What is a stablecoin?

Summary:

A stablecoin is a cryptocurrency asset that is pegged to the value of a stable asset such as fiat currency or precious metals. The development of stablecoins aims to avoid the drastic volatility commonly seen in the cryptocurrency market.

There are three types of stablecoins: fiat-backed, cryptocurrency-backed, and algorithmic stablecoins. They maintain their peg by holding reserves of convertible fiat currency for fiat-backed stablecoins, overcollateralization of their tokens for cryptocurrency-backed stablecoins (such as DAI), or controlling the supply without the need for reserves for algorithmic stablecoins.

Stablecoins have strong utility and a high market value, attracting close attention from regulatory bodies. Some governments are even developing their own stablecoins to control their currency.

Introduction:

In the field of cryptocurrency, not all digital assets are designed with the aim of price volatility. On the contrary, some coins are specifically designed to maintain a fixed value, and these are known as stablecoins. In the cryptocurrency market, other digital currencies and tokens may experience significant price fluctuations over short periods of time, while stablecoins aim to provide a relatively stable value reserve.

For traders and investors who wish to maintain a certain level of stability in the face of market volatility, stablecoins can be an ideal choice. Unlike other cryptocurrencies, stablecoins are typically pegged to fiat currency or other stable assets, which makes them relatively immune to market fluctuations.

If you are not yet using stablecoins in your trading or investing activities, it is essential to understand their advantages and disadvantages. The advantages include relatively stable value, reduced impact of market volatility on investment portfolios, and ease of valuation during transactions. However, it is also important to note that stablecoins are not perfect and may have issues related to regulatory risks and trust in the issuing entity. Therefore, a deep understanding of the working principles and characteristics of stablecoins is crucial for making wise investment and trading decisions.

Cryptocurrency stablecoins are digital assets that are pegged to the value of fiat currency or other assets, with the aim of tracking their value and providing a relatively stable digital token. The design purpose of these stablecoins is to address the significant price volatility seen in traditional cryptocurrencies.

How do stablecoins work?

The operational principles of stablecoins vary depending on their support mechanisms, with fiat-backed stablecoins being the most common. Here is a brief explanation of how fiat-backed stablecoins work:

1. Reserve holdings: Fiat-backed stablecoins maintain their value by holding a certain amount of fiat currency (e.g., US dollars, euros) or other legal assets. These fiat reserves are typically held by the stablecoin issuer or a partnering entity and serve as reserves to support stablecoin issuance.

2. Fixed exchange rate: Each fiat-backed stablecoin has a corresponding fiat reserve held at a fixed ratio. For example, each stablecoin may be equated to 1 US dollar, and this fixed ratio remains unchanged over a certain period of time.

3. Fiat conversion: Users can exchange a certain amount of fiat currency with the stablecoin issuer or recognized trading platforms to obtain an equivalent quantity of fiat-backed stablecoins. These conversions are conducted at a fixed exchange rate, ensuring that users can acquire stablecoins at a relatively stable ratio.

4. Arbitrage opportunities: If the market price of a fiat-backed stablecoin deviates from its fixed fiat exchange rate, arbitrageurs will enter the market. If the stablecoin price is higher than the fixed fiat exchange rate, arbitrageurs can buy stablecoins and sell them in the market, bringing the price back to the 1:1 fixed exchange rate. Conversely, if the price is below the fixed exchange rate, arbitrageurs can buy stablecoins and convert them into fiat currency, driving the price back up to the fixed rate.

Fiat-backed stablecoins maintain their stability through fiat reserves and fixed exchange rates, while the arbitrage mechanism helps maintain consistency between market price and the fixed exchange rate.

Cryptocurrency-backed stablecoins:

Cryptocurrency-backed stablecoins have some similarities to fiat-backed stablecoins in terms of operation, but they have different collateral and management mechanisms. Here are the main operating methods of cryptocurrency-backed stablecoins:

1. Cryptocurrency collateral: Unlike fiat-backed stablecoins, cryptocurrency-backed stablecoins use other cryptocurrencies as collateral. This means that a certain amount of cryptocurrency needs to be provided as collateral in order to create the corresponding stablecoin.

2. Overcollateralization: Due to the volatile nature of the cryptocurrency market, cryptocurrency-backed stablecoins usually require overcollateralization, meaning that more cryptocurrency than the required stablecoin value is provided as collateral. This helps counteract price fluctuations and prevents instability in the system.

