How Stablecoins stay Stable?
 

How Stablecoins stay Stable?


Let's first define, what is a stablecoin?

Stablecoins are cryptocurrencies that use various methods to keep their value fixed.

Stablecoins are cryptocurrencies designed to maintain the price stability of (strong) fiat currencies while maintaining the security, speed, and low cost of virtual asset transactions. This was initially done to minimize the impact of the price volatility of cryptocurrencies in trading and as a bridge to mainstream spending and financial institutions. Now they are beginning to branch out into mainstream banking to ease the cost and burdens of making payments.

There are four basic types of stablecoins. The three centralized stablecoins are backed by fiat currencies, commodities, or cryptocurrencies, while decentralized ones rely on algorithms and smart contracts to automatically maintain value.

What is a fiat-backed stablecoin?

A fiat-backed stablecoin keeps prices level by storing fiat backing each coin on a one-to-one basis.

The first and simplest stablecoin is fiat-backed, notably the U.S. dollar, as well as the euro, yen, and others, at a one-to-one ratio. So long as the underlying currency — or basket of currencies as Libra originally proposed — stays stable, the stablecoin will maintain its value. They are, essentially, backed by the “full faith and credit” of the fiat issuer, with a value defended by that nation’s central bank.

Far and away the largest of these is Tether, with a market capitalization of $82.7 billion at this writing. But other leading stablecoins include Circle and Coinbase’s USD Coin ($23 billion), Binance USD ($9.6 billion), and DAI ($4.8 billion).

What is a crypto-backed stablecoin?

Crypto-backed stablecoins use what amounts to overcollateralized loans to keep their value correctly pegged.

Crypto-collateralized stablecoins are backed by a basket of one or more other cryptocurrencies. As these are themselves highly volatile, these stablecoins are highly overcollateralized and require purchasers to lock their collateral tokens into smart contracts that will be liquidated if the collateral drops in value too much. The collateral that can be collected by replacing the stablecoins.

One of the best-known crypto-backed stablecoins is MakerDAO’s DAI, pegged to $1. However, as MakerDAO learned during the March 12, 2020 “black swan” event in which ETH’s value was cut in half in less than 24 hours after it got overwhelmed by liquidations, making sure the system can handle extreme conditions is vital — forcing it to implement substantial governance and auction management changes.

Created on 26th Apr 2022

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