What are Stablecoins and How Do They Work?

What are stablecons? Understand the meaning, working, importance, types and working of stablecoins. Can they replace the normal cryptocurrencies?

What are stablecons? Understand the meaning, working, importance, types and working of stablecoins. Can they replace normal cryptocurrencies?

Stablecoins, meaning, working, importance and examples

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If you are reading this article, then you must be familiar with cryptocurrencies. Some of you might be trading on cryptocurrencies like Bitcoin, Ethereum, etc. Have you ever spent or seen anyone spending Bitcoin for purchasing products in a normal way? Does he redeem Bitcoins for buying daily life essentials?

In most cases, the answer to these questions is, no. Why it is so? Because we cannot predict what will be the value of our currency after we have spent it. We are not sure whether the price will rise or fall. This makes us not treat cryptocurrencies like regular currencies.

What are Stablecoins in Short?

What are stablecoins in short?

As the name suggests, stablecoins are cryptocurrencies that have a stable value and are not subject to market fluctuations. They act as a bridge between cryptocurrencies and fiat currencies as they are stable like fiat currencies and use blockchain technology like other cryptocurrencies. These are backed by some external reserves for keeping their value no-volatile.

The external reserve may be a currency of a region, a physical or digital asset, or any commodity which has low fluctuations in the market. 

Let's discuss the key points of stablecoins,

  • These are more stable as compared to other cryptocurrencies.

  • Purchasing power is backed by a stable commodity.

  • These provide a good option for replacing fiat currencies.

  • Transactions can be made with a very low amount of tax and within no time.

Importance of Stablecoins?

Importance of stablecoins

Stablecoins act as a bridge between traditional currencies and cryptocurrencies. Generally, a cryptocurrency cannot be used for making day-to-day transactions. It is not strange to see the value of a cryptocurrency falling or rising by 10% within a span of few hours.

Let me explain to you with an example. On December 2, 2021, one Bitcoin was worth over $56,000 and on 4th December it shrank to $49,000. The price decreased by almost 15% in two days which shows how much volatile is it?

Just imagine this. You go to a shop and pay a Bitcoin worth $10 in exchange for a commodity. Will you have paid the Bitcoin if you knew that its value will increase to $15 just two seconds after the transaction? Obviously not. A case just opposite to this may also happen. In both situations, there is always a chance of you being in uncertainty.

So, you cannot use cryptocurrencies for regular payments because of the fluctuations in prices. In the same go, cryptocurrencies are the need of the hour as these are more secure and protect our privacy. Stablecoins solve both of these problems as they tend to fill the gap between fiat currencies and cryptocurrencies.

While traditional currencies also have ups and downs in their prices but these are very minute. The changes in their value do not affect the normal buying and selling of goods. This makes these currencies more useful and simple. It is very hard to directly endorse cryptocurrencies. Stablecoins provide solutions to these problems.

How Do Stablecoins Work?

working of stablecoins

Stablecoins are pegged to a stable reserve so that their value does not fluctuate. The external reserves may be the currency of a country like USD, EUR, POUN, a commodity like precious metal or oil, or a physical asset like real estate.

They take the hint of these external assets to keep their prices no-volatile. 

Types of Stablecoins

Based on the type of external reserve they use for maintaining their prices at a stable position, there are four types of stablecoins. Let's discuss these one-by-one.

1. Fiat-Collaterlized Stablecoins

These stablecoins are pegged to a fiat currency of a country for the price hint. There can be the traditional currency of any country giving their support to the stablecoins. These are also known as off-chain stablecoins as their value is regulated by something that doesn't use blockchain.

The common examples of this type of stablecoins are Tether Coin(USDT), Gemini dollar(GUSD), USD Coin(USDC), etc.

How do these work? Let's take the example of Tether. The organization behind this coin generally tries to maintain its price 1-to-1 with United States Dollar. Suppose the value of Tether goes down to $0.75, then the company reduces the supply of the coins by 25% to maintain its price at one dollar.

2. Crypto-Collateralized Stablecoins

Crypto-collateralized stablecoins use other cryptocurrencies such as Ethereum to maintain their value. These are key elements of a DeFi system. These are also known as on-chain stablecoins as the reserve behind their prices runs on blockchain technology.

The common examples of such types of stablecoins are MakerDAO, Havven, etc.

3. Commodity-Collaterlized Stablecoins

Commodity-backed stablecoins use some physical asset like precious metals, oil, real estate, or any other. However, it is not uncommon for their prices to fluctuate in the market. This factor makes it difficult for such stablecoins to be used in daily life.

Such stablecoins allow us to invest in these assets if it is not possible for us to store these physical assets. The common examples of the stablecoins collateralized to gold are Tether Gold(XAUT), Paxos Gold(PAXG), etc.

4. Algorithmic Stablecoins

These stablecoins are different from the three types of categories that we discussed above. They do not use any external reserve for maintaining thei price. Rather they are powered by algorithmic functions and smart contracts for their functioning. Whenever the price of a commodity seems to go higher, the programming instructions running the blockchain automatically add new coins and vice versa.

Wrapping Up

conclusion of stablecoins by Uncoverify

So far, we have seen how a stablecoin works and what are the types of stablcoin. A stablecoin is a good alternative to normal cryptocurrencies but it too has some limitations. As we can see in every type of stablecoin, except the algorithm-based stablecoin, there is a body governing the functioning of the coin. These bodies are often seen to manipulate the prices.

In algorithmic stablecoins, which are run by smart contracts, the working is quite hard and is not up to the mark. Though experts are trying to make this process simpler but currently there is no such scenario where we can freely use these coins.

Now, it's time for your thoughts. What do you think of stablecoins? Can they replace the traditional fiat currencies? Are they better than other cryptocurrencies? I want your personal thoughts in the comment section.

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