3. Smart contract management: Cryptocurrency-backed stablecoins use smart contracts to manage token creation and destruction. These self-executing contracts ensure a balanced supply and demand of stablecoins, with token destruction occurring when necessary to maintain price stability.

4. Decentralized Autonomous Organization (DAO) operation: Some cryptocurrency-backed stablecoins may operate through a decentralized autonomous organization (DAO), allowing the community to participate in project decision-making. Community members can vote to support changes to the project, but this also requires trust in the DAO or direct involvement in it.

5. Incentives and forced liquidation: When the price of a stablecoin falls below $1, the system may implement incentives to reduce the stablecoin supply by returning stablecoins as collateral, thereby reducing supply and pushing the price back up. Conversely, when the price is above $1, the system may incentivize users to create more tokens, increasing supply to lower the price. In some cases, forced liquidation mechanisms may exist to prevent system instability.

Cryptocurrency-back stablecoins maintain stability through smart contracts and collateralization mechanisms, while relying on incentives and on-chain algorithms to address price fluctuations. Different projects may adopt different designs and mechanisms to achieve this goal.

Algorithmic stablecoins:

Algorithmic stablecoins are stablecoins that do not rely on actual reserves and instead use algorithms and smart contracts to manage token supply, similar to central banks' monetary policies. Here are the main characteristics and operating methods of algorithmic stablecoins:

1. No reserve requirement: Unlike fiat-backed or cryptocurrency-backed stablecoins, algorithmic stablecoins do not require reserves to support their stability. Instead, their stability is achieved through smart contracts and algorithmic mechanisms.

2. Smart contract and algorithmic management: The supply management of algorithmic stablecoins relies mainly on smart contracts and algorithms. These smart contracts can automatically adjust token supply based on market conditions to maintain the stablecoin's value.

3. Token supply adjustments: If the market price of an algorithmic stablecoin falls below the tracked fiat value, the system takes measures to reduce token supply. This may be achieved through methods such as locking collateral, token burning, or token buybacks. This helps increase the stablecoin's value.

4. Issuance of new tokens: If the market price of an algorithmic stablecoin exceeds its fiat value, the system may issue new tokens and release them into the market, increasing the supply to lower its value.

5. Dynamic market response: Algorithmic stablecoins have the advantage of being more flexible in responding to market dynamics. Without the constraints of actual reserves, the system can adjust token supply quickly to adapt to market changes, thereby maintaining stability more effectively.

Although algorithmic stablecoins offer greater flexibility, their operational complexity is higher and requires careful design and adjustment. Since they do not rely on physical reserves, the stability of these systems depends primarily on the effectiveness of the algorithms and the execution of smart contracts.

Advantages and disadvantages of algorithmic stablecoins:

Advantages of stablecoins:

1. Everyday payments: One of the major advantages of stablecoins is their stability, making them suitable for everyday payments. Merchants and individuals can more easily accept stablecoins as currency without worrying about extreme price fluctuations.

2. Global transfers: Stablecoins have the advantage of global transfers due to their blockchain-based nature. Users can send stablecoins to anywhere in the world within seconds, often without the need for intermediaries, reducing the complexity and costs of transactions.

3. Risk hedging: Stablecoins serve as effective tools for hedging portfolio risks for investors and traders. Allocating a portion of assets to stablecoins can reduce overall risk, especially in times of significant market volatility.

Disadvantages of stablecoins:

1. Peg maintenance risks: Stablecoins cannot guarantee the effective maintenance of their peg to fiat currency or other assets at all times. Some stablecoin projects may face challenges that prevent them from maintaining the promised value stability.

2. Transparency issues: Some stablecoin projects face transparency issues, with some projects not providing complete public audits. This may lead to doubts about the true value of stablecoins and the quality of reserve holdings.

3. Centralization risks: Fiat-backed stablecoins may be more centralized as the collateral being held is controlled by centralized institutions. This exposes these stablecoins to risks related to external regulations and institutional controls.

Overall, the advantages of stablecoins lie in their widespread use and practicality. However, users should remain cautious of peg maintenance risks, transparency issues, and centralization risks. When choosing stablecoins, understanding the workings of the project and the reputation of the issuing entity is crucial.

Contact Us：

hedy@biton.one/GvuLsLYVMTviDOO4kL
logan@biton.one/GvuLsLYVMTviDOO4kL
cara@biton.one/GvuLsLYVMTviDOO4kL
barton@biton.one/GvuLsLYVMTviDOO4kL
lucas@biton.one/GvuLsLYVMTviDOO4kL

Official Media：

Sign up｜Twitter｜Linktree｜Telegram EN｜Facebook｜