What are stablecoins? A comprehensive guide by Digimagg

Stablecoins are digital currencies that strive to maintain a fixed value by pegging it to another asset, typically a fiat currency. For instance, a stablecoin linked to the U.S. dollar aims to stay at a value of $1. This provides a stable alternative to the volatility often seen in other cryptocurrencies.

Many believe stablecoins are inherently safe and reliable in maintaining their intended value, but this is often a misconception. Despite the aim to remain pegged, stablecoins can deviate from their target, posing risks. While stablecoins play a vital role in the cryptocurrency market, it's essential to comprehend their mechanics before investing.

Types of stablecoins

There exist 4 types of stablecoins:

• Commodity-backed stablecoins
• Fiat-backed stablecoins
• Crypto-backed stablecoins
• Algorithmic stablecoins

Commodity-backed stablecoins

Commodity-backed stablecoins are supported by reserves consisting of tangible assets like precious metals, real estate, or oil. Precious metals, particularly gold, are frequently utilized to back stablecoins of this kind.

These stablecoins maintain a peg to their respective reserve asset. For instance, a gold-backed stablecoin's value would be tied to the price of gold. Investors benefit from the ability to acquire digital representations of commodities without the necessity of acquiring or storing the physical assets themselves.

Fiat-backed stablecoins

Fiat-backed stablecoins are supported by reserves consisting of fiat currency. These reserves act as collateral to ensure the stablecoin's value, ideally matching the circulating supply. For instance, a fiat-backed stablecoin pegged to the U.S. dollar with 1 million coins in circulation should hold $1 million in reserves.

This stablecoin type is generally considered safe as long as the managing organization maintains adequate reserves. To validate the reserves, regular audits conducted by an independent third party should be provided by the organization.

Crypto-backed stablecoins

Crypto-backed stablecoins rely on cryptocurrency reserves, often utilizing major cryptocurrencies like Bitcoin (BTC) or Ethereum (ETH) as collateral.

Given the volatility of cryptocurrencies, these stablecoins require over-collateralization. Their reserves must exceed the circulating supply significantly to mitigate potential price fluctuations.

Algorithmic stablecoins

Algorithmic stablecoins employ algorithms and smart contracts to regulate the circulating supply. They may lack reserves, and even if they do have them, they are typically under-collateralized. Algorithms adjust the supply based on the stablecoin's price relative to the tracked asset, increasing supply if the price is high and reducing it if it's low, akin to how central banks manage fiat currency.

These stablecoins carry higher risk because they lack sufficient reserves to address issues. TerraUSD (USTC) serves as a notable example of this risk, as it lost its peg in May 2022, leading to a significant decrease in value.

What sets stablecoins apart?

Stablecoins stand out by mirroring the value of another asset, unlike other cryptocurrencies whose prices fluctuate based on demand and utility. This unique characteristic makes stablecoins more suitable for use as digital currency, offering stability for transactions and eliminating concerns about price volatility.

The origins of stablecoins

J.R. Willett, a prominent figure in the early Bitcoin community, is credited with inventing stablecoins. He introduced the concept of asset-pegged cryptocurrencies in 2012, outlining it in the white paper for his MasterCoin protocol.

The initial stablecoin, BitUSD, was launched in 2014 as a crypto-backed stablecoin. However, it experienced difficulties maintaining its peg to the U.S. dollar and ultimately failed to recover. Tether (USDT 0.04%), the first fiat-backed stablecoin, debuted later in the same year. Despite facing controversies and price fluctuations, Tether has largely managed to retain its peg to the U.S. dollar.