What are Stablecoins and how do they work?

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Put simply, stablecoins are the bridge between fiat currencies like the Canadian Dollar or British Pound and cryptocurrencies. Each digital currency exists on the blockchain while maintaining the same price stability as a user’s local currency. Prices remain more consistent since issuing organizations back these tokens in a given ratio to a “stable asset.” These assets could be anything, although they typically fall under four collateral structures: commodity-backed, fiat-backed, crypto-backed and algorithmic. The structure may vary slightly between coins; however, one truth remains; all stablecoins aim to keep prices consistent.

In contrast, the prices of other digital currencies, such as bitcoin or Ethereum, aren’t pegged to a stable asset. Instead, their value comes directly from cryptography and peer-to-peer technology.

How stablecoins work

To consider how stablecoins work, we will start by looking at the four major types.

Stablecoins backed by commodities

Issuing organizations may back stablecoins by any physical asset like gold or silver, real estate, or oil. Today, the most popular is likely a digital gold backed cryptocurrency. Since gold bars typically vary in size, each token typically represents 1 ounce of gold (rather than a bar). If users were to redeem their tokens, they could take possession of the underlying gold through the issuing organization’s vault. Other commodities like real estate have yet to see many active projects, making it difficult to picture how this type of stablecoin would operate.

Stablecoins backed by fiat currencies

Another of the more popular stablecoins are those that are backed 1:1 with fiat currencies. Since the underlying asset is not a cryptocurrency, an issuing organization will hold these assets in a safe location like a financial institution. These assets exist in direct proportion to the number of stablecoins that the organization has issued. For example, if the issuing organization had $15 million of fiat currency, they would only issue 15 million stablecoins, each worth one dollar.

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Investors should remember that although prices are stable, fiat-backed currencies are not entirely safe since they are relatively new and don’t have a long history to reference.

Stablecoins backed by cryptocurrencies

Organizations collateralize crypto-backed stablecoins with another digital currency. To make this possible, the entire collateralization process is conducted on-chain with a technology known as smart contracts. Smart contracts are programmable pieces of code stored on the blockchain and run when a predetermined set of conditions occur. In this case, cryptocurrencies are locked into a smart contract that verifies a set of tokens of equal value. Users then put their stablecoins into the smart contract when they are ready to take their original collateral amount out.

The significant difference between stablecoins backed by digital currencies and those backed by fiat currencies is that crypto-collateralized assets are over-collateralized. Over-collateralization in this example ensures that some wiggle room exists for potential price fluctuations. For example, let’s say you wanted $10,000 worth of crypto-backed stablecoins. In this scenario, the platform may require you to deposit $15,000 worth of the underlying cryptocurrency. For the mathematicians, this works out to a 150% collateralization ratio. Therefore, if the price of the cryptocurrency drops but remains above a certain price point, any excess collateral will act as a buffer. Alternatively, additional collateral is put back into the smart contract if the price drops below a specific price.

Crypto-backed currencies are typically slightly less stable than fiat-backed since the prices of cryptocurrencies may fluctuate. For investors, it becomes essential to track the performance of the underlying asset, as well as the stablecoin itself.

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Stablecoins backed by algorithms

The final type of stablecoins is the ones backed by algorithms. This form of stablecoin isn’t technically backed by any collateral but a specialized algorithm and smart contract that help to manage the total number of tokens in circulation. With this system, the number of coins will automatically decrease when the market price falls below the cost of the tracked asset. On the other side, if the price of the stablecoin rises above the tracked asset, more tokens will enter into circulation to lower the value of each stablecoin.

Why use stablecoins

The reason why these digital currencies have gained in popularity is their ability to withstand volatility. Unlike bitcoin, in which prices may fall 50% or more overnight, prices of fiat-backed stablecoins have stayed right around the $1 mark, with stablecoins of other backings behaving similarly. While they might not make great investments, seeing as their value remains consistent, they offer mobility, faster transfers, accessibility, which give them an advantage over fiat currencies.

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