Stablecoin and how it works
Although the cryptocurrency market is developing rapidly, it is still subject to large changes in value. According to Coinmarketrate.com A stablecoin uses a mechanism that links its value to the value of existing assets, such as gold or, say, the US dollar.
Such a mechanism reduces the volatility of other cryptocurrencies, which makes stablecoin ultimately a type of asset that facilitates everyday cryptocurrency trading and the transfer of funds between different exchanges.
The combination of the stability offered by traditional currencies and the flexibility of digital assets has proven to be a popular idea among investors. This is evidenced by the market capitalization of all stablecoins, which until recently was about $ 180 billion.
Why is it important?
A stablecoin can be defined as a type of digital currency that links its value to the value of assets, such as gold or some other fiat currency, to maintain price stability.
Take, for example, the currently most popular stablecoin Tether. Tether is a cryptocurrency that pegs its value to the value of the US dollar in a ratio of 1:1. Since it has coverage in US dollars, the price of Tether is always around one dollar.
Despite the fact that the stablecoin has the characteristics of a traditional asset type, it relies on blockchain technology. This can be seen from the following features:
- Stablecoins are global and available to everyone online 24 hours a day.
- All transactions made with the help of a stablecoin are stored on the blockchain network.
- They can be transferred quickly and safely, and the cost of delivery is low.
How stablecoin works
To make it easier to explain how stablecoin works, we will use an example. Let’s say you have some Bitcoin and Ethereum in your portfolio and you want to buy more. Since Bitcoin and Ethereum are separate blockchain networks, they cannot be easily replaced. What is needed is to have a currency that will serve as an intermediary between Ethereum and Bitcoin.
What you need to do is replace part of Ethereum with a specific stable coin. Then you will use this stablecoin to buy Bitcoins. In addition to being used as an intermediary between two cryptocurrencies with different blockchain networks, a stable coin can also be used as a means of preserving value. For example, if you have made a certain profit by trading cryptocurrencies, and you want to protect it from a possible market fall.
The next thing you need to do in such a situation is to exchange the desired cryptocurrency for a stablecoin. If the market falls, your portfolio will remain stable precisely because the stablecoin retains value.
What can stablecoin be used for?
- Protection against cryptocurrency market volatility
The value of cryptocurrencies is subject to big changes, it changes every minute. Stablecoin in some way protects investors from large price changes. For example, if an investor transfers certain cryptocurrencies to the Tether stablecoin, he can be sure that the value of the token will not rise or collapse in an unpredictable way at some point.
- Trading or saving
The stablecoin is based on blockchain technology, which means that you don’t need to have a bank account to have a stablecoin. You can use Stablecoin anytime, anywhere, and even as savings.
- Interest on profits
On many platforms, you can deposit stablecoins for a longer period and thus receive interest rates that are higher than bank interest rates (currently, interest rates on savings in banks are about 0.01%).
- Easy money sending
Thanks to the advantages of blockchain technology, stablecoins can be sent anywhere in the world at high speed with low commission.
What types of stablecoins are there
Currently, the most popular stablecoins on the market are those whose value is related to the value of the fiat currency. However, there are other types of stablecoins.
There are 3 categories of stablecoins, and they differ in the mechanisms used.
- A stablecoin supported by a fiat currency
As mentioned earlier in the text, this type of stablecoin associates its value with some type of real property; fiat currencies, precious metals, oil, etc. Most stable coins today most often use US dollars as the value to which they are pegged.
Stablecoins backed by fiat currency should usually have reserves of the same fiat currency as collateral for the issuance of new coins into circulation.
For example, if a certain amount of stablecoins is put into circulation, then the same amount, expressed in fiat currency, should be stored in its own reserves to ensure full coverage of the stablecoin.
The most famous stablecoins supported by fiat currencies:
- Teter (USDT)
- US Dollar Coin (USDC)
- Binance USD (BUSD)
- Terra USD (UST)
- Stablecoin supported by cryptocurrencies
Cryptocurrency-backed stablecoins work the same way as fiat-backed stablecoins, but use cryptocurrencies as collateral instead of fiat currencies.
Since cryptocurrencies have higher value spikes, this type of stablecoin must use a set of protocols to ensure that the price of the issued stablecoin remains at the level of one dollar.
How does it work in practice?
Let’s say you deposited 200 ETH to get a $100 stablecoin in return. When you deposit these 200 ETH stablecoins, you get a deposit of 200%. This is important because if the price of Ethereum drops by 25%, the stablecoins can still retain their value, since there is still $150 of collateral left to support the value of the stablecoins.
The most famous stablecoin supported by cryptocurrency: DAI (DAI)
- Algorithmic stablecoin (stablecoins without collateral)
Compared to previous types of stablecoins, algorithmic stablecoin does not use software. In fact, it is a stablecoin controlled by an algorithm and smart contracts. This algorithm determines the price, the number of tokens that can be found in optics, and other variables that will help to better manage a stable coin.
The work of an algorithmic stablecoin may somewhat resemble fiat currencies. The reason is that algorithmically, stablecoins are managed by a sovereign authority, just as a country’s central bank manages a country’s currency.
This is an algorithm that prevents potential spikes in the value of a stablecoin. If the value of such a stable coin is set at $ 1, in the event of an increase in the price of the same stable coin due to high demand, the algorithm will issue an additional number of tokens to lower the price.
If the price of this stable coin falls below one dollar, the algorithm will reduce the bid to help raise the price.
The idea of a stablecoin is to combine the best features of a fiat currency and blockchain technology. Currently, stablecoins are used as protection against the high volatility of the cryptocurrency market. However, it can also be used as a tool to increase transparency and decentralization.
This type of asset has revolutionized the crypto space, and it has a great future.