What is a Stablecoin?
Stablecoins are cryptocurrencies designed to maintain a stable value by pegging or linking its value to a currency, commodity, or financial instrument. They offer a more predictable alternative to highly volatile currencies, including Bitcoin, thereby making them more suitable for everyday transactions and reducing investment uncertainty.
How do Stablecoins Operate?
Stablecoins maintain their market value by linking or pegging their price to an external reference, typically a fiat currency. Unlike volatile cryptocurrencies, they serve as a more reliable medium of exchange. Their value may be tied to currencies like the U.S. dollar, commodities such as gold, or managed through algorithmic mechanisms that regulate the control supply. Stability is further maintained through reserve assets as collateral or through the algorithmic formulas designed to control supply.
Algorithmic Stablecoins
Algorithmic stablecoins may or may not be backed by reserve assets. A major distinguishing factor of algorithmic stablecoins is that it maintains price stability by regulating supply through an algorithm, a computer pre-programmed formula which adjusts the supply as required. This approach is similar to central banks which also do not depend upon reserve assets for the purposes of maintaining the stability of the value of the currency issued by them. However, central banks, such as the U.S. Federal Reserve operates with transparent monetary policies, following well-established principles. Its status as the issuer of legal tender significantly enhances the credibility of the policies. Conversely, algorithmic stablecoin lack such institutional backing, thereby rendering them more vulnerable in the time of crisis. For instance, the TerraUSD (UST), on 11th May 2022 lost its peg to the U.S. dollar, plunging over 60%, while its supporting Luna token (pegged with Terra) collapsed by more than 80% overnight.