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What are stablecoins and how they work

The idea behind stablecoins is reflected in its name – those are digital currencies designed to maintain stable prices and be used on the cryptocurrency market. The point behind creating a stable was to minimize the volatility of cryptocurrency and make trading on the crypto market more sustainable for both large private investors and institutional clients.

Today stablecoins went far beyond regular cryptocurrency trading thanks to the DeFi industry. Now they are being used as a part of decentralized banking and financial services which reduces the costs and volatility that comes with the utilization of various smart contracts

There are numerous types of stablecoins presented on the market. The main difference is the assets that they are backed with. Some stablecoins rely on physical settlement assets, some of them work purely on algorithms and smart contracts.

Fiat-backed stablecoins

The most popular type of stablecoins presented on the market is the assets backed with actual fiat currencies like the U.S. dollar or Euro. The price level of each coin is being maintained due to the linkage between actual fiat currency and each coin.

First-ever created stablecoins were fiat-backed since it’s the simplest solution that you can think of. Pegged with real-world currencies stablecoins are presented on most cryptocurrency exchanges. The most popular currency-based stablecoins are USD Coin presented on Coinbase, Binance USD, and DAI. Tether which might be considered as the most popular is not actually backed by fiat currency only, instead, their funding includes various non-disclosed holdings.

Assets-backed stablecoin

While fiat-based stablecoins mostly hold cash or its equivalent, asset-backed stablecoins are tied to various physical assets like gold, silver, or even real estate.

The value of a stablecoin backed by commodities is being stabilized by the store of value of the collateral behind every coin. It’s important to notice that to maintain a stable price of the coin, assets behind it should have high liquidity. Low-liquidity assets can’t be used for price stabilization since you will have problems realizing those assets on the market.

The most notable example of asset-backed stablecoin is Pax Gold which was created by Paxos CEO Charles Cascarilla with the usage of smart contract technology. It’s backed by the troy ounce of London Good Delivery gold.

Algorithmic stablecoins
We’ve already mentioned smart contracts that can be used for the stabilization of the stablecoin’s price. Smart contracts are algorithms that are being used for increasing or decreasing the supply of the coin in addition to using market making to maintain a specified price level for an asset.

The most technically advanced type of stablecoins is the algorithm-based coins that are not backed by any assets like currencies or commodities. Value or the price of each algorithmic stablecoin is being controlled by the code behind it. If the market price of stablecoins falls below a specified value, a smart contract changes the supply or burns some amount of coins to change its value. The same rule is applied whenever a price rises, but in that case instead of burning, new coins are being added to the market.

The main advantage of smart-contract-based stable coins is their decentralized nature which allows using it without any verification.

Cryptocurrency-backed stablecoin

With the rapid growth of the DeFi industry, a new type of stablecoins has been presented on the market which are stable coins backed by cryptocurrency collateral. Similar to algorithmic stablecoins, crypto-backed ones are utilizing smart-contract technology that manages an overcollateralized asset.

The collateral itself consists of the basket of various currencies. To avoid instability in stablecoin’s price due to the volatile nature of cryptocurrencies, stablecoin is being largely overcollateralized.