Stablecoins Definition and Functionality

Stablecoins are cryptocurrencies whose value is anchored to that of another currency, such as the US dollar. The goal of these coins is to provide an alternative to the high volatility of more popular cryptocurrencies, such as Bitcoin (BTC). These are also Altcoins.

While Bitcoin remains the most popular cryptocurrency, it suffers from high price volatility. For example, in March 2020, the price of Bitcoin went from a low of $4,000 to almost $65,000 in April 2021, only to drop by almost 50% in the following two months. Fluctuations within 24 hours can be very high, with movements of up to 10% in a few hours.

Volatility may be good for traders, but it makes routine transactions for buyers and sellers quite risky. Merchants do not want to end up losing if the price of the cryptocurrency crashes immediately after they receive payment. Stablecoins were created to address this problem by keeping the value of the cryptocurrency stable in various ways.

There are three types of stablecoins based on the mechanism used to stabilize their value.

Fiat-backed Stablecoins

Fiat-backed stablecoins maintain a reserve of a currency such as the US dollar, which guarantees the value of the coin. Although most fiat-backed stablecoins have reserves in US dollars, other forms of collateral can include precious metals such as gold or silver. These reserves are entrusted to independent custodians and regularly verified. Tether (USDT) is the most famous and popular stablecoin and also the most traded.

Crypto-backed Stablecoins

Crypto-backed stablecoins are covered by other cryptocurrencies. Since the reserve cryptocurrency may be subject to high volatility, the value of the cryptocurrencies held in reserve exceeds the value of the stablecoins issued. For example, a cryptocurrency worth €2 million could be held as a reserve to issue stablecoin worth €1 million, thereby ensuring it against a 50% drop in the price of the reserve cryptocurrency. Technically speaking, a stablecoin of this type is DAI, which is backed by Ethereum (ETH).

Algorithmic Stablecoins

The third type of stablecoin is algorithmic, which may or may not hold collateral reserves. The main feature is the strategy of keeping the value of the coin stable by controlling its supply through an algorithm. Everything works through a computer program. An example of this type of stablecoin is Terra, which collapsed miserably in May 2022, causing a domino effect on other virtual currencies.

Key Features of Stablecoins

Stablecoins are free from the volatility associated with cryptocurrencies like BTC not anchored to currencies or precious metals, but they have inherited some of their most interesting characteristics. For example, stablecoins are open, accessible to anyone via the Internet, 24 hours a day, 7 days a week, worldwide. They are fast, convenient, and can be transferred safely. They are virtual currencies, fully native to the Internet and compatible with any crypto wallet. By reducing risk, they are strategic for international traders.

Regulation of Stablecoins

In light of the rapid growth of this $130 billion market and its potential impact on the financial system as a whole, stablecoins continue to be a focus of regulatory authorities’ attention.

Today, they are considered systemically important by regulators because they can destabilize markets. Politicians are therefore increasing calls for stricter regulation, bringing it to a level similar to that of banking institutions.

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