What are Stablecoins: Types, Functions, and How They Work

For all their excellent qualities, cryptocurrencies come a little short in terms of volatility. Based on market sentiments and other prevailing factors in the financial market, they can fluctuate widely in price within a very short period. And while crypto traders love that very much, it’s not particularly healthy for financial transactions. 

But what if we could have a unique type of cryptocurrency that retains all the other good qualities of cryptocurrencies but isn’t as volatile? What if there was a coin that retained the stability of fiat currencies and commodities while being decentralized, fast, and built on the blockchain? 

Enter stablecoin development — the best of both worlds if you would like. 

So, what are stablecoins? Are there different types of stablecoins? How do stablecoins work? 

If you’re curious about questions like this, this article will explore everything you need to know. 

Without further ado, let’s begin with a succinct stablecoins definition. 

What are Stablecoins? 

Stablecoins are a category of digital currency or crypto assets whose values are “pegged”  or “tied to”  the value of an external reference such as fiat currency, commodity, or financial instrument. They are structured in a way that ensures they are one-to-one tethered to this other external financial reference. 

Let’s assume a stable currency is tied to the price of the US dollar; this means that the price or value of 1 unit of that stablecoin is equivalent to the price of 1 US dollar. There’s no need to assume any longer because that stablecoin exists, and it is called the Tether (USDT.) For more context, Tether Limited created this stable currency to function as the internet’s digital dollar. And that sums up all the main things you need to know about stablecoins. 

Stablecoins try to offer the best of both worlds by being price-stable crypto assets that behave like fiat currencies (in terms of stable value) while maintaining the mobility and utility of cryptocurrencies. 

Despite all the good qualities of cryptocurrencies and blockchain technology, their erratic volatility makes them unfit for use as a common exchange of value. We’ve all noticed this with the constant rise and fall of crypto prices. For example, Bitcoin prices rose as high as USD 70,835 in March 2024, dropped to USD 64,000 in September, and ended the year just below USD 100,000. Talk about all over the place. 

This means it’ll be difficult to set the prices of goods and services using these cryptocurrencies. Stablecoins, on the other hand, are more stable because their prices are pegged to the prices of either fiat currencies or other commodities. 

As such, they can be used to make cross-border payments and buy or sell crypto assets. Stablecoins use different techniques to maintain the same market value as the external assets backing them. This is the basis for the existence of different kinds of stablecoins, which we’ll discuss later in this article. 

Explore More: Meme Coin Development Services

How do Stablecoins Work? 

By now, we’ve already established the fact that stablecoins are created to maintain a fairly stable value by tying their prices to an external benchmark. For this to work, a number of steps have to be followed. These include: 

1. Coin creation

First things first, businesses need to create these digital assets and deploy them on the blockchain. The process is technical and is best handled by a stablecoin development company. After creation, the organization must tie its value to an external benchmark using one of two methods:

So, after creating the digital entities, the organization has to tie its value to an outside benchmark. Depending on the type of stablecoin being created, there are different ways of doing this. 

The two major ways include: 

• Asset Backing: Asset backing means using tangible physical assets like fiat currencies (e.g., USD) or commodities like gold, silver, etc., as the necessary backing for the stablecoin. In this case, the organization must acquire a corresponding amount or value of the external benchmark (USD, gold, or silver) and keep it in reserve. 

For instance, if you’re backing your stablecoin with the US dollar, you must acquire US dollars equivalent to the total amount of stablecoin you’ll be issuing. This is how the organization maintains a link between the stablecoin and the commodity backing it. 

• Algorithmic Backing: This is another common technique for maintaining the value of stablecoins. This managerial use of intelligent algorithms, smart contracts, and advanced digital technology helps to control the supply of stablecoins and achieve price stability. 

2. Token Issuance

Once the stablecoin is created and linked to the external benchmark, the organization can now make it accessible to members of the public using an infrastructure known as a ledger. The ledger keeps records of individuals owning the stablecoins and their transactions and also facilitates the transfer of these stablecoins from one holder to another. 

