This article will provide you with information all about stablecoins. A stablecoin is a crypto asset that is related to another asset. It doesn’t stand alone; an example is fiat currencies or precious metals. Its name represents the price stability that it holds. The notion behind stable coins is to maintain a stable price and avoid the volatility and risks of the crypto market.
Types of stabelcoins:
Fiat-backed, crypto-backed, and algorithmic are the three types of stable coins out there. An example of a fiat-backed stablecoin is BUSD which stands for Binance USD. These stabelcoins are pegged to the traditional fiat currency. DAI is an example of a crypto-backed stablecoin, and to factor in the volatility of cryptocurrencies, these stabelcoins over-collateralize their tokens. Algorithmic stablecoins regulate supply without involving reserves. As stablecoins have become practical for many traders and investors, regulators have begun to look deeper into them. Governments have also considered creating their own in order to gain control of the currency.
How is a stable coin connected to cryptocurrency?
Stablecoins are digital assets associated with the value of fiat currencies or, for that matter, any asset. An example would be just like buying tokens that are associated with the dollar, yen, euro, oil, and gold. A stablecoin allows you to hold the profits and losses and transfer the value at a stable price via peer-to-peer blockchain networks.
As we know, Bitcoin and Ether have always been volatile. Of course, people have been using these currencies for a long time, as it does have their advantages. However, volatility also brings challenges, whether it be for day-to-day payments or anything else.
Initially, there was no way for crypto investors and traders to lock in a profit or avoid volatility without converting crypto into fiat. Stablecoins provided a simple alternative for this problem. Today, you can freely enter and exit the crypto market using stablecoins such as BUSD or USDC.
All about Stablecoins – How do they work?
As we mentioned above, stablecoins are pegged to another asset. So how does the pegging work? Let’s discuss the three types and how they are pegged.
Fiat backed
These stabelcoins keep a fiat currency like USD or GBP in reserves. Each BUSD, for example, is backed by a real US dollar held as collateral. Users can exchange fiat for stablecoins and vice versa at the set price. If the token’s fee differs from the underlying fiat, arbitrageurs will quickly bring it back to the original set rate.
If BUSD were trading for a dollar, arbitrageurs would turn the US dollar into BUSD, raise the price and sell it on the market. This, in turn, increases the supply of BUSD for sale and lowers the price to one dollar again. When the BUSD falls below one dollar, traders buy it and convert it to USD. This increases demand for the BUSD, causing its price to go back to one.
Crypto backed
Like fiat-backed stablecoins, crypto-backed stablecoins use cryptocurrencies as collateral instead of dollars or another currency. These stablecoins, by use of smart contracts, can manage the minting and burning. This is a more reliable and efficient process because users can control the contracts. There are crypto-backed stablecoins that Decentralized Autonomous Organizations run. In this case, the community can vote for any changes they want to see in the project. Or they can put their trust in the DAO to manage the project.
Algorithmic
This type of stablecoin stands apart from the first two. Algorithmic stablecoins don’t use reserves in place; they use algorithms and smart contracts. This is a pretty rare form of stablecoin and also happens to be less successful.
An algorithmic stablecoin system, in essence, reduces the token supply if the price falls below the fiat currency it measures. This could be achieved through locked staking, burning, or buy-backs. If the price exceeds the value of the fiat currency, new tokens are issued to reduce the value of the stablecoin.
Conclusion
Stablecoins are an efficient way to make payments and transfers worldwide. In addition, they can also be used to earn passive income with staking in the Defi ecosystem. However, just like everything, they have their disadvantages as well. As versatile as they are in the crypto world, they are still considered a cryptocurrency and have similar risks.
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