Crypto EDU

Stablecoin

  • September 15, 2021
  • Intermediate
Stablecoin icon 01 Large

For anyone who wants to use cryptocurrency as regular money—to buy pizza or drapes or dozens of other items—the extreme volatility of most coins poses a problem. It can be hard to do any sort of financial planning when you don’t know if your $1,000 of a particular asset will be worth twice as much or half as much next week. Plus, very few sellers are willing to accept payments through currencies that may not have the same value 30 minutes after the purchase. Stablecoins were created to make these buyers and sellers happy.

Most stablecoins avoid violent price swings by tying their value to a more stable asset. One way of doing this is by maintaining a reserve of fiat currency. This is known as “backing” or “pegging.” A cryptocurrency called TrueUSD, for example, is backed by U.S. dollars. If a TrueUSD owner wants, they can theoretically exchange their digital coins for an equal amount of U.S. currency held in a bank. Similarly, you can peg stablecoins to the prices of commodities, such as precious metals. PaxGold, for example, is backed by gold held in Brink’s vaults in London.

The second way to stabilize a cryptocurrency is by tying its value to other cryptocurrencies. Coin providers, in this case, can prevent price swings by holding extra reference currency in reserve, which is called “overcollateralizing.” For example, the stablecoin Dai is linked to a reserve of Ether—much more than the Dai is worth. That way, even if Ether’s value goes down, there would still be enough of it to keep Dai’s value stable.

The third way, which is much less common, is to set up a selection of algorithms that maintain price equilibrium the same way a central bank would. The cryptocurrency Ampleforth does this. Its algorithms create or destroy coins as demand changes. If the value goes down, coins are removed from circulation. If it goes up, coins are added. Either way, the value stays close to $1 and the coin’s performance is no longer linked to the rest of the crypto market.

Why should you care about stablecoins?

Stablecoins behave more similarly to fiat currencies than other cryptocurrencies, making them useful as collateral for financial activities, or enticing alternatives to physical money in places where government exerts tight-fisted control over financial markets, such as Hong Kong, or in places with uncertain economic futures, like Brazil.

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