In digital asset, a stable coin is a token whose value is pegged on to the price of a national currency or to exchange traded commodities such as rare/precious metals or industrial metals to try and combat the volatility of the coin. Think of a stable coin as a cryptoasset that doesn’t have the volatility of a cryptoasset. Stable coins are tokenized asset that are meant to hold stable values a good example of a stable coin is the USDEX, which is a tokenized asset whose value is pegged to the dollar. 1 US dollar is equal to 1 USDEX.
There are different types of stable coins today. Every stable coin has a special set of mechanism though they generally work in the same way.
How does a stable coin work?
Like we have said, a stable coin is a tokenized asset tied to a stable asset like the dollar or gold and has low volatility. The stable coins hold some sort of collateral and help incentivize the market to trade the coin for not more or less than one US dollar or gold . The different mechanisms behind every stable coin are complex but the common thing is they are coins meant to hold a stable value. However, some stable coins such as Tether USDT may not be backed 100% by fiat currency. Tether had recently stated on its website that every Tether is backed 1 to 1 by traditional currency meaning 1 USDT is always equivalent to 1 USD. The company has however made a quiet adjustment to the statement. Today, they are saying every tether is always backed 100% by their reserves, including cash equivalents and traditional currency. From time to time, however, this might include other assets and receivables from loans made by Tether to third parties. Thus every Tether is 1 to 1 pegged to the US dollar meaning 1 USDT is valued by Tether at 1 USD. all this suggests that Tether may hold part of its US reserves in cryptoassets since no one knows exactly what “other assets” might refer to in their statement.
In the digital assets world, its challenging to circulate dollars due to the numerous regulations and restrictions. The main aim of the stable coin here is to have it as a substitute for the dollar. To understand how stable coins’ work, you have to know what fiat currency is. Fiat currency is legal tender with its value backed by a government. The US dollar and the euro plus many other major currencies in the world are fiat money.
To create stable coin, you need to have a certain amount of fiat currency or other assets such as oil, gold, etc as collateral and the digital asset are issued at a ratio of 1:1.
Advantages of using stable coins
Cryptoassets are highly volatile and the price can increase or decrease in a short time. This is one reason why most businesses are reluctant to use crypto directly.
- Stable coins enhance quick transition to the dollar
- Stable coins also increase the liquidity of some assets
- They offer a medium of exchange, a unit of account and a store of value without the risk of volatility
- Offer all the benefits of a blockchain without the intrinsic volatility of cryptoasset
It is good to note that stable coins require third parties because most of the exchanges are centralized. This is a means to control the assets to provide their value stability and price.