What are Stablecoins and How They Work

Unlike highly volatile cryptocurrencies such as Bitcoin, the price of stablecoins is not meant to fluctuate. Stablecoins have become a popular option for consumers wanting to own cryptocurrencies but who also desire the stability and predictability of fiat how does stablecoin work currencies. As of writing this article, the stablecoin market is worth nearly 140 billion U.S. dollars. The stablecoin with the highest market capitalization value is Tether, which is pegged to the U.S. dollar as its fiat-backed currency. Tether has a total market value of just over 66 billion U.S. dollars. Stablecoins are another type of decentralized digital currency that can be bought and sold on the blockchain.

Why Are Stablecoins Important to Cryptocurrency?

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Fiat-Collateralized Stablecoins

The investing information provided on this page is for educational purposes only. NerdWallet, Inc. does not offer advisory or brokerage services, nor does it recommend or advise investors to buy or sell particular stocks, securities or other investments. As their name suggests, stablecoins are inherently stable assets, making them a suitable store of value, which encourages their use in everyday transactions. Further, stablecoins improve the mobility of crypto assets throughout the ecosystem. Stablecoins allow investors to move in and out of different cryptocurrencies while staying within the cryptocurrency realm.

Definition: What are stablecoins?

If you’re curious about cryptocurrency, think about using some “fun money” — those dollars left over after you’ve built your savings and paid for essential expenses. If you’re looking to add some riskier assets to your portfolio, individual stocks can also fill that role. Typical examples include selling governance tokens that allow buyers to gain voting control over the stablecoin’s future or locking up funds into smart contracts on the blockchain to earn interest. TerraUSD (UST) was the biggest algorithmic stablecoin, reaching a market cap of more than $18.7 billion at its peak on May 5 before it began to plummet sharply after it slipped below its peg. Recent events have taught us that not all stablecoins are created equal.

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A stablecoin worth $1 aims to maintain the price of $1; nothing more, nothing less. A stablecoin is a cryptocurrency that aims to maintain price stability by pegging its monetary value to a given fiat currency, typically on a one-to-one basis. Collateralised stablecoins maintain a pool of collateral to support the coin’s value. Whenever the holder of a stablecoin wishes to cash out their tokens, an equal amount of the collateralising assets is taken from the reserves. In comparing various financial products and services, we are unable to compare every provider in the market so our rankings do not constitute a comprehensive review of a particular sector. While we do go to great lengths to ensure our ranking criteria matches the concerns of consumers, we cannot guarantee that every relevant feature of a financial product will be reviewed.

One algorithmic stablecoin is AMPL, which its creators say is better equipped to handle shocks in demand. Commodity-backed stablecoins are collateralized using physical assets like precious metals, oil, and real estate. The most popular commodity to be collateralized is gold; Tether Gold (XAUT) and Paxos Gold (PAXG) are two of the most liquid gold-backed stablecoins. However, it is important to remember that these commodities can, and are more likely to, fluctuate in price and therefore have the potential to lose value.

• For example, the reserve of a fiat-backed stablecoin like USDC may contain $1 million in U.S. dollars to serve as collateral for a million USDC.
• Both these factors occurring simultaneously sent the stablecoin spiraling, making it essentially worthless overnight.
• These are called algorithmic stablecoins, and they can be riskier than stablecoins backed by assets.
• Others, like Ethena’s USDe, leverage delta-neutral strategies to earn yield from funding rates and basis spreads in the derivatives market.
• For example, you can purchase tokens pegged to the dollar, euro, yen, and even gold and oil.
• As of writing this article, the stablecoin market is worth nearly 140 billion U.S. dollars.

Our partners cannot pay us to guarantee favorable reviews of their products or services. Stablecoin technology drives innovation, provides an on-ramp to the crypto ecosystem, and bridges traditional finance with DeFi. In 2020–21, the stablecoin market exploded, its market cap expanding by almost three times. Although not to the same extent as TerraUSD, investors worried about the reliability of reserves, and whether Tether was fully collateralized. USDC’s reserves are held in safe assets that should retain their value, such as cash and U.S Treasurys.

Commodity-backed stablecoins are backed by reserves of physical assets like precious metals, oil and real estate. It’s important to note that while commodities markets may not be as volatile as cryptocurrencies, commodity-backed stablecoins are still riskier than fiat-backed stablecoins. While not particularly popular among the general cryptocurrency population, most commodity-backed stablecoins are used as a way to access asset classes that were previously inaccessible to small investors. Stablecoins attempt to peg their market value to some external reference, usually a fiat currency. They are more useful than volatile cryptocurrencies as a medium of exchange. Stablecoins may be pegged to a currency like the U.S. dollar, the price of a commodity such as gold, or use an algorithm to control supply.

Stablecoins have caught regulators’ interest worldwide due to their unique mix of fiat and crypto. As they are designed to maintain a stable price, they are useful for reasons other than speculation. They can also facilitate high-speed transactions internationally at a low cost. Some countries are even experimenting with creating their own stablecoins. As a stablecoin is a type of cryptocurrency, it will likely fall under the same regulations as crypto in your local jurisdiction.

Stablecoins are not without their pain points and have certain drawbacks to be aware of. To purchase DAI, users may use any major exchange, like Coinbase and Gemini. Counterparty risk is the probability that the other party in the asset may not fulfil part of the deal and default on the contractual obligation. We want people to have confidence in the different ways they pay for things. It’s an important way to avoid large disruption to the UK’s financial system and economy. Counterparty risk is the probability that the other party in the asset may not fulfill part of the deal and default on the contractual obligation.

The Bank of England and HM Treasury have seen that the way people pay for things is changing. Learn more about Consensus 2024, CoinDesk’s longest-running and most influential event that brings together all sides of crypto, blockchain and Web3. There are still problems with this innovative model, however; for example, if the smart contracts underpinning MakerDAO don’t work exactly as anticipated.

Unlike Ethereum, stablecoins aim to maintain a stable value and are often pegged to a stable asset like the US dollar. The information provided by Forbes Advisor is general in nature and for educational purposes only. Any information provided does not consider the personal financial circumstances of readers, such as individual objectives, financial situation or needs. Forbes Advisor does not provide financial product advice and the information we provide is not intended to replace or be relied upon as independent financial advice. Your financial situation is unique and the products and services we review may not be right for your circumstances. Performance information may have changed since the time of publication.

In fact, stablecoins are specifically designed to maintain a fixed price. In an industry where coins and tokens can crash overnight, there is a massive demand for currencies that mix blockchain benefits with the ability to track a more stable asset. If you haven’t started using stablecoins while trading or investing, it’s worth learning more about them as well as the benefits and drawbacks they bring. Somewhat of a sub-category of fiat-collateralized coins, commodity-backed stablecoins are cryptocurrencies that are pegged to the market value of commodities such as gold, silver, or oil. These stablecoins generally hold the commodity using third-party custodians or by investing in instruments that hold them. Treasuries, YBS can offer greater stability than regular stablecoins relying purely on crypto-based collateral.

Even though they are an integral part of crypto and have enabled the creation of a new financial system, you shouldn’t underestimate the risks. We’ve seen stablecoin projects with failing pegs, missing reserves, and lawsuits. So while stablecoins are incredibly versatile tools, do bear in mind that they’re still cryptocurrencies and hold similar risks.