How Do Stablecoins Work?
Stablecoins are a type of cryptocurrency designed to minimize price volatility by pegging their value to an asset, typically a fiat currency like the US Dollar. This makes them particularly useful in the DeFi (Decentralized Finance) ecosystem.
Types of Stablecoins
- Fiat-collateralized: These stablecoins are backed 1:1 by fiat currencies held in reserves. Examples include Tether (USDT) and USD Coin (USDC).
- Crypto-collateralized: Backed by other cryptocurrencies, these stablecoins maintain their value through smart contracts that over-collateralize the assets. MakerDAO’s DAI is a notable example.
- Algorithmic: These stablecoins use algorithms to control supply and demand, adjusting the quantity in circulation to stabilize prices. Examples include Terra (LUNA).
How They Work
When users trade fiat for a fiat-collateralized stablecoin, the equivalent amount is locked in a reserve. For crypto-collateralized stablecoins, users deposit cryptocurrencies, which are locked in smart contracts. Algorithmic stablecoins adjust supply dynamically based on the market conditions.
Benefits in DeFi
Stablecoins are pivotal in DeFi as they provide liquidity, enabling users to engage in lending, borrowing, and trading without the inherent volatility associated with other cryptocurrencies. This stability fosters broader adoption and increases usage in decentralized applications.