Stablecoins: What Are They and How Do They Work?

Cryptocurrencies are known for their price volatility, with major assets like Bitcoin (BTC) and Ethereum (ETH) often experiencing significant fluctuations within hours. In contrast, traditional financial assets, such as stocks, typically see smaller price changes over a longer period. Due to this volatility, stablecoins were introduced as a more predictable category of cryptocurrencies.
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In this lesson, we will examine what stablecoins are, how they function, and which ones are the most widely used.

Contents

• What Is a Stablecoin?
• The Role of Stablecoins in the Crypto Market
• Types of Stablecoins
• Popular Stablecoins

What Is a Stablecoin?

A stablecoin is a type of cryptocurrency designed to maintain a fixed value, typically by being pegged to a fiat currency. The most common stablecoins are pegged to the US dollar, given its dominant role in global finance. However, some stablecoins are tied to other currencies, such as the Euro.
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Unlike traditional money issued by central banks, stablecoins are created by private companies. The first stablecoin, Tether (USDT), was launched in 2014 – five years after Bitcoin’s introduction. Before stablecoins, crypto traders had to store their funds in highly volatile assets or cash out to fiat, a process that was slow and incurred additional costs. Stablecoins solved this issue by offering a way to hold crypto in a stable form without converting it to traditional currency.
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Traders can now use stablecoins to secure their profits, move funds between exchanges efficiently, or wait for better market conditions before reinvesting. Beyond trading, stablecoins are also used in remittances, decentralized finance (DeFi), and cross-border payments due to their speed and lower transaction costs compared to traditional banking systems.

The Role of Stablecoins in the Crypto Market

Stablecoins provide a hedge against the price swings of traditional cryptocurrencies. Instead of converting assets to fiat through a bank, traders can swiftly move funds between crypto and stablecoins on exchanges.
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Stablecoins are especially useful in different market conditions:
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• Bull markets: When prices are rising, traders can use stablecoins for quick trades or fixing profits.
• Bear markets: When prices fall, stablecoins allow investors to avoid losses by temporarily exiting volatile assets.

Overall, stablecoins help mitigate risks and provide liquidity, making them essential for the crypto economy. They also serve as a bridge between traditional finance and blockchain-based systems, enabling smoother adoption of crypto assets.

Types of Stablecoins

Stablecoins are categorized based on how they maintain their value. The three main types are:

1. Fiat-Collateralized Stablecoins

These stablecoins are backed by traditional currency reserves. Issuing companies hold the equivalent amount of fiat money in bank accounts to ensure a 1:1 ratio. Third-party audits verify these reserves to maintain trust.
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For example, if a company issues 1 million USD-backed stablecoins, it must hold $1 million in a secure account.

2. Crypto-Collateralized Stablecoins

Instead of fiat reserves, these stablecoins use cryptocurrencies as collateral. Since crypto is volatile, these stablecoins are often over-collateralized, meaning they hold more assets than the stablecoin supply to absorb price swings.
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To prevent price instability, issuers may inject additional funds when market fluctuations threaten the stablecoin’s peg. Many of these stablecoins operate on DeFi platforms, using smart contracts to manage reserves and ensure transparency.

3. Algorithmic Stablecoins

Unlike the previous two types, algorithmic stablecoins rely on software-driven supply adjustments instead of collateral. They use an algorithm to automatically increase or decrease the number of coins in circulation to stabilize the price.
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Although innovative, algorithmic stablecoins are riskier. In 2022, the collapse of TerraUSD (UST), a major algorithmic stablecoin, caused a massive financial loss when it lost its peg to the US dollar.

Popular Stablecoins

Here are some of the most well-known stablecoins in the market:
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• Tether (USDT): Launched in 2014, USDT was the first stablecoin and remains the most widely used. It allows traders to avoid crypto price volatility while keeping funds within the digital asset ecosystem.
• USD Coin (USDC): Issued by the Centre consortium in 2018, USDC is fully backed by fiat reserves and audited regularly. It is widely used for trading and payments.
• Dai (DAI): A decentralized stablecoin governed by MakerDAO, it uses Ethereum-based collateral to maintain its value and allows users to generate new Dai by depositing assets into smart contracts.
• TrueUSD (TUSD): A fiat-backed stablecoin offering real-time, on-chain audits, allowing anyone to verify that its reserves match the total supply.

Stablecoins continue to play a crucial role in the digital economy, providing stability, liquidity, and efficiency for traders and investors.

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