How Do Stablecoins Work?
Stablecoins are a type of cryptocurrency designed to maintain a stable value by pegging their worth to a reserve of assets, such as fiat currencies like the US Dollar or commodities like gold. The primary purpose of stablecoins is to provide users with the benefits of cryptocurrencies, such as fast transactions and security, while minimizing the volatility typically associated with cryptocurrencies like Bitcoin and Ethereum.
There are three main types of stablecoins:
- Fiat-collateralized stablecoins: These are backed 1:1 by a reserve of fiat currency stored in a bank. For every stablecoin issued, an equivalent amount of fiat is held in reserve.
- Crypto-collateralized stablecoins: These are backed by other cryptocurrencies, often over-collateralized to account for volatility. Example protocols use smart contracts to manage collateralization ratios.
- Algorithmic stablecoins: These are not backed by any assets but rely on algorithms to control supply and demand, automatically increasing or decreasing the supply to maintain price stability.
Stablecoins play a crucial role in the Decentralized Finance (DeFi) ecosystem, facilitating lending, borrowing, and trading without the volatility risk, thus ensuring a more stable transactional medium for users.