, this type of stableoin must use a set of protocols to ensure that the price of the issued Stablecoin remains at the value of one dollar.
How does that work?
Let’s say you deposit 200 ETH to get $100 worth of stablecoin in return. When you deposit 200 ETH, stablecoins will have collateral worth 200%. This is important because if the price of Ethereum falls by 25%, stablecoins can still retain their value as there is still $150 left in collateral that supports the value of stablecoins.
Most popular crypto-backed stablecoins:
- Multi-collateral DAI
3. Algorithmic stablecoin (stablecoin without collateral)
Compared to the previous two types, algorithmic stablecoin does not use collateral. This is a type of stablecoin that runs on a specific algorithm and smart contracts.
The algorithm determines the price of the stablecoin, maximum supply, and other important variables that are essential for managing a stablecoin.
The algorithm prevents the potential value fluctuations of a stablecoin. Let’s say that the value of algorithmic stablecoin is set at 1$. If there is a high demand for the stablecoin, the algorithm will release an additional amount of tokens into circulation to lower the price and put it close to the value of 1$.
If the price of that stablecoin falls below one dollar, the algorithm will reduce the number of tokens (burn process), in order to increase the price.
The idea behind stablecoin is to combine the best features of fiat currencies and blockchain technology. Currently, stablecoins are used as protection against high volatility of the cryptocurrency market. However, it can also be used as a tool to increase transparency and decentralization.