A Stablecoin is a cryptocurrency with a fixed-price by means of being pegged to other assets like fiat currencies, gold, precious metals and other cryptocurrencies. They have plenty of use cases including ,but not limited to, being used as a non volatile store of value to investors, earning interest on, transferring between exchanges, and lending.
How Do They Work
Traditional/Commodity:
Traditional asset-backed stablecoins, are pegged at a 1:1 ratio to an asset like gold or a national currency. A stablecoin pegged to the U.S. dollar for example, would have $1 that is held by the issuer or financial institution for each stablecoin that’s issued. Similarly, a stablecoin pegged to the price of gold would have a specific amount of gold held for each stablecoin issued.
Algorithmic:
Like the name, algorithmic stablecoins don’t use fiat or cryptocurrency as collateral. They use algorithms and smart contracts to stay at a fixed price by managing the supply of tokens in circulation. When the market price falls below the price of the fiat currency it tracks they will reduce the number of coins in circulation. Vice versa, if the price of the coin exceeds the price of the fiat currency it tracks, new coins are issued into circulation to adjust the value of the stablecoin downward. Having no regulatory bodies over the supply and demand, algorithmic stablecoins are viewed as truly decentralized.
Cryptocurrency backed:
Also, like the name, these stablecoins are backed by other cryptocurrencies like Ethereum or Bitcoin on-chain and held in smart contracts instead of relying on a central issuer or institution. When you buy this kind of stablecoin, you lock your cryptocurrency into a smart contract to receive coins of equal representative value. You can then put your stablecoin back into the same smart contract to withdraw your original collateral amount. And since the amount of crypto that backs up these stablecoins is more than the value of the stablecoin itself, price fluctuations of the underlying crypto don’t affect the value of the stablecoin. Ex: DAI
Cons
One of the cons of traditional asset backed stablecoins is that retail investors have to trust that the issuer/institution is actually backing their stablecoins and is properly regulated.