This article will help you understand what Stablecoins are and how they differ from other cryptocurrencies.
What are Stablecoins?
These are newer cryptocurrencies specifically designed to avoid the price volatility that is characteristic of alternatives such as Bitcoin. Traditional cryptocurrencies are unfit for everyday usage as their prices can swing wildly even within a single day. In other words, users are not very likely to adopt a currency if they cannot accurately predict its daily purchasing power. Similarly, constant inflation or deflation will also significantly affect whether a currency is spent or saved. To solve these issues, Stablecoins peg their value to a more consistent currency or asset such as the US dollar or gold.
How do Stablecoins achieve price stability?
The primary mechanisms that allow Stablecoins to maintain their steady prices are essentially taken from the system of fiat currencies. The US dollar, for example, maintains its relative value through collateral and central authority. Different Stablecoin projects use different variations of these concepts.
A Stablecoin that pegs its value to a single US dollar can then hold the same amount of dollars for every token they issue. Having fiat currency as collateral helps them manage and control the value of their coins effectively.
Stablecoins that use other cryptocurrencies as collateral are slightly more complex. Because their underlying reserve cryptocurrencies are subject to high volatility, they must maintain a number of assets with a total value that surpasses that of its tokens. For example, to issue $100 worth of tokens, they must first acquire $200 worth of cryptocurrencies in reserve, or over-collateralize their coin. This allows for a cushion that can accommodate up to a 50% price swing.
Some Stablecoins hold no collateral reserves, but rather imitate a central banking system instead. They rely on actions taken by a central authority that decides when more coins need to be issued or taken away. This close monitoring and controlling of supply helps maintain a target price level.
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