Furthermore, the ledger establishes a connection between the stablecoins currently in the holder’s custody and the stable assets in the organization’s reserve. This connection is important because it gives the holders or investors confidence that they can get their money’s worth for their stablecoin whenever they please—the money is in the organization’s custody. 

3. Coin Usage

Finally, holders can now use the stablecoin for their preferred purposes. This could include exchanging value for common purchases or making larger investments. 

Usually, at this stage, holders are able to store the units of stablecoins they own in digital wallets, which other companies often provide. This digital wallet can be used on a smartphone or other electronic devices to store, trade, and invest stablecoins. 

Types of Stablecoins

Although they all try to offer a stable digital currency with limited price fluctuations, the different types of stablecoins differ from each other based on the assets used to collateralize their value. Based on these different collateral structures, the following are the different types of stablecoins: 

1. Fiat-backed Stablecoins

Fiat-backed stablecoins are the most straightforward types of stablecoins available. As their name implies, these types of stablecoins are collateralized by a reserve of fiat currencies such as the US dollar. This implies that for every single unit of that stablecoin issued by the token issuer, there is a corresponding amount of fiat currencies held with an independent custodian. 

To ensure that the issuer actually has the number of fiat currencies it claims to have, regulatory bodies in the jurisdiction regularly audit it for transparency and compliance. The stablecoin issuer is often expected to have fiat reserves equal to or greater than the amount of stablecoin in circulation. 

Common examples of fiat-backed stablecoins include Tether (USDT), TrueUSD (TUSD), and USD Coin (USDC).  

2. Crypto-backed Stablecoins

As you might expect, crypto-backed stablecoins are stablecoins whose values are pegged to the current market value of other cryptocurrencies. These kinds of stablecoins are generally considered to be “over-collateralized.” As a result, they do not offer as much stability as fiat-backed stablecoins. Consequently, many investors do not consider them to be relatively stable or less volatile like fiat-backed stablecoins. Nonetheless, issuers still have to hold a large amount of that cryptocurrency being collateralized in reserves. The additional difference here is that the token issuer has to hold a lot more than just the amount of stablecoins in circulation in the cryptocurrency reserves to account for price fluctuations. 

DAI is an excellent example of a decentralized stablecoin. Although its value is pegged to the United States Dollar, the coin’s issuer actually backs it with a reserve of cryptocurrencies like Ethereum.

If you’re planning to build a secure, scalable stablecoin, you need to hire blockchain developers who specialize in stablecoin architecture to ensure seamless integration and compliance.

Related Read: What is A Security Token Offering? 

3. Algorithmic Stablecoins

Unlike other types of stablecoins, algorithmic stablecoins are not backed by assets held in reserves. They do not use either fiat, cryptocurrencies, or commodities as collateral. Rather, the stablecoin’s value is kept fairly stable by controlling its supply and demand with the use of specialized algorithms and smart contracts. 

These specialized algorithms and smart contracts maintain this value by tracking an established fiat or cryptocurrency to which they intend to peg the value of the stablecoin. Whenever this established benchmark increases in value, the specialized algorithm or smart contract is programmed to reduce the number of tokens (stablecoins) in circulation. Likewise, the total stablecoin supply is reduced when its value starts to exceed that of the established benchmark.  

This is similar to the way central banks around the world maintain the value of the national currencies without holding reserves. They simply just adjust the money supply by controlling the buying and selling of securities in the open financial markets. 

The fact that algorithmic stablecoins do not need collateral is a good thing because it keeps the coin totally independent and decentralized (which is the main advantage of switching to digital assets on the blockchain). However, this also opens them up to some significant disadvantages, like being susceptible to speculative attacks and market sentiments. More so, it means the issuer must take extra precautions to create a truly robust algorithm and smart contract that is capable of handling the highly unpredictable market dynamics. 

