What are stablecoins and how do they stay stable?
A stablecoin is a cryptocurrency with a tied value equal to the value of a fiat currency or another financial instrument. Unlike fiat assets, stablecoins maintain the speed and low cost of cryptocurrencies. The initial purpose of stablecoins was minimizing the impact of the price volatility of cryptocurrencies when trading or investing in these.
Currently there are three major types of stablecoins.
FIAT backed stablecoins
Fiat backed stablecoins have to be collateralized by a fiat currency as the U.S. dollar. Other collateral currencies or precious metals like gold or silver as a reserve are also possible. In order to keep the price of the stablecoin stable, a backing of each coin on a one-to-one basis is necessary. Whether every coin is actually backed on a one-to-one basis is questionable. Moreover, the most popular stable coin Tether (USDT) with a market capitalization of more than 80 billion revealed its cash reserves, which contain about 3% cash. Other popular stablecoins are Coinbase’s USD Coin (USDC) and Binance USD (BUSD).
Crypto backed stablecoins
Crypto-collateralized stablecoins have cryptocurrencies as a collateral. As cryptocurrencies are highly volatile, it is necessary to hold significantly more collateral reserves in value than the value of stablecoins issued in order to maintain the price of the stablecoin stable.
Algorithmic stablecoins are usually not backed by collateral. The stablecoins value is kept by an algorithm which controls the stablecoins supply in order to keep the price stable with the fiat currency price it tracks. The purpose of these kinds of stablecoins is to create a decentralized central bank that controls the supply needed automatically depending on the market conditions.