In the past year, a large portion of the crypto market has been captivated by the substantial growth in stablecoins’ market value. Stablecoins’ earlier days experienced the U.S. Dollar Tether (USDT) token becoming the first of its kind to garner widespread adoption among investors and traders. This milestone took place following the token’s launch in 2015, which gave allowed the market to enter and exit volatile digital currencies with ease. And they could do so without needing to switch back to a fiat currency.
Fast-forward almost six years later and there are a variety of other stablecoins available and proving themselves to be strong enough to dominate the market. Moreover, they have become worthy alternatives for eager investors. Their popularity has triggered the creation of trading platforms made specifically for backed cryptos such as Goldexchange.com.
Types of stablecoins
The term ‘stablecoin’ represents a variety of cryptocurrencies whose market value derives from an external reference. It basically means that, unlike fiat currency, they are backed by a reserve asset similar to how it was during the era of the “gold standard.” Stablecoins aspire to challenge price fluctuations by way of tying cryptocurrency values to comparatively more stable assets, like fiat. Fiat is the government-issued currency typically used on a daily basis, such as dollars and euros. Generally speaking, this type of currency maintains its stability over time.
Stablecoins are typically categorized in one of three groups based on their working mechanisms: fiat-collateralized, crypto-collateralized, and non-collateralized.
- Fiat-Collateralized stablecoins – Just as the name implies, fiat-collateralized stablecoins are backed by sovereign currency, like the U.S. dollar or the pound. To issue a specific number of tokens of a cryptocurrency, the issuer needs to offer dollar reserves that are worth the same as collateral. Commodities, such as gold, are allowed to be used here. Maintenance of the reserves is in the hands of custodians that operate independently and are regularly assessed for compliance. Examples of cryptocurrencies that are backed by dollar deposits are Tether (USDT) and TrueUSD.
- Crypto-Collateralized stablecoins - The value of these particular stablecoins are pegged to the value of other cryptocurrencies. With the underlying asset also being a cryptocurrency, it makes sense to interpret this as being unsafe and also highly volatile. A term frequently used to refer to this brand of stablecoin is ‘over-collateralization’, meaning that a hefty amount of reserve cryptocurrencies may be required to distribute a small number of tokens.
- Non-Collateralized (aka. Algorithmic) stablecoins - Non-collateralized stablecoins do not involve the utilization of reserve assets. In place of this, their stability primarily comes from a working mechanism, like that of a central bank. An example of this would be the cryptocurrency base coin using a consensus mechanism, hence the alternative name of “Algorithmic stablecoins.” With this system, it can determine if it should increase or decrease the token supply on the grounds of what the overall level of need is.
How they work
It is imperative that stablecoins have a currency to hold as collateral for every dollar of cryptocurrency they distribute to an investor. Arguably, the most practical way for this to work is to hold actual fiat dollars in reserve. However, as one might expect, this is not the only method. For example, the crypto-backed stablecoin, Dai, utilizes collateralized debt so that it can create tokens and guarantee their value.
On top of being connected to underlying value, stablecoins need to be capable of staying as close as possible to one dollar in value. They must do this by making sure that buy and sell orders in the market are bringing each stablecoin’s value back to one dollar continuously. This means that stablecoins are not actually worth one dollar. In fact, they can either be worth more or less. Moreover, knowledgeable day traders could potentially generate a profit off of that minor volatility.
Even though a stablecoin may be worth a little less or more than one dollar, the price difference will be small enough that the broader market will still hold the stability in high regard. What’s more, the market values it over any potential inefficiencies that could come into existence at any point.