Stablecoins are digital assets designed to mimic the value of fiat currencies like the dollar or the euro. They allow users to cheaply and rapidly transfer value around the globe while maintaining price stability.
Cryptocurrencies like Bitcoin and Ethereum are notorious for their volatility when priced against fiat. This is to be expected, as blockchain technology is still very new, and the cryptocurrency markets are relatively small. The fact that the value of a cryptocurrency isn’t tethered to any asset is interesting from a free-market perspective, but it can be cumbersome when it comes to usability.
As mediums of exchange, cryptocurrencies are excellent from a technological standpoint. However, the fluctuations in their value have ultimately rendered them highly risky investments, and not ideal for making payments. By the time a transaction settles, coins can be worth significantly more or less than they were at the time they were sent.
But stablecoins have no such problem. These assets see negligible price movement and closely track the value of the underlying asset or fiat currency that they emulate. As such, they serve as reliable safe-haven assets amid volatile markets.
There are a number of ways in which a stablecoin can maintain its stability.
The most popular kind of stablecoin is that which is directly backed by fiat currency with a 1:1 ratio. We also call these fiat-collateralized stablecoins. A central issuer (or bank) holds an amount of fiat currency in reserve and issues a proportionate amount of tokens.
For instance, the issuer may hold one million dollars, and distribute one million tokens worth a dollar each. Users can freely trade these as they would do with tokens or cryptocurrencies, and at any time, the holders can redeem them for their equivalent in USD.
There is evidently a high degree of counterparty risk here that can’t be mitigated: ultimately, the issuer must be trusted. There is no way for a user to determine with confidence whether the issuer holds funds in reserve. At best, the issuing company can attempt to be as transparent as possible when it comes to publishing audits, but the system is far from trustless.