Blog: What is stablecoin?

Blog: What is stablecoin?

Stablecoin is a cryptocurrency whose main task is to keep its value as stable as possible in all situations. Almost always, this means that the value of one stablecoin should stay as close as possible to one dollar. Stablecoins offer excellent protection against the high volatility of the cryptocurrency market. This text aims to tell you about the different stablecoins and describe more about where they are needed.

Different types of stablecoins

There are currently several different types of stablecoins in the cryptocurrency market. Stablecoins can be divided into three distinct groups depending on how the value of stablecoin is guaranteed. These groups include stablecoins based on traditional currencies, precious metals or similar value-added commodities, cryptocurrency-based stablecoin, and algorithm-based stablecoin. Thus, the value of stablecoins can be based on, for example, US dollars, precious metals, oil, cryptocurrencies, or an algorithm-based solution.

The most popular way to guarantee the value of stablecoin is definitely to use the US dollar as collateral. This means that the value of one Stablecoin should be as close as possible to one dollar. The price of stablecoin is then based directly on the exchange rate of the pegged dollars. In practice, this means that there is also one US dollar for each stablecoin deposited in an account designated by the entity that issued that stablecoin. The accounts of reliable operators holding such reserves should audit regular times to ensure compliance with the requirements.

The value of stablecoin can also be secured by using cryptocurrencies. Due to the high volatility of cryptocurrencies, cryptocurrency-based stablecoins operate mainly through over-collateralized. In other words, a more significant number of cryptocurrencies guarantees a smaller amount of stablecoin issued than a deposit. Therefore, even large market fluctuations do not reduce the value of stablecoin to a level below collateralization. Stablecoin, which uses cryptocurrencies as collateral, also aims in most cases to keep its exchange rate as close as possible to the US dollar so that the value of one stablecoin would correspond to the value of one dollar.

In addition to the stablecoins mentioned above, uncollateralized stablecoins operate entirely based on an algorithm. While the lack of collateralization may seem daunting, it is suitable for everyone to remember that traditional currencies such as the euro and the dollar also do not have any collateral. In practice, stablecoins based on algorithms utilize blockchain technology and smart contracts in their operations. Although uncollateralized stablecoins do not use physical collateral, in most cases, they still include a workable technical implementation that keeps their price as stable as possible. Also, the goal of algorithm-based stablecoin is most often to keep the stablecoin exchange rate as close to the US dollar as possible.

Digital currencies, long developed by central banks, are also basically stablecoins. For example, based on the blockchain technology designed by the European Central Bank, the digital euro exchange rate is likely to be pegged to the traditional euro exchange rate. As a result, its exchange rate development follows the current exchange rate of the euro.

What are the uses of stablecoins?

The importance of stablecoins to today’s cryptocurrency market is enormous. The primary function of stablecoins is to protect investors from sharp exchange rate fluctuations in the cryptocurrency market. With stablecoin, an investor can receive interest income on their investment from various Defi services without the risk of possible sharp exchange rate fluctuations. In addition, many cryptocurrency exchanges do not offer exchange pairs for euros or dollars, making buying stablecoin the only way to hedge their holdings from market movements. The need for stablecoins with the lowest possible volatility is very high in the world of cryptocurrencies. Of all the cryptocurrencies on the market, stablecoin is most similar to traditional currencies like the euro and dollar.

Stablecoins have their place in the cryptocurrency market. Stablecoin fills the gap between traditional currencies and cryptocurrencies. The price stability provided by stablecoins allows investors, for example, to enjoy tens of percent of annual interest income offered by Defi services without the risk of exchange rate fluctuations and to maintain their assets in cryptocurrency wallets or exchanges without fear of sharp exchange rate fluctuations. In addition, stablecoins also serve as an excellent medium of exchange. Their price stability allows people to be confident that exchange rate fluctuations in the cryptocurrency market will not affect their purchasing power.

Mikko Soon Cryptocurrency specialist
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Last updated: 10.03.2022 14:46
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