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Stablecoins: What Are They & How Do They Work?

Global financial markets are in a state of flux right now as the cryptocurrency industry becomes increasingly popular. Far from being considered a passing phase, the cryptocurrency industry has started to disrupt financial markets by introducing a new, speculative, and volatile, yet incredibly lucrative asset class for you to consider.

Traditional financial markets and the cryptocurrency industry were largely seen as disconnected and unlinked with each other, causing a lot of hesitation from institutional investors when entering the space. However, that may become a concern of the past with the advent of stablecoins.

Stablecoins are another type of cryptocurrency that is effectively offering a way to bridge the gap between traditional currencies with decentralized currencies. This post will tell you everything you need to know about stablecoins to understand what they are, how they work and make more informed investment decisions as a crypto trader.

What Are Stablecoins?

Stablecoins are a class of cryptocurrencies that are designed to offer price stability by backing its value against a reserve asset. Stablecoins are inherently stable, making them quite different from the more popular cryptocurrencies like Bitcoin and Ethereum.

Stablecoins are price-stable digital assets that behave in a manner somewhat similar to fiat currencies, but they retain the utility and convenience offered by cryptocurrencies.

Price stability being integrated into the assets themselves makes stablecoins a novel solution to one of the biggest woes in the cryptocurrency world: high volatility.

How Do Stablecoins Work?

Cryptocurrencies are susceptible to market forces, much like any emerging asset class. As crypto becomes more commonplace, several crypto projects are coming forth with the intention to identify ways to reduce risk and encourage broader participation in the industry.

Stablecoins present one of those solutions by building price stability directly into the assets themselves, creating a whole new class of cryptocurrency. As the name suggests, these tokens are designed to function with stability.

2021 saw the broader cryptocurrency industry go through a boom, and stablecoins also saw a surge in investor interest. Understanding the basics of stablecoin taxonomy can help you understand the driving force behind the appeal for this new asset class.

Understanding Stablecoin Taxonomy

Stablecoins are effectively digital currencies that are created on blockchain networks, much like Bitcoin. However, stablecoins are also identifiable by one of four underlying collateral structures: fiat-backed, crypto-backed, algorithmic cryptocurrencies, or commodity-backed.

Traditional Collateral

The most popular stablecoins are those backed at a 1:1 ratio to traditional fiat currency. Since the underlying collateral in the structure is not another crypto, the stablecoin is called an off-chain asset. The fiat collateral remains in reserve with a central authority, and it has to remain proportionate to the number of stablecoins in circulation on the blockchain network.

Crypto Collateral

The name already suggests what it means. Stablecoins that follow a crypto collateral structure are backed by another cryptocurrency as collateral. This process means that the collateral and the crypto itself use blockchain technology, making it an on-chain stablecoin. 

Crypto-collateralized stablecoins do not rely on a central authority. Instead, you lock your cryptocurrency into a smart contract to obtain other tokens of equal representative value. You can then put your stablecoin back into that smart contract and withdraw the original collateral amount.

These cryptocurrency assets are over-collateralized to offer a buffer against price fluctuations that might occur with the required collateral asset.

Algorithm-Based Stablecoins

Algorithmic stablecoins are the only type of stablecoin that do not rely on any assets held as collateral. The price stability in these stablecoins occurs through specialized algorithms and smart contracts integrated into the blockchain network that can manage the supply of tokens in circulation on the network.

Algorithmic stablecoin systems reduce the number of tokens in circulation when the market price for the token falls below the fiat currency it is tracking. The algorithmic stablecoin system adds more new stablecoin tokens into circulation to adjust the stablecoin’s value downward.

Commodity-Backed Stablecoins

Commodity-backed stablecoins are a type of asset that uses physical assets as collateral for digital currencies. Tether Gold is one of the most popular commodity-backed stablecoins. The stablecoin relies on collateralizing gold to back its value. Commodity-backed stablecoins can also use other physical assets like real estate, oil, and other precious metals besides gold as collateral.

It is important to remember that these stablecoins rely on the performance of the underlying asset held as collateral to define the price changes in the market value of the stablecoin. It means that if gold prices surge, the value of a gold-backed stablecoin will likely increase. Similarly, a downturn in the value of the underlying commodity backing the stablecoin could result in a downward movement in its price.

Commodity-backed stablecoins allow people to invest in the performance of commodities that might otherwise be inaccessible to them. For instance, it is not possible to buy a bar of gold and store it safely in some regions. Investors can use commodity-backed stablecoins to enjoy the returns from gold’s performance instead of worrying about storing the physical commodity.

Commodity-backed stablecoin holders can take possession of the underlying commodity by taking possession of the underlying tokenized asset from the stablecoin issuer.

Wrapping It Up

Stablecoins are leading the way to bring the traditional financial markets together with the decentralized finance industry that will shape the future of global finance. Stablecoins manage to achieve stability in the cryptocurrency industry, something that most crypto tokens in the industry do not offer.

Widespread adoption of stablecoins will likely lead to revolutionizing several aspects of our lives through the benefits of cryptocurrency while retaining much of the utility that was previously only available through traditional fiat currency.

Did you find this post on stablecoins helpful? Keep following The Crypto World for more informative posts about stablecoins and the broader cryptocurrency industry.

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