How Stablecoins Remain Stable Explained

The crypto industry has suffered from strong volatility ever since Bitcoin first got its price. With no real-world asset to back up the coins, their price was always subjected to change. Supply, demand, market sentiment, various events, adoption rate, and similar things have been affecting how much the coins’ prices would go up or down.

However, while this did offer a chance to make a great profit, it also meant great losses for any investor who made a wrong move. Plus, it also meant that investors and traded had to immediately sell their coins for fiat as soon as the prices started going down, or commit to a long-term wait before the prices recover. This was not a very practical solution, and it made crypto quite risky, with only a few options to protect your wealth.

A solution needed to be found, which led to the creation of a new type of coin — one that would be immune to volatility and sudden price changes. This new type of coin was named stablecoin, with its most important feature — price stability — right there in the name.

What are stablecoins?

Stablecoins emerged as cryptocurrencies that can ignore market trends and volatility and keep their price at the same level, regardless of the market sentiment, supply and demand, and other aspects that usually determine the value of a digital coin. They are cryptocurrencies in the sense that they are digital money that operates on top of blockchain technology.

Just like other digital currencies, stablecoins are capable of making instant payments anywhere in the world, their payments are immutable, and alike. However, their ability to keep their price fixed has been a major game-changer for the crypto industry.

Suddenly, the crypto sector got an asset that can act as a safe haven in times of great volatility — a safe place for when the bearish wave strikes, and when prices start to crash. This led the entire crypto community to buy them during great price drops, and keep their wealth safe, while also keeping it inside of the crypto industry, instead of having to sell their coins for traditional currencies.

How do stablecoins work?

The way stablecoins work is rather simple. Essentially, all that is needed is to have each coin backed by another asset. That can be fiat currencies, such as the USD, GBP, EUR, and alike; or it can be real-life goods, such as oil, gold, silver, and alike. Finally, stablecoins can also be backed by other cryptocurrencies, or they can act as so-called algorithmic stablecoins, which are by far the most complex.

With that said, let’s now take a look at all of these different types of stablecoins and see how each of them works.

1. Fiat-backed stablecoins

First, we have fiat-backed stablecoins. These are by far the most common and the most widely used stablecoins that use fiat currencies to keep their prices stable. The way they work is quite simple. All that stablecoin issuers need to do is create their coins and prove that they hold enough money to cover every coin with an appropriate amount of cash.

Since these stablecoins are typically pegged to the USD, where 1 coin equals $1, that means that the issuer’s account needs to have enough money to cover the coin’s supply. In other words, if there is a million coins in circulation, then there needs to be $1 million in the issuer’s account.

If there is more coins than money in the account, the price per coin would drop. If there are fewer coins than dollars in the account, the coin’s price would increase. Of course, stablecoin issuers need to be very transparent with how much money they have in order to appear trustworthy and for their coin to be truly reliable.

Some examples of this kind of stablecoin include Tether (USDT), which is by far the largest one in the industry, and the third-largest crypto by market cap. Then, there are coins like USD Coin (USDC), Binance USD (BUSD), and others.

2. Crypto-backed stablecoins

Next, there are crypto-backed stablecoins. These can be backed by one cryptocurrency or even an entire basket of them. These coins tend to be quite overcollateralized, as cryptocurrencies are extremely volatile, which led to the creation of stablecoins in the first place. The reason why these stablecoins even exist is the crypto industry’s desire to have decentralized stablecoins.

The way they work is also pretty simple. Users who wish to mint stablecoins are required to lock up their collateral tokens into a smart contract. If the collateral drops in value, it gets liquidated to make up for the price change. And, if you want your collateral back, all you need to do is return the stablecoins.

One of the best examples of this type of coin is MakerDAO’s DAI. Like fiat-based stablecoins, DAI is also pegged to $1.

All in all, this is a good approach to having decentralized stablecoins, although its biggest flaw is the fact that it uses digital currencies, who can be extremely volatile at times — sometimes even so volatile that even an overcollateralized stablecoin can be endangered by it.

3. Asset-backed stablecoins

The third kind of stablecoin is the commodity-backed, or asset-backed stablecoins. As mentioned, these are stablecoins that are backed by real-world assets, such as precious metals, real estate, or some other asset that has value in the real world, and can, therefore, be used to provide assets to the stablecoin, as well.

Similarly to how stablecoins are backed by fiat currencies, these are also directly linked to a specific amount of the commodity and stored in a known location. They must also be regularly audited, since physical goods can be sold, as well as stolen or destroyed, depending on what exactly is being used.

The best-known example of this kind of stablecoin is Pax Gold — an Ethereum-based stablecoin created by Charles Cascarilla, the CEO of Paxos. This coin is backed by one fine troy ounce of London Good Delivery gold, stored in Brinks’ LBMA-approved gold vault in London.

Another example would be Venezuela’s Petro, a cryptocurrency created in early 2018 and backed by the country’s oil reserves. Although, most people do not consider Petro to be a real cryptocurrency, much less a stablecoin, due to the fact that it was created by the country’s president who has been trying to make his citizens switch to the coin to battle hyperinflation. However, the people were never that interested in this particular stablecoin, and would much rather use regular cryptocurrencies.

4. Algorithmic stablecoins

Last, but not least, we have algorithmic stablecoins. These are the most complex of all stablecoins, as they rely on algorithms and smart contracts to protect their price stability.

Essentially, what they do is use algorithms and smart contracts to control the stablecoin’s supply. They increase it and decrease it per need, in order to maintain a level price. That means that these coins are not backed by any kind of collateral. Instead, their value remains the same, but their supply changes in accordance with the fiat currency whose price it tracks.

Essentially, it can be pegged to any fiat currency, be that dollar, euro, or something else. If the market price of the stablecoin starts to fall below that value, the algorithm will quickly remove tokens from circulation. Since there will now be fewer tokens, their value will jump back to normal. The same is true in the opposite scenario. If the stablecoins start seeing an increase in price, the algorithm will simply dump more of them into circulation in order to prevent a price surge.

This kind, while the most complex, is also probably the most decentralized kind of stablecoin there is. It is all completely automatic, so it doesn’t depend on the amount of money or some other asset that the issuer has in storage, nor does it risk being devalued due to a sudden bearish wave that knocks down the price of a collateral coin.

With none of that weighing it down, this type of stablecoin might be the most popular type in the future. For now, however, the industry is still relying on centralized coins primarily, as they are the most reliable, provided that their issuer can be trusted.

Conclusion

Stablecoins emerged as a very useful type of cryptocurrency — one that can offer safety and reliability in times when the bears rule the market, and crypto users need a safe place to store their wealth. They are also very convenient, often paired with most, if not all coins on every exchange on which they get listed.

There are multiple types, as we have seen in this guide, and while some are better than the others, in the end, they are all doing the same thing, which is helping you stay in crypto even when the market conditions are unfavorable.