How Do Stablecoins Keep Their Values?

How Do Stablecoins Keep Their Values?

Stablecoins aim for low or no volatility by being linked to price-stable assets such as the US dollar or gold. Stablecoins achieve price stability through a variety of methods. They can be classified into three categories:

Fiat-collateralized stablecoins: These stablecoins issue crypto coins using a specific amount of a standard fiat currency, such as the US dollar, as collateral. Precious metals like gold and silver, as well as commodities like oil, can be used as collateral.

This method is one of the simplest ways to create and operate a stable cryptocurrency because the number of crypto coins issued is in a 1:1 ratio to the pegged fiat currency. It is seen as a potential solution that central banks could use to issue their own versions of cryptocurrencies.

This method, however, necessitates the use of a custodian to hold the fiat currency or commodity collateral and guarantee both the issuance and redemption of the stablecoin tokens. It also necessitates operational processes, such as frequent audits, to ensure that the collateral is kept in good working order.

Tether (USDT) and TrueUSD are popular crypto coins that are backed by dollar deposits and have the same value as a single US dollar.

Crypto-collateralized stablecoins are similar to fiat-collateralized stablecoins, with the exception that the underlying collateral is another cryptocurrency rather than a tangible commodity or fiat currency.

Stablecoins are “over-collateralized” to compensate for the negative impact of the collateral cryptocurrency’s volatility. In other words, a more valuable cryptocurrency is used to create less valuable stablecoins.

It isn’t an ideal system. The stablecoin valuation will plummet if the collateral cryptocurrency goes bankrupt, or if there are procedural issues with the audit process, or if demands for additional top-ups of collateral are not met in a timely manner, defeating the entire purpose of a stablecoin.

Many proponents of stablecoins are wary of this approach because of such scenarios.

Stablecoins that are not collateralized: These stablecoins are not backed by any collateral, but they operate in such a way that their value is expected to remain stable.

A non-collateralized stablecoin, for example, could include a rule that ensures that the coin supply is adjusted in proportion to changes in the coin’s value. This is similar to a central bank’s actions of increasing or decreasing banknote printing to keep the fiat currency stable.

It is possible to achieve this by implementing a smart contract on a decentralized platform that can run independently.

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