What are Stablecoins and How Do They Work?

What are Stablecoins and How Do They Work?

Reading Time: 5 Minutes

You might have heard much about Bitcoin (BTC) and Ethereum (Ether) but the term ‘Stablecoins’ has also made rounds in the cryptocurrency circle. They're like the chill cousin in the crypto family as they offer a more stable option in a world where digital currencies can be volatile and unpredictable. 

What are Stablecoins?

As the name suggests, Stablecoins are a type of cryptocurrency that is known for their price stability. They differ from cryptocurrencies like Bitcoin and Ethereum, which tend to be unpredictable. While the prices of Bitcoin and other cryptocurrencies can be extremely volatile, Stablecoins can act as the opposite.

Its stability comes from how it is made. Usually, Stablecoins are pegged to something stable and tangible like gold or fiat currencies like the US dollar (USD), euro (EUR), or Japanese yen (JPY). This strategy keeps the price of the Stablecoin from moving too much in the crypto market.

Types of Stablecoins & How They Work

Fiat-Backed Stablecoins

Think of fiat-backed Stablecoins like a savings account for each coin. For every one of these Stablecoins, there's real, actual money tucked away somewhere safe. This money can be in the form of dollars, euros, or any other traditional currency. It's like having a dollar bill stored in a vault for every single digital coin you own. This method is straightforward. One digital coin equals one real-world dollar (or another currency). Examples include Tether (USDT) and USD Coin (USDC).

Crypto-Backed Stablecoins

These are a bit more like a puzzle. Crypto-backed Stablecoins use other cryptocurrencies as their safety net. Imagine you have a box of Legos, with each Lego piece representing a different type of cryptocurrency. You build a structure using these Legos, and this structure supports your stablecoin. It's a bit more complex because the value of these 'Legos' (other cryptocurrencies) can change. So, the system constantly adjusts by using smart contracts (which are like complex digital agreements) to keep the Stablecoin's value stable. Think of smart contracts as robot referees that constantly watch the value of the Stablecoins and the supporting crypto. If the value of the supporting crypto changes, the smart contracts adjust things to keep the stablecoin's value steady.

Algorithmic Stablecoins

Besides crypto and real money, what else can a stablecoin be tied to? Like cash or other cryptocurrencies, non-collateralised Stablecoins don't have a physical backup. Smart systems keep track of their value. The programme will bring the stablecoin's value back to the middle if it goes too high or too low. It's like having a system that is always working to keep the coin stable without having to back it up with real money or other crypto. However, they can be more susceptible to market volatility, as seen with tokens like Terra (LUNA).

Pros & Cons of Stablecoins

Its stability can help those who want to trade in crypto but don't want to deal with the volatile movements of digital currencies like Bitcoin. You can also pay your bills or shop for things you need without worrying about the value of the coin changing at any given time. You can enjoy the convenience of digital cash with the dependability of regular money. Those who want to get into crypto but are afraid of how unpredictable it can be can also do so, as stablecoin can make a great choice for people who are just starting out.

But those who are willing to take big risks and want big gains might not be interested in Stablecoins as they don't fluctuate in price that much. There is also a problem with assurance. You need to believe that these coins are backed by real assets or money as claimed. The laws and rules that control crypto are another problem that comes up a lot. 

Crypto-clusion

Stablecoins are an interesting form of digital currency as they represent a more stable choice than their crypto relatives. If you're new to crypto, you might want to learn more about Stablecoins.  It's important to do your own research and know what you're getting into when it comes to making any financial decisions.