What is a stablecoin?

Understanding stablecoins and their role in cryptocurrency

Stablecoins play a unique and important role in the crypto market. The value of cryptocurrencies can fluctuate dramatically, making it difficult to know when to buy, sell, or hold. Stablecoins bridge the gap between crypto and traditional currencies. But what are stablecoins and what do they do?

In the simplest of terms, stablecoins provide the cryptocurrency market with price stability, but it’s much more complex than that. Stablecoins are an attempt to create a cryptocurrency that’s backed by an asset with a stable price.
At BTC Markets, we provide reliable and up-to-date information about various cryptocurrencies, including stablecoins, to help our investor community buy, sell and trade cryptocurrencies safely.

Understanding stablecoins

To better understand stablecoins, let’s first begin with the question: what is a stablecoin? A stablecoin is a type of cryptocurrency whose value remains stable against a pegged external traditional asset. The pegged asset could be a single fiat currency (like the USD), a commodity (such as gold), or other assets. By backing its value against a conventional asset, stablecoins... stabilise price.

Stablecoins provide security and decentralisation of cryptocurrencies with the stability of fiat currencies. Their primary purpose is to create a stable environment to increase cryptocurrency trading.

How do stablecoins work?

So now we know what a stablecoin is, but how do stablecoins work?

Stablecoins provide an alternative to the price fluctuations of popular cryptocurrencies like Bitcoin (BTC), which can make them potentially more suitable for everyday transactions. Stablecoins can be used in blockchain-based financial services and can even be used to pay for common goods and services.

The different types of stablecoins include fiat-collateralised, crypto-collateralised, and algorithmic stablecoins. The most popular kind of stablecoins are fiat-backed stablecoins, which are tied to currencies such as the U.S. dollar.

Fiat-collateralised stablecoins

Fiat-collateralised stablecoins, such as Tether (USDT) and USD Coin (USDC), are backed at a 1:1 ratio and maintain their value by holding an equivalent amount of fiat currency in reserve. Meaning that, for each stablecoin that exists, there is fiat currency held in the treasury.

The idea is to create a fixed price stablecoin using real fiat in real bank accounts so that users can redeem their stablecoins for fiat currency at a 1:1 ratio, thereby maintaining the stablecoin's value.

Fiat-backed stablecoins' structure is simple, and fiat is considered stable, and the low volatility is an enticing selling point. Fiat-collateralised stablecoins are the simplest stablecoin category, but also the most centralised.

Crypto-collateralised stablecoins

Cryptocurrencies themselves can also be used to back stablecoins. A crypto-backed stablecoin works similarly to a fiat-backed stablecoin. Only instead of using fiat as collateral, crypto-collateralised stablecoins use cryptocurrencies as collateral to peg to the stablecoin. Typically, they may even over-collateralise to account for price volatility so that even if the value of the collateral falls, the stablecoin can maintain its peg.

The main benefits of crypto-collateralised stablecoins are that no regulations or audits are required and it's decentralised due to being based on blockchain.

Benefits of stablecoins

Stablecoins offer many advantages for cryptocurrency users, such as ease of use, reduced volatility, and its role in decentralised finance (DeFi).

Like fiat currency, stablecoins can easily be used for transactions. This makes them useful for everyday purchases or sending and receiving payments without the price fluctuations of traditional cryptocurrencies.

Unlike other cryptocurrencies, stablecoins offer a more predictable price. This makes them a valuable tool for hedging against market downturns and facilitating easier entry and exit points for investors.

Stablecoins also play an important role in DeFi. They are used for lending, borrowing, and earning interest on DeFi platforms.

Common uses of stablecoins

Trading and hedging

Traders often use stablecoins to hedge against the volatility of the cryptocurrency market. By converting assets into stablecoins, traders can lock in profits or avoid losses during market downturns. Stablecoins are also used in trading pairs to provide liquidity and facilitate smoother trading.

Payments and remittances

Stablecoins can also be used for payments and remittances due to their stable value and low transaction fees.

Platforms and services process transactions using stablecoins, their stable value and low transaction fees make them a great alternative for cross-border payments and everyday transactions. Stablecoins make cross-border payments faster, cheaper, and more efficient compared to traditional methods.

How do stablecoins make money?

Decentralised finance (DeFi)

So now that we understand how stablecoins work and their benefits, how do stablecoins make money?

Stablecoins can generate revenue through a variety of methods. Some platforms that process stablecoin transactions may charge a small fee for each transaction processed, while fiat-collateralized stablecoin issuers may earn interest on the fiat reserves they hold. Also, partnerships with financial institutions can create additional revenue streams.

Stablecoins help DeFi platforms operate more efficiently by providing liquidity and stability and allow users to lend, borrow, and earn interest.

Are stablecoins safe?

Risks and challenges

Like any asset, stablecoins are not without risks. Regulatory scrutiny is a concern, as governments worldwide seek to better understand and regulate these digital assets.

The transparency of reserves is another issue as users need assurance that stablecoins are adequately backed by the reserves they claim they are.

Stability mechanisms also pose challenges. If the underlying mechanism fails, the stablecoin could lose its peg and users could suffer losses.

For tips on staying safe while trading with cryptocurrencies, check out our guide on protecting yourself online.

Explore stablecoins with BTC Markets

Stablecoins are an important component in the cryptocurrency market. They offer things like price stability, ease of use, and a foundation for DeFi platforms. Whether you're looking to trade or just want to learn more about cryptocurrency, starting with stablecoins is great option.

BTC Markets is Australia’s trusted platform for trading and learning about cryptocurrency. For more information, visit our learn section where you can find our beginner’s guide and learn more about cryptocurrency and blockchain technology.