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  1. How does Stablecoin work?
  2. Fiat-backed stablecoins
  3. Crypto-backed stablecoins
  4. Commodity-backed stablecoins
  5. Algorithmic stablecoins

Stablecoin is an important asset class in the crypto market, designed to provide investors with a haven from the high volatility of most cryptocurrencies. In addition to USD, stablecoins can also be pegged to other fiat currencies such as Euro, Australian dollar, British pound, as well as other types of physical assets such as gold, silver, etc.

Stablecoins make trading cryptocurrencies easier because they are designed to withstand the high volatility that characterizes the crypto market. At the same time, it provides a convenient solution for traders to preserve the value of their assets without having to withdraw their funds from the market. Let’s learn about stablecoins on the market today and how they work with BHO Network!

How does Stablecoin work?

The mechanism and essence of all stablecoins are the same: They are cryptocurrencies minted on the blockchain that users can buy, sell, and trade on an exchange like any other cryptocurrency. People can store stablecoins in hot or cold wallets just like storing bitcoin or any other altcoin. Stablecoins are, at their core, stable, meaning that their value is virtually unchanged, or only fluctuates slightly, and is pegged to the real-world price of a certain asset (usually a fiat currency, such as USD or Euro).

For transparency, most stablecoins are linked to a reserve fund that holds other assets, be it cash, commodities like gold, or commercial debt products like commercial paper or bonds, etc. In most cases, the company or corporation that develops the stablecoin owns reserves equal to the number of stablecoins in circulation. This ensures that any stablecoin holder can exchange their stablecoin for fiat at any given time.

Currently, there are 4 types of stablecoins on the crypto market:

  1. Fiat-backed stablecoins
  2. Crypto-backed stablecoins
  3. Commodity-backed stablecoins (gold, stocks, bonds, etc.)
  4. Algorithmic stablecoins

Fiat-backed stablecoins

Fiat-backed stablecoins are the most popular stablecoins on the market. For example, USD coin (USDC) or Tether (USDT) are the two largest stablecoins in the market that are collateralized by US dollars (USD) at a ratio of 1:1. Several other less popular stablecoins are pegged to the Euro, British Pound, Japanese Yen and Chinese RMB to fully serve the needs of international investors. Issuers of these stablecoins will have to hold collaterals in their reserves at a ratio of 1:1 to the amount of stablecoins circulating in the market, to ensure that users can sell stablecoins for fiat money quickly when needed.

Crypto-backed stablecoins

Stablecoins backed by a cryptocurrency are collateralized by another more popular cryptocurrency. For example, MakerDAO is one of the most popular crypto-backed stablecoins. It uses a smart contract – a type of self-executing contract based on code – along with the Ethereum blockchain to raise enough ether (ETH) to use as collateral for its stablecoin. Then, when the amount of collateral reaches a certain level in the smart contract, the user can generate DAI - MakerDAO's stablecoin.

Commodity-backed stablecoins

As the name suggests, commodity-backed stablecoins will be pegged to certain commodities such as precious metals, industrial metals, oil or real estate. Commodity investors love this stablecoin option as it allows them to invest in gold without the hassle of sourcing and storing gold. Tether gold (XAUT) is an example of a commodity-backed stablecoin. This coin is backed by a gold reserve held in a vault in Switzerland. One ounce of gold is equal to one XAUT.

Algorithmic stablecoins

As for the group of stablecoins that are not backed by any real world commodity, they use an algorithm to adjust the supply based on market demand. In short, these algorithms automatically destroy (permanently remove coins from circulation) or create new coins based on the stablecoin's variable demand at any given time.

You can think of algorithmic stablecoins as an outdoor bucket of water with a water level marker inside. To keep the water in the bucket at exactly a certain level, you set up a mechanism that adds or subtracts water depending on how far the water has deviated from the mark. This is controlled by a computer algorithm such that if it rains and the bucket starts to fill with water, the algorithm instructs the mechanism to drain the water out of the bucket until the water level mark is reached. Conversely, if it's a hot day and the water evaporates out of the bucket, the computer algorithm instructs the mechanism to add water to the bucket until the correct level is reached.

The application of algorithmic stablecoins in the crypto ecosystem has been through a lot of trial and error, and the failure of Terra's stablecoin UST has shown that things can turn upside down if the algorithm can't respond to sudden changes.

Published on August 01, 2023

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