Stablecoins: What they are and how they work

Stablecoins: What they are and how they work

What are stablecoins?

Stablecoins are cryptocurrencies the value of which is based / pegged to a certain or basket of specific real-world assets like fiat currencies or other assets like gold, silver, etc. The purpose of stablecoins are to combine the benefits of blockchain-based digital currencies (transparent, decentralized, efficient, global, nearly instant transaction settlement) with the stability of physical real-world assets or commodities.

Stablecoins are designed to eliminate the enormous volatility most cryptocurrencies are exposed to (which is also the reason for the popularity of crypto trading). After all, even the biggest cryptocurrency Bitcoin can have daily price swings between 5-10 per cent, lending it relatively useless as a form of payment. There is an increasing number of stablecoins in circulation, the most popular ones by far are USDT (USDTether) and USDC, both stablecoins being pegged to the value of the US-Dollar.

Readers who wonder where to buy USDT/USDC should know that it is with crypto-exchanges like Blocktrade that they can be exchanged with fiat or other cryptocurrencies. Hence, it is easy to know how to buy USDT/USDC if you have found a crypto-exchange of your choosing.

How do stablecoins work?

Stablecoins are digital tokens on the blockchain issued by a centralized entity that manages the underlying assets (collateral) to which the price of the stablecoin is pegged (also referred to as “collateralized stablecoins”). The centralized entity has to make sure that all issued tokens are covered by the respective amount of underlying real-world assets so that the value of the coin can remain stable (constant). This means that the underlying reserves have to be increased/decreased in accordance with the demand for that token on the crypto markets.

For example, the leading stablecoin USDTether is issued and managed by Bitfinex Inc. For every newly issued USDT that comes into circulation, Bitfinex must increase its reserves by the value of 1 USD in order to maintain a 1:1 pegging between USD:USDT.

As stablecoins are centrally issued and managed, a common point of critique is a lack of transparency concerning the underlying reserves managed. For example, USDT issuer Bitfinex had to settle a lawsuit with the US Commodity Futures Trading Commission (CTFC) over allegations that the issued USDT were insufficiently backed by underlying reserves (actual reserves were lower than publicly stated).

More recently, there is a new type of stablecoin: non-collateralized, algorithmic stablecoins. These stablecoins are not backed by any underlying asset. Instead, they utilize a working mechanism of buying and selling reference assets in order to ensure price stability. It can be compared to the monetary policy central banks engage in to keep valuation of a fiat currency relatively stable. While growing in number, non-collateralized, algorithmic stablecoins have not (yet) gained a lot of traction.

What are stablecoins used for?

Stablecoins enjoy increasing popularity in a number of use cases. For example, they are the “safe haven” that crypto traders park their money in during volatile market phases – or when they want to realize their trading gains without converting the money back to fiat currencies (right away). They are also highly popular for remittance payments / payment transactions between individuals worldwide as they offer 24/7 nearly instant, extremely cheap settlement.

Moreover, stablecoins like USDT/USDC are extremely popular in the world of decentralized finance (DeFi) where conservative users can realize between 5-12 % p.a. by staking their stablecoin credits with a DeFi protocol / service provider.

Finally, stablecoins are also popular with a growing number of online shops and retailers who accept USDT/USDC to appeal to a crypto-affine target market / client base.

This is not financial advice. Mentioning coins and tokens is not a recommendation to buy, sell, or participate in the associated network. We would like to encourage you to do your own research and invest at your own risk. 

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This is not financial advice. Mentioning coins and tokens is not a recommendation to buy, sell, or participate in the associated network. We would like to encourage you to do your own research and invest at your own risk.

Editorial team

We are a team of crypto enthusiasts. Each of us has extensive theoretical and practical experience in trading, cryptocurrencies, and blockchain. We also like to dig deep and explore. Our goal is to help you make the right and relevant decisions.

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