Stablecoins are a type of cryptocurrency whose value is tied to an external asset to reduce volatility. Therefore, the value of a stablecoin is linked to the much more stable value of fiat currency – or government-issued currency such as dollars or euros. Thus, reducing the price volatility of the cryptocurrency to make it more appealing for transactions.
Typical cryptocurrencies like Bitcoin and Ethereum have revolutionized how people send and receive money. However, the main criticism of these currencies is their volatility and the subsequent uncertainty that this creates for everyday users. Consumers need to be relatively sure of the purchasing power of a currency, otherwise it may be devalued.
As the name suggests, the value of stablecoin is tied to the much more stable value of fiat currency – or government-issued currency such as dollars or euros. While fiat money is not without volatility, it is much more stable than traditional cryptocurrencies because it is backed by an underlying asset. Stability is also increased by a central authority actively managing supply and demand in response to market volatility.
The four categories of stablecoins
Depending on the nature of the collateral, stablecoins can be divided into four categories:
- Fiat-backed stablecoins. When stablecoins use fiat money as collateral, an entity may choose to back one million units of stablecoin with $1 million held in a bank. The U.S. dollar is a popular form of collateral, but any currency subject to strict auditing and regulation is suitable.
- Commodity-backed stablecoins. Here, value is tied to commodities such as gold and silver. Oil is also being used to back stablecoins, with the Venezuelan government-issued “petro” a prime example. One unit of stablecoin is typically worth one unit of the predetermined commodity and may vary as a result. That is, gold value may be determined by ounces and oil by barrels.
- Crypto-backed stablecoins. The most volatile stablecoins. They often need to be “over-collateralized” to account for large swings in value. This means that a large number of cryptocurrency tokens serve as a reserve for a relatively low number of stablecoins. Smart contracts are used to handle the issuance of units and maintain integrity.
- Algorithmic stablecoins. These stablecoins track a fiat currency but are not backed by an underlying asset. Instead, their supply is managed by algorithms in much the same way central banks manage national currencies. In very general terms, the algorithm will reduce supply if the stablecoin price is below the fiat currency it tracks. If the price is higher than the fiat currency, new coins will be released to reduce stablecoin value.
Some inherent risks of using stablecoins
While stablecoins are less volatile than traditional cryptocurrencies, it’s important to understand that some degree of risk remains. Ultimately, stablecoins are tied to the potential risks associated with the underlying asset. These risks include market fluctuations, theft, regulation, algorithm manipulation, or a change in consumer sentiment.
Fiat-collateralized stablecoins are also less decentralized than Bitcoin because a central entity must provide and hold the collateral. Users should research the entity to determine whether it has the necessary protocols in place to protect stablecoin value. Hypothetically, a central authority could print money without oversight and cause stablecoins to become backed by a hyperinflated currency.
- Stablecoins are a type of cryptocurrency backed by an external asset to reduce volatility and increase stability.
- Stablecoins can be divided into three categories based on the type of collateral used: fiat-backed, commodity-backed, and crypto-backed. The fourth category, algorithmic, maintains stablecoin value by manipulating supply and demand
- Stablecoins are less volatile than traditional cryptocurrencies, but they can be subject to the same risks encountered by the underlying asset.
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