How Stablecoins Work


In this article, we will discuss the four different varieties of stablecoins, and how they work...

How do Stablecoins work? Stablecoins are price-stable, digital assets that bridge the gap between the cryptocurrency market, and fiat currencies, such as the U.S. Dollar. As the name suggests, stablecoins are price-stable digital assets, that mimic fiat currencies, while maintaining the mobility of cryptocurrency. Stablecoins are defined by stability being built directly into the asset, however there are four subcategories of stablecoins, which we will be reviewing in this article.

These categories are:

  • Traditional collateral stablecoins

  • Crypto collateral stablecoins

  • Commodity-backed stablecoins

  • Algorithmic stablecoins

Traditional Collateral Stablecoins

Traditional collateral stablecoins are backed by fiat currency at a 1:1 ratio and are by far the most popular variety of stablecoins on the market. These are considered off-chain assets. this is because the fiat equivalent of these coins is kept in reserve, by financial institutions or central issuers. The amount of tokens must remain exactly equivalent to the amount of fiat currency that is used as collateral. Some of the biggest stablecoins in this category by market cap, are Tether (USDT), Coinbase (USDC), Gemini Dollar (GUSD) and True USD (TUSD).

Crypto Collateral Stablecoins

Crypto collateral stablecoins are stablecoins which are backed by crypto. This process occurs on-chain. Rather than relying on a central issuer, these stablecoins rely on smart contracts. When these variety of stablecoins are purchased, the backing cryptocurrency is locked into a smart contract, in order to receive these stable tokens of representative value. I say representative value and not equivalent value, because these tokens are not backed by a 1:1 ratio, but rather a 2:1 ratio, unlike their off-chain counterparts. If you wanted 100 DAI stablecoins for example, you would have to deposit $200 worth of Ethereum tokens into the smart contract. On-chain stablecoins are over-backed by the cryptocurrency which they represent, to buffer against price fluctuations.

Commodity Backed Stablecoins

Commodity backed stablecoins are backed by physical assets, such as property, oil, and precious metals. The most common commodity backed stablecoins are those backed by gold, such as Tether Gold (XAUT) and Pax Gold (PAXG). Commodity backed stablecoins serve several purposes. First, they provide a convenient solution for individuals who would like to take advantage of a market – such as gold – by trading and or holding the tokens. Second, commodity tokens can be exchanged, directly for the commodity which they represent. Pax Gold (PAXG) as an example will exchange their tokens for physical gold, although the number of tokens this requires is significant. Each PAXG token is equivalently worth the same amount as one ounce of gold, and Pax Gold will not exchange any amount less than 430 oz of gold bars, for 430 PAXG tokens.

Algorithmic Stablecoins

Algorithmic stablecoins are stablecoins that are not backed by fiat currency, cryptocurrency, or commodities. Instead, these stablecoins are smart contracted and algorithmically generated. An algorithmic stablecoin system will increase and reduce the number of coins in circulation, on order to match the price to that of which it represents. The system will remove tokens when the stablecoin falls below the price of the asset and will add tokens when the stablecoin increases in value. An example of this can be seen with Empty Set Dollar (ESD).

In Conclusion

Stablecoins have gained a significant amount of popularity within the last several years. in fact the total stablecoin market value has increased by nearly 300% within the last year. Hopefully this article has helped you understand a little more about how these useful stablecoins work, and how much potential the stablecoin market can unlock in the future!

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