Stablecoins are crypto assets designed to be tied to the value of another asset, such as fiat currencies like the U.S. dollar or commodities like gold.
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What are stablecoins?
Stablecoins are cryptocurrencies designed to maintain a stable price by being pegged to the value of another asset, such as a fiat currency like the U.S. dollar or commodities like gold.
Since the price of many crypto assets can change frequently, stablecoins were created to be a more stable alternative with minimal price swings.
Stablecoins use different methods to maintain their stable values. Some are backed by reserves of fiat currency, commodities, crypto, or other physical assets, while others use algorithms.
Video tutorial: What are stablecoins?
What are the different types of stablecoins?
Fiat-collateralized stablecoins
Fiat-collateralized stablecoins are backed by a reserve of government-issued currencies, like the U.S. dollar or euro.
These stablecoins are designed to maintain their value by ensuring that an equivalent amount of fiat currency is held in reserve for every stablecoin issued.
Some examples of fiat-collateralized stablecoins include Tether USD (USDT), USD Coin (USDC), Paxos (USDP), and Gemini Dollar (GUSD).
Crypto-collateralized stablecoins
Crypto-collateralized stablecoins are backed by a reserve of other cryptocurrencies.
Because the price of crypto can vary, these stablecoins are often overcollateralized to account for any potential price changes. This means the value of the crypto assets held in the reserve is greater than the amount of stablecoins issued.
DAI (DAI) is an example of a crypto-backed stablecoin. DAI tokens are backed by a reserve of Ethereum-based assets.
Commodity-collateralized stablecoins
Commodity-collateralized stablecoins are backed by a reserve of physical assets such as gold or other precious metals.
Paxos Gold (PAXG) is a well-known example of a commodity-backed stablecoin. Each PAXG token is backed by one fine troy ounce of a London Good Delivery gold bar.
Algorithmic stablecoins
Algorithmic stablecoins aim to maintain the same value as another asset, often a fiat currency such as the U.S. dollar.
However, algorithmic stablecoins are not backed by any collateral or reserve of assets.
Instead, they rely on algorithms to control the supply and demand of tokens to maintain their target price. They often do this by increasing the token supply if the price is higher than the target or decreasing it if it falls below the target.
What are the benefits of stablecoins?
Price stability: Stablecoins aim to provide the benefits of crypto without being exposed to the price swings common with many crypto assets.
Crypto payments without price swings: Stablecoins make crypto payments more practical by reducing the risk of sudden value changes. For example, a café owner might not want to sell a $2 cup of coffee if there's a chance the crypto they receive could be worth only $1 shortly after.
Fast transactions and low fees: Since stablecoins are cryptocurrencies, they can take advantage of blockchains' fast speeds and low fees. For example, traditional international payment methods can be expensive and slow. Stablecoins can be a quicker and more affordable alternative for those who want to send money internationally to friends and family.
What are the risks of stablecoins?
Counterparty risk: This is the risk that the stablecoin issuer fails to keep the token's value stable. For example, the issuer might not hold sufficient reserves, or an algorithmic stablecoin might not function as intended, leading to a loss of stability.
Not always the exact value: Although stablecoins aim to match the value of another asset, multiple factors, such as market conditions or supply and demand, could cause the token's price to vary.
Risk from the underlying asset: Even if the stablecoin works as intended, if the asset it's tied to drops in value, the value of the stablecoin will also drop.