A Stablecoin is a digitized currency that is collateralized (has solid value behind it) and assigned a specific monetary value.
In theory, any stablecoin can be redeemed for its assigned value at any time in the fiat currency that backs it. This offers them stability, but with a bit more flexibility.
The most popular stablecoins are issued by companies with centralized operations.
This makes it easier to maintain value, as the companies issuing them can quickly issue, burn, and redeem them as necessary. These centralized operations also manage their social media campaigns and marketing projects.
In short, they work to not only manage the coins but also help promote cryptocurrency usage and adoption.
What kinds of Stablecoins are there?
There are four different kinds of stablecoins. The differences between them come down to which blockchains they can be used on and how they are collateralized.
The first type of stablecoins are collateralized by fiat currency, and include coins such as Tether (USDT) and TrueUSD.
The companies that issue these stablecoins promise that each coin is backed by US$1.
They then promise to carefully audit and monitor the reserves, guaranteeing that they exist, and are sufficient to cover the issued currency.
The next type of stablecoins is crypto based. These stablecoins are collateralized by cryptocurrency.
The cryptocurrencies used to back a stablecoin may include Ethereum, Bitcoin, among many others.
In fact, these types of coins are often overcollateralized. That means that the companies have more crypto on reserve than is needed to guarantee each coin's value.
This is necessary because of the extra volatility, and it ensures they have enough to cover the fluctuations.
The third group of stablecoins are those backed by real-world assets.
They could be backed by physical objects such as precious metals (e.g., gold, silver), natural resources (e.g., oil, natural gas), or physical assets (e.g., real estate, corporate inventory).
Ultimately, the companies issuing these types of currency promise to have sufficient reserves to guarantee the coins they have in circulation.
Lastly, there is the algorithmic stablecoins group, also known as non-collateralized stablecoins. These coins aren’t backed by fiat currency, cryptocurrency, or any real-world assets.
Instead, they are controlled by an algorithm, or in other words - software. The algorithm changes the supply of coins in circulation based on the market valuation of the coin.
For example, if the stablecoin's value is dropping in value, the algorithm will remove coins from circulation, increase demand and raise the market value.
However, if the value is rising, the algorithm will increase the number of coins in circulation, decreasing their demand and lowering their market valuation.
How do Stablecoins work?
Stablecoins work like cryptocurrency.
In this sense, they can be used in the exact same way that Bitcoin and Ethereum are used on the blockchain.
They are hosted by specific blockchains that allow smart contracts, for example, the Ethereum blockchain. These coins are permitted as a form of payment for transactions.
Importantly, the value assigned to them by the company that issued them is accepted by the blockchains that host them.
When used as a form of payment in smart contracts, it’s the smart contracts which specify which stablecoins can be accepted as a form of payment.
Let's say two people agree that Party A will do something, and, when it's done, Party B will pay Party A 10,000 USDT.
When Party A confirms that the work has been done and the smart contract registers the confirmation, Party B's payment, held in escrow by the smart contract, will be immediately sent to Party A.
However, if Party A doesn't complete the work before the expiration date of the smart contract, Party B's payment will be returned to Party B's crypto wallet.
Another benefit is that blockchains allow people who use smart contracts to pay their transaction fees using stablecoins, too.
This makes it much easier and less expensive to process smart contracts on blockchains, as both parties can simply use stablecoins to do so.
As a quick recap…
Stablecoins are less volatile than cryptocurrencies which makes them more suitable for financial transactions.
However, the downside is, you must trust the companies that issue the stablecoins to have enough in their reserves. There are cases where the company doesn’t have enough and the value of the stablecoin plummets.
How do Stablecoin-issuing companies make money?
That's a great question!
We know they're in the business of making money, and how can they make money selling tokens worth a preset value, like US$1.00?
Firstly, users have to pay a fee to purchase and redeem stablecoins.
Secondly, if the stablecoins-issuing company is a centralized operation, the company may invest its fiat currency reserves into high-yielding assets - like commercial paper and Treasury bills.
Thirdly, decentralized stablecoin companies have a variety of ways to earn income.
Some ways they could earn income are by selling governance tokens. They may also lock up their stablecoins in smart contracts on a blockchain that earns them interest.
Conclusion
Stablecoins are a kind of digitized currency with a fixed value. They can be used on blockchains, in smart contracts, and in decentralized finance transactions.
There are four kinds of collateralized stablecoins: fiat, crypto, real-world assets, and algorithmic. You can use the kinds of stablecoins that provide you with the greatest guarantee of value.
