What are Stablecoins and How They Work

what is a stablecoin

That’s why most people would be unwilling to spend bitcoin, and most merchants would not take bitcoin as payment today. There is a wide variety of stablecoins with differing levels of transparency. Stablecoins come in a few variations, but most are pegged to the U.S. dollar. While we are independent, we may receive compensation from our partners for featured placement of their products or services. Usually, you expect to pay a transaction fee when buying or selling cryptocurrencies with an exchange.

what is a stablecoin

It creates “trust” in TUSD by submitting the stablecoin’s reserves to frequent auditing and attestations by independent external parties. At the time of writing, TUSD is not at peg with the US Dollar (99c). Likewise, many investors make their stablecoins available to cryptocurrency exchanges to facilitate trades in what are called liquidity pools. Investors who engage in this practice are called liquidity providers, or LPs, and they reap fees for providing their stablecoins to platforms like Uniswap. If a stablecoin loses its intended value and is unable to quickly recover it, it becomes functionally useless.

What Is a Stablecoin?

Stablecoins are cryptocurrencies whose value is pegged, or tied, to that of another currency, commodity, or financial instrument. Stablecoins aim to provide an alternative to the high volatility of the most popular cryptocurrencies, https://www.tokenexus.com/ including Bitcoin (BTC), which has made crypto investments less suitable for common transactions. Fiat currencies, such as the U.S. dollar or the British pound, don’t see this level of price volatility.

what is a stablecoin

The management of reserve assets is a key factor in determining the value and credibility of a stablecoin. If doubts arise about the adequacy of the reserve backing the stablecoins in circulation, that could undermine their value. Treasury and the European Central Bank have expressed concern about this potential flaw in the system and fear stablecoins could melt down and harm investors if they fail. The notion of something called a stablecoin may strike some as an oxymoron. Cryptocurrencies, after all, are synonymous with volatility in a market routinely whipsawed by hype and speculation.

Dai Decentralized Stablecoin (DAI)

The algorithm controls the coin’s demand and supply, which are dictated by smart contracts, affecting its value. Since there is no centralized reserve for these stablecoins, they can easily be dubbed decentralized. One well-known algorithmic stablecoin is the TerraUSD (UST) which lost its peg in 2022. One of the main uses for stablecoins is as a reliable means of exchange. These coins can be traded just as any other coin and can be used as an intermediary between sending and receiving payments. This is great for both institutions as well as retail users of crypto since they can be sure the price will not alter between transactions.

what is a stablecoin

For example, merchants may take $5 in BTC for a coffee one day but find that their BTC is worth 50% less the next. This makes it challenging to plan and operate a business that accepts crypto payments. Federal Reservewarned stablecoins are increasingly used to facilitate leveraged trading in other cryptocurrencies. Binance USD (BUSD) is the third largest stablecoin by market cap and is pegged to the dollar on a one-to-one basis. According to its partner developers, Binance and Paxos, BUSD is 100% backed by an “equal amount” of U.S. dollars and treasury bills. Stablecoins aim to maintain their pegged rates using different means.

Stablecoins in the crypto market

Crypto-backed stablecoins work in a similar way to fiat-backed stablecoins. But instead of using dollars or another currency as reserve, we have cryptocurrencies acting as collateral. As the crypto market is highly volatile, crypto-backed stablecoins usually over-collateralize the reserves as a measure against price swings. Yet because they hew to the value of what is a stablecoin a single fiat currency, they act as a sort of temporary refuge for investors looking to secure their funds during a bear market. In this way, stablecoins are like blockchain-enabled versions of the dollar. Stablecoins are a type of cryptocurrency designed to maintain a stable price over time, pegged to the value of an underlying asset, like the U.S. dollar.

  • The idea behind stablecoins is to help reduce some of the volatility seen in other cryptocurrencies.
  • This type of crypto can offer cheaper, faster transactions and greater security — in some cases.
  • Stablecoin advocates believe these cryptocurrencies are critical for bridging “real-world” assets like fiat currencies with digital assets on the blockchain.
  • A cryptocurrency worth $2 million might be held as reserve to issue $1 million in a crypto-backed stablecoin, insuring against a 50% decline in the price of the reserve cryptocurrency.

Essentially, stablecoins were created to reduce price volatility and produce a reliable environment for cryptocurrency adoption. Fiat-collateralized stablecoins maintain a reserve of a fiat currency (or currencies) such as the U.S. dollar, as collateral assuring the stablecoin’s value. Other forms of collateral can include precious metals like gold or silver as well as commodities like crude oil, but most fiat-collateralized stablecoins have reserves of U.S. dollars. Some would argue that stablecoins are a solution in search of a problem given the wide availability and acceptance of the U.S. dollar. Many cryptocurrency adherents, on the other hand, believe the future belongs to digital tender not controlled by central banks.