What are Stablecoins and How They Work

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  • The value of most cryptocurrencies is largely determined by what the market will bear, and many people who buy them are doing so in hopes that they will increase in value.
  • One crypto-backed stablecoin is dai, which is pegged to the U.S. dollar and runs on the Ethereum blockchain.
  • In the crypto economy, where transactions occur on a decentralized blockchain, digitized fiat cash—which is not a decentralized asset—may not be recognizable within the network.
  • Stablecoins achieve stability by pegging themselves to a less volatile asset such as gold or fiat currency.
  • You should not construe any such information or other material as legal, tax, investment, financial, or other advice.
  • This means it’s often tricky for investors to swiftly cash out their cryptocurrencies when the going gets tough.

Hence, stablecoin owners who expect the price to eventually fall (i.e. expect other owners to sell) will sell anticipating a profit, thus causing the stablecoin price to decrease towards its peg. This stabilization mechanism works in the opposite direction as well, causing a loss rather than a capital gain for stablecoin holders. Stablecoins have become a key component of a developing class of products known as DeFi, or decentralized finance, in which transactions can be carried out without a middleman such as a bank or broker.

Board of Governors of the Federal Reserve System

As mentioned earlier, Binance USD is issued by Paxos, a regulated financial institution, which means that it is subject to strict regulatory oversight. The Paxos Trust Company, which issues BUSD, is audited monthly by a leading accounting firm to ensure that the number of BUSD tokens in circulation is equal to the number of U.S. dollars held in reserve. This provides users with transparency and confidence in the stability of BUSD. Tether can be used to purchase other cryptocurrencies or traded on cryptocurrency exchanges. Because of its stable value, Tether is often used as a way to hedge against market volatility or to move funds between exchanges without having to convert to fiat currency, such as the U.S. dollar. In fact, Tether has become one of the most widely used cryptocurrencies in the world.

This mechanism breaks down, however, when the market loses faith in its ability to maintain the peg. Expecting the stablecoin to lose value, stablecoin holders have an incentive to request redemption of their stablecoins in an attempt to recover the collateral. The incentives of stablecoin holders are similar to those of depositors who withdraw their real-world currency from an uninsured brick-and-mortar bank if they suspect it might fail, thus precipitating a run on such a bank. Once redemptions are underway, the value of the collateral assets might decrease further if such assets are sold to be converted into currency in a fire sale. The asset to which the stablecoin is pegged could be a fiat currency, such as the U.S. dollar, or another asset, such as gold.

What Is the Purpose of Stablecoin?

The value is the property of the owner and is stored in a wallet, while the owner interacts with the payment system directly and has total independent control over the value. The No.2 stablecoin, USD Coin, has a market cap of $49 billion, according to CoinMarketCap data. We believe everyone should be able to make financial decisions with confidence. NerdWallet, Inc. is an independent publisher and comparison service, not an investment advisor. Its articles, interactive tools and other content are provided to you for free, as self-help tools and for informational purposes only. NerdWallet does not and cannot guarantee the accuracy or applicability of any information in regard to your individual circumstances.

Well-known examples of gold-collateralized coins include PAX Gold (PAXG) and Tether Gold (XAUT). While stablecoins can present themselves as risk-free assets, they’re certainly not immune to risk and can fall into trouble during testing periods for the wider crypto ecosystem. Once in circulation, https://www.xcritical.com/ anyone can send and receive stablecoins, although the central entity issuing them may have the power to freeze funds on addresses. Stablecoins have been frozen in the past, as issuers assisted law enforcement in their investigations or attempted to recover stolen funds, for example.

What are stablecoins and how do they affect the cryptocurrency market?

You can convert cash to stablecoin and stablecoin to cash, but you can’t use a stablecoin to perform the function of cash. Since that time, Tether has reduced its holdings of some types of these non-cash assets. These other assets may act like actual cash much of the time, but they’re not real cash. Our goal is to give you the best advice to help you make smart personal finance decisions.

what is a stablecoin in cryptocurrency

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Commodity backed stablecoins

Nothing contained herein shall constitute a solicitation, recommendation, endorsement, or offer by Crypto.com to invest, buy, or sell any coins, tokens, or other crypto assets. Returns on the buying and selling of crypto assets may be subject to tax, including capital gains tax, in your jurisdiction. Any descriptions of Crypto.com products or features are merely for illustrative purposes and do not constitute an endorsement, invitation, or solicitation. Stablecoins are a form of altcoin in cryptocurrency that seeks to ensure price stability within the cryptocurrency market. Although its values can be pegged to a range of different assets, its ultimate goal is to maintain a constant value regardless of wider crypto market fluctuations. If stablecoins aren’t properly regulated, there’s concern from governments that they could also enable illicit financial activity like money laundering and tax evasion.

Some even use complex algorithmic programs to maintain the peg by controlling supply, although this doesn’t always work. Stablecoins provide some of the stability that is lacking in most cryptocurrencies, making them unusable as actual currency. But those using stablecoins should know the risks they’re taking when they own it.

Traditional asset-backed stablecoins

Experts recommend that investors carefully assess the risks and benefits of using algorithmic stablecoins before relying on them for financial transactions or investments. Algorithmic stablecoins use algorithms and smart contracts to regulate the coin’s supply in response to changing market demands. This type of stablecoin, which is typically backed by a reserve of another cryptocurrency, will automatically mint or burn coins to maintain a stable value. Commodity-collateralized coins are popular because they can provide investors with a hedge against inflation and other types of economic instability.

what is a stablecoin in cryptocurrency