What is a stablecoin?

A stablecoin refers to a type of cryptocurrency that has a stable value. Unlike other types of cryptocurrencies — which can be volatile — the price of stablecoins usually doesn't change over time. That's because their value is tied to another asset, like the U.S. dollar.

Learn about how stablecoins work, types of stablecoins, the potential benefits and risks of using them, and how they may fit into the world of digital currencies.

How do stablecoins work?

Stablecoins are normally pegged to an external asset, like a traditional currency or commodity, so their prices remain relatively stable. This may be different from other types of cryptocurrencies like Bitcoin and Ethereum. Their value typically isn't tied to any traditional currency, so their prices may change drastically based on supply and demand.

How do stablecoins maintain stability? This is usually done with one of two common methods:

• Collateralization. Assets backing the stablecoin's value — like U.S. dollars — are kept in reserves. If and when a stablecoin owner wants to cash out, they should be able to access those reserves and get their funds.
• Algorithmic controls. Algorithmic stablecoins aren't backed by collateral. Instead, they're created or removed (a.k.a. "burned") to adjust supply based on the currency's target price. If the target price is $1 but the value drops to $0.85, the algorithm will automatically burn a certain number of coins to increase scarcity and raise that value back up to $1.

Purpose of stablecoins

Stablecoins are tools aiming to bridge the gap between traditional financial systems and the world of cryptocurrencies. Generally, the purpose of stablecoins is to provide a more reliable, less volatile cryptocurrency option. They may offer the speed and affordability of popular cryptocurrencies like Bitcoin with the stability of traditional currencies like the U.S. dollar.

Types of stablecoins

There are different types of stablecoins to choose from. Stablecoins are often categorized by the kind of collateral that backs them. Three main types of stablecoin collateral include:

• Fiat collateral. Stablecoins pegged to a fiat currency like the U.S. dollar, backed by dollar deposits or other collateral.
• Crypto collateral. Stablecoins backed by another cryptocurrency, such as Ether.
• Commodity collateral. Stablecoins backed by physical assets. This may include precious metals like gold or silver.

Collateral can be considered “on-chain”, like crypto collateral, or “off-chain”, like fiat or commodity collateral. Off-chain collateral means the assets are kept in reserve outside of the blockchain by a bank or financial institution.

What are stablecoins used for?

Stablecoins have a variety of different use cases. Here are some examples:

• Remittances. People can use stablecoins to quickly pay businesses, friends, or family for goods or services. Like other cryptocurrencies, stablecoins may come with low transaction fees, potentially making them useful for international transactions. When paying a merchant with any cryptocurrency, the cryptocurrency will be sold and converted to fiat currency to pay the merchant.
• Cryptocurrency transactions: Stablecoins can be used to facilitate transactions between cryptocurrencies, from traditional currency to cryptocurrency, and vice versa.
• Decentralized finance applications. Cryptocurrencies like stablecoins fall under the umbrella of decentralized finance (DeFi). Instead of being processed through something like a central bank, they operate across peer-to-peer computer networks and are verified by blockchain technology.

Potential benefits and risks of stablecoins

It's important to understand the potential advantages and risks of stablecoins. For example, possible benefits of stablecoins include:

• Fast transactions. Since stablecoins operate on decentralized networks that are not managed by a third party, they may potentially be transferred or used for transactions quickly.
• Lower volatility. Stablecoins may be less volatile than other types of cryptocurrencies.

Potential risks of stablecoins include:

• Regulatory challenges. Since stablecoins are a relatively new type of currency, they're still subject to changing regulations from government organizations.
• Counterparty risk. Though stablecoins operate on decentralized blockchains, there is another party involved in ensuring their value: the institution holding collateral. If that party — such as a traditional bank — fails to maintain its collateral or reserves, stablecoins could lose their value.