If you trade in crypto, then you know that there are thousands of different cryptocurrencies. You could put all these cryptocurrencies into different categories. These include payment tokens, DeFi tokens, metaverse tokens, and, of course, stablecoins. The latter, stablecoins, are one of a kind. This is because the value of stablecoins is always equal to that of a fiat currency.

When you first come across such crypto coins, you might ask yourself what their purpose is. Indeed, you cannot earn a return on stablecoins by trading them. Nevertheless, stablecoins have an important function within the crypto space. Below, we explain to you what stablecoins are and how these stable crypto coins work.

What is a stablecoin

A stablecoin is a digital currency, in the form of a cryptocurrency, that has a stable value. The value of this cryptocurrency is stable because it is linked to another financial product and backed by collateral. In most cases, the value is linked to a fiat currency, such as the US dollar or euro.

It is important that a stablecoin has its own collateral. Normally, the value of a cryptocurrency is determined by supply and demand. When demand increases, relative to supply, the price will rise. This is because more scarcity is then created. Does demand decrease, relative to supply? Then the price will also fall, as there is a surplus in the market.

To avoid being exposed to supply and demand, collateral must be provided. This collateral should be equal to the number of coins issued.

Have 10 million euro stablecoins been issued? Then the developer of the stablecoin will have to store products of equal value (10 million euro) somewhere. The moment the value of the collateral does not equal the number of coins issued, the value of stablecoin may collapse.

Why stablecoins are needed

When you hear about crypto, it is often about making money. Cryptocurrencies are incredibly volatile, allowing you to realise big profits and losses. While the world's first cryptocurrency (Bitcoin) was once developed as a means of payment.

However, a currency that is highly volatile is anything but useful as a means of payment. Both sending and receiving parties cannot assume the lasting value that the currency has. If you receive 300 euros in crypto today, this value could easily have fallen by 10% tomorrow. So it is virtually impossible to trade or make payments with such currencies.

Stablecoins, on the other hand, will always retain their value, provided the stablecoin is securely developed. This is because each stablecoin works in a different way. When the value is always equal to the US dollar or euro, it is easy to make payments with stablecoin.

The stable value makes this type of cryptocurrency very important for DeFi protocols and applications. Without stablecoins, DeFi could not work properly.

What types of stablecoins are there?

Stablecoins work in different ways. Consequently, there are different types of stablecoins. The main difference is in the way stablecoins are collateralised. Collateral should provide stability, although collateral can look different for each cryptocurrency.

Fiat-backed

The most widely used and best-known stablecoins are backed by fiat money. This means that the managing party ensures that fiat money is kept in a bank account or in a vault. The moment the demand for stablecoin rises, more fiat money will also be held.

Secured by crypto

It is also possible to have the value of stablecoins backed by other cryptocurrencies. Again, the value of the underlying cryptocurrencies must equal the number of stablecoins issued. Because the value of cryptocurrencies fluctuates more than the value of fiat currencies, a special mechanism is used. This mechanism ensures that cryptocurrencies are automatically sold when needed, and new cryptocurrencies are purchased when the collateral needs to increase in value.

Commodity-backed

The value of a stablecoin is not always linked to a fiat currency. There are also stablecoins that have their value tied to a commodity, such as gold or oil. These are commodities that have a high value, and can therefore easily be used as collateral. In this case, too, it is important that the managing party ensures that the value of the underlying commodity equals the number of stablecoins issued.

Regulation of stablecoins

Governments view stablecoins as a special currency, and are therefore not seen as 'regular cryptocurrency'. In many countries, stablecoins are therefore placed under strict regulation. Regulation should ensure that stablecoins operate in a secure manner, protecting citizens from loss of value.

The moment a company issues a stablecoin, stating that the value is always the same, that company has to make sure of that. The value of the stablecoin must then not collapse.

Strict regulation of stablecoins is also coming within the European Union. In 2024, MiCa, which stands for Markets in Crypto Assets Regulation, will come into force. This is new regulation for cryptocurrencies, which aims to better protect European citizens.

Most widely used stablecoins

Several companies and organisations have issued stablecoins. In many cases, stablecoins can be traded on different blockchains, making them widely used. If you want to make use of a particular stablecoin, it is better to research the crypto currency's security first.

Below you can see an overview of the most widely used and important stablecoins at the moment:

• Tether (USDT) is undoubtedly the most popular and widely used stablecoin. Launched on Bitcoin's blockchain in 2014, this coin can be used on several blockchains today, including Ethereum, EOS and Algorand.
• USD Coin (USDC) is pegged to the US dollar and founded by Circle and Coinbase. Despite being launched in 2018, you can trade the stablecoin on Solana, Ethereum, Binance Smart Chain, and 30 other blockchains, among others.
• Binance USD (BUSD) is the stablecoin launched by Binance in partnership with Paxos on the Binance Chain. BUSD is pegged to the US dollar and available as ERC20 and BEP2 tokens.
• Dai (DAI) runs on Ethereum's blockchain and has its value pegged to the US dollar. Collateral is provided in the form of cryptocurrencies through Maker Protocol and MakerDAO.
• TerraUSD (UST) was the stablecoin kept equal to the US dollar by the Terra protocol. This changed in May 2022, when a flood of UST entered the market. The value could no longer be stabilised, after which it collapsed completely.

Conclusion

Stablecoins are cryptocurrencies whose value is always the same. In most cases, the value is linked to the value of a fiat currency, such as the US dollar or euro. To keep the value equal, collateral must be offered. This collateral must be equal to the value of the number of stablecoins issued at all times. Only then can the value of the stablecoin remain the same.

Collateral can be provided through fiat currency, commodities or cryptocurrency. It is especially important to have enough collateral. In many cases, you can see on a stablecoin's website how big the collateral is, and how they provide it. This way, you can determine whether a stablecoin is safe enough.

After all, things can also go wrong. TerraUSD lost its value in May 2022, when its peg to the US dollar was broken. Investors lost confidence, and decided to sell UST coins. Other popular stablecoins, such as Tether (USDT), USD Coin (USDC), Binance USD (BUSD) and Dai (DAI) do have a stable value pegged to the US dollar.

Discover more blogs