What Are Stablecoins and How Do They Work?

(Last Updated On: )

Stablecoins are digital assets designed to mimic the exchange rate of fiat currencies such as the dollar or euro. They allow users to exchange stable currencies cheaply and quickly anywhere in the world.

Cryptocurrencies are known for their volatility compared to fiat currencies. This is to be expected as blockchain technology is still in its early stages and cryptocurrency markets are relatively small. The fact that the value of a cryptocurrency is tied to an asset is interesting from a free-market perspective, but it can be a problem when it comes to usability.

In turn, stablecoin does not have such a problem. This type of asset tracks insignificant price movements and changes in the value of the underlying asset or the fiat currency that they emulate. As such, stablecoins act as a haven asset amid volatile markets.

There are several ways in which a coin can maintain its stability. In this article, we will look at some of the mechanisms, as well as their advantages and disadvantages.

How do stablecoins work?

There are several types of stablecoins, each of which has a different peg of its units to fiat currency. Some of the more common types are listed below.

Fiat-backed stablecoins

The most popular type of stablecoins  is one that is directly pegged to fiat currency at a 1:1 ratio. We also call these fiat-backed stablecoins. The central authority issuer stores a certain amount in reserve currency and issues a proportional amount of tokens. So, price fluctuations are not considered. 

For example, an issuer might have one million dollars and distribute one dollar for each of the million tokens. Thanks to this, users can exchange their cryptocurrencies for tokens at any time, the value of which is equivalent to the US dollar.

Crypto-backed stablecoins

The crypto-backing of stablecoins mirrors their fiat counterparts, with the main difference being that the crypto assets are used as collateral. However, because the cryptocurrency is digital, only smart contracts handle the issue of units.

Crypto-backed stablecoins minimize the necessary trust, for this reason, it should be noted that their monetary policy is determined by the voters, by analogy with government structural elements. In this case, you cannot completely trust the issuer, but you believe that all network participants will always act in the interests of users.

To get this kind of stablecoins, users block the required cryptocurrency in a contract, which then issues a certain number of requested coins. In the future, to return the collateral, users send stablecoins to the same contract for reverse currency exchange (taking into account various commissions or interest rates).

The specific mechanisms of their work, which provide this very link to another asset, vary depending on the design of each of the systems. Suffice it to say that the combination of game theory and chain algorithms encourages participants to maintain a stable coin value.

Algorithmic stablecoins

Algorithmic stablecoins are not pegged to fiat or cryptocurrency. Instead, price stability is achieved solely by algorithms and smart contracts that manage the delivery of the token issue. From a functional point of view, their monetary policy has similarities with the management of national currencies represented by central banks.

At its core, the algorithmic stablecoin system reduces the supply of tokens if the price falls below the value of the monitored fiat currency. If the price exceeds the required value of the pegged currency, then new tokens come into circulation to reduce the cost of the stablecoin.

Pros and cons of stablecoins

The main advantage of stablecoins is the additional ability to fix balances and exchange digital currencies. Due to the high level of price volatility, cryptocurrencies have not been able to find their use in everyday life, for example, for making various payments. By providing a higher level of stability, such stable currencies act as a solution to this problem.

As a way to protect their capital from market volatility, stablecoins are becoming a feature in the integration of cryptocurrencies with traditional financial markets. Currently, the two markets exist as separate ecosystems with very little interaction. With the stable form available for digital currencies, cryptocurrencies will likely see a wider range of use cases in the loan and lending market, which to this day are dominated only by government-issued currencies – fiat currencies.

In addition to their usefulness for financial transactions, traders and investors can use stablecoins to hedge their portfolios. Allocating a certain percentage of your portfolio in stablecoins is an effective way to reduce your overall risk. At the same time, maintaining a certain amount of funds of savings that can be used to buy other cryptocurrencies during periods of their decline can be an excellent trading strategy. Likewise, these coins can be used to “lock-in” the gains made on the rise in prices without the need to cash out.

Despite their ability to support massive crypto adoption, stablecoins still have certain drawbacks. Fiat-backed options are a less decentralized solution than conventional cryptocurrencies, as there is still a need for a central institution to store ancillary assets. As for crypto-backed and unsecured stablecoins, users will need to trust the community (and source code) to guarantee the long-term performance of the system, but for now, these are still relatively new technologies, so they will take some time to mature.

So what?

While stablecoins have some drawbacks, they are a critical component of the cryptocurrency market. Thanks to various mechanisms, this type of digital currency can remain more or less stable, with its own fixed price. This allows them to be reliably used not only as a medium of exchange but also as a way to fix their balance for traders and investors.

While stablecoins were originally developed as an effective risk management tool, their scope goes beyond trading. This type of digital currency is a powerful tool that can help strengthen the cryptocurrency ecosystem as a whole, as well as an alternative store of value in cases of high market volatility. Here in the CoinRabbit, we support two stablecoins: USDC and USDT.

What is USDT?

USDT is a Tether, which is a cryptocurrency that is tied to a fiat currency for stability. It is released on the Bitcoin blockchain through Protocol Omni. Its value is the exchange rate is fixed or tethered, to the value of the US dollar.

The only reason why 1 USDT is worth $1 is that exchanges keep a reserve of USD to back every USDT in existence. USDT can be spent, traded, or transferred, like Bitcoins or any cryptocurrency. They can also be stored in specialized wallets that are Omni compatible.

Tether has its place among cryptocurrencies filling a niche where fluctuations will not do. As with any cryptocurrency be vigilant and continue to research and keep your eye on the news for any information as you begin loaning.

What is USDС?

USD Coin (USDC) is a cryptocurrency called stablecoin. You can always exchange 1 USD Coin for 1 USD to make its value more stable. So, it is a digital stablecoin that is pegged to the United States dollar and runs on the Ethereum blockchain.

Unlike regular US dollars, USD Coin does not require a bank account. Moreover, you do not need to live in any particular country. Sending USD Coin worldwide can be done at a very low cost and in just a few minutes. USD Coins aren’t just being printed out of thin air. Every USDC token is backed with a single US dollar. The process of turning US dollars into USDC tokens is called tokenization. 

Loan Advantages on CoinRabbit

• The loan flow is fast and streamlined – the loan is yours in just 3 simple steps;
• Once you deposit your collateral on the address (we support such coins as BTC, ETH, BCH, NANO) your loan is sent to you within minutes – why spend time on lengthy flows when you can use your time on for many other important things?
• We don’t require you to sign up, remember passwords, or go through elaborate procedures to get your awesome loan – all you need is a wallet to accept the loan and your phone number to track it. Easy!
• We don’t think limiting you, your money or your earning potential would be fair. The loan term is unlimited – you can keep your funds with us for a day, week, or year.
• At any moment you can pay your collateral back. To do this, you need to pay the full price of Repayment, and when we get it, we return your collateral