A stablecoin is a new kind of cryptocurrency that seeks to offer price stability through a reserve.
Cryptocurrencies, as we know, have high price volatility. This is a fact that discourages many people from investing in bitcoins, for example. Stablecoins, in this sense, are a very attractive solution. They try to offer the best of both currencies: the speed and security of payments in cryptocurrencies, and the price stability of fiat currencies.
Where does the stability of fiat currencies come from?
The stability of fiat currency prices is allowed by its complete regulation and timely intervention in the market by the supervisory authorities. Even in extreme cases where a fiat currency collapses, there are authorities that step in and manage the supply and demand for the currency to maintain price stability.
The fiat currency has been deeply integrated into our political and economic system for centuries, and it is against everyone’s interest that the euro, the dollar, the yen, should swing sharply.
The Stablecoin Solution
Cryptocurrency, on the other hand, is still in its infancy, which is why most cryptocurrencies lack these key features: they do not have a central authority and are not fully regulated.
Stablecoins follow a strategy that fiats have already attempted in the past: to anchor themselves to more stable assets.
These assets can be of two macro-types:
- fiat currency reserves
- cryptocurrency reserves
These coins rely on a fiat currency reserve, usually the US dollar, as collateral for the issuance of an appropriate number of coins. Other forms of collateral may include precious metals such as gold or silver, as well as commodities such as oil, but most current fiat-backed stablecoins use dollar reserves.
These reserves are controlled by independent custodians and are regularly monitored by government financial authorities. Tether (USDT) and TrueUSD are popular cryptocurrencies that have a value equivalent to a single US dollar and are backed by dollar deposits.
These stablecoins are supported by other cryptocurrents. Since reserve cryptocurrencies can also be subject to high volatility, this type of stablecoin is “over-collateralised“, i.e. supported by a reserve that has more cryptocurrency units than issued stablecoins.
For example, $2,000 of ETH can be held as a reserve for the issuance of $1,000 of a stablecoin. The DAI stablecoin does something similar: backed by ethereum, it is pegged to the US dollar 1:1 value and allows a series of crypto-assets to be used as a reserve.