These challenges create a serious potential for rapid devaluation and loss of investor confidence. We can see this with UST (TerraUSD), one of the most notable algorithmic stablecoins in recent times. This stablecoin used a governance token called LUNA as its reference asset and maintained the same value as this token using a mint and burn mechanism. Unfortunately, however, UST and its blockchain collapsed after it couldn’t keep up with the LUNA token

4. Commodity-backed Stablecoins

These are stablecoins whose value is backed by the real market value of non-blockchain assets or commodities like gold, crude oil, silver, precious metals, or real estate. Any stablecoin issuer offering this stablecoin to members of the public generally establishes the link between the coin and these commodities by either buying and storing the chosen commodities in reserve or investing in financial instruments holding these commodities. 

For example, Tether Gold (XAUT) is an example of a commodity-backed stablecoin issued by Tether Limited. The company links the value of this stablecoin to the current market value of gold by actually holding an amount of gold that is equivalent to the total amount of Tether Gold (XAUT) in circulation in Swiss vaults. In fact, the company makes provisions for any XAUT holder who wishes to receive their physical gold to get them when they choose. However, such individuals have to meet up with certain requirements before this can happen. For instance, Tether Gold (XAUT) holders have to complete the TG commodities Limited verification process and hold a minimum of 430 XAUT before they redeem their token holdings for physical gold. 

Compared to fiat-backed stablecoins, commodity-backed stablecoins are more likely to experience price fluctuations because the underlying commodity, such as gold, can also fluctuate in price depending on demand. This possibility presents both earning potential and investment risks to investors. 

Related Read: What Are Meme Coins and How Do They Work?

Benefits of Stablecoins: Why are Stablecoins Important? 

Stablecoins offer so much value to our current financial systems, whether in the cryptocurrency space specifically or in other financial landscapes. Some of these benefits include the following: 

1. Price Stability

They effectively solve one of the major problems associated with setting the prices of goods and services in cryptocurrencies. Because they maintain a fairly stable value, merchants and consumers don’t have to worry about major financial losses due to price fluctuations. 

2. Transaction Speed

Stablecoins are digital assets built on the blockchain, which offers one of the major advantages of cryptocurrencies: speed. Compared to traditional banking transactions, stablecoins can be sent and received in seconds. 

3. Privacy and Security

Payments with stablecoins are generally safe and secure compared to most other traditional forms of payment. 

4. Integration with Decentralized Finance (DeFi) and Traditional Finance Systems

Having provided price stability, stablecoins play a major role in various financial applications like yield farming, lending, and borrowing. Usually, many users face the problem of deciding what currencies to use as a medium of exchange on these platforms. On the one hand, conventional cryptocurrencies are too volatile, and on the other, many platforms do not accept fiat payments. However, stablecoins offer the best of both worlds, as they are digital assets offering stability. 

Consequently, they allow users to earn, gain liquidity, and engage in other financial activities with ease and without the risks of volatility. 

5. Global User Access

This is yet another benefit of being a digital asset built on the blockchain. Stablecoins, like cryptocurrencies, can be sent and received from anywhere in the world and thus can be used for cross-border payments. More importantly, they’re appealing and accessible to anyone regardless of their social status. 

6. Flexibility

Stablecoins can be used to facilitate transactions quickly and easily using different platforms and devices. More so, they can be bought quickly using a variety of methods, such as bank transfers and credit cards. 

Conclusion

Stablecoins have advanced the cryptocurrency industry by a long shot by solving the volatility issues associated with digital currencies. The use of either asset or algorithmic backing when creating these digital currencies boosts investor confidence and, in turn, further maintains the coin’s stability in value. 

From fiat-backed and commodity-backed stablecoins to crypto-backed and algorithmic stablecoins, each of these types of stablecoins plays a major role in bridging the gap between conventional finance and the world of cryptocurrencies. So, whether you’re looking to use them for remittances, trading, or simply as a means of preserving value, understanding what stablecoins are helps you make the right decisions. 

Finally, if your organization wants to take advantage of these benefits by issuing your native stablecoin, you should get expert stablecoin development services from a reputable crypto token development company like Debut Infotech. 

Get in touch today and explore how stablecoin development can drive business growth!

Frequently Asked Questions (FAQs)