What are stablecoins?

Stablecoins are meant to facilitate the usage of cryptocurrency as a medium of exchange. Cryptocurrencies like Bitcoin and Ether can be quickly converted into stablecoins to later be converted into another crypto or fiat currency, while in theory holding a constant value.

How stablecoins accomplish this, though, can vary considerably.

There are four types of stablecoins:

1. Fiat-Backed Stablecoins: The most common type of stablecoins, these are collateralized by traditional currencies. Often this is the U.S. dollar, which has long played the role of global reserve currency. That means that for every $1 in stablecoin created, there should be $1 in USD, euros, or whatever fiat currency the stablecoin is backed by, in its treasury. Likewise, for every $1 taken out, one stablecoin is “burned” to maintain balance. Examples of fiat-backed stablecoins include GYEN, PAX, USDC, and USDT.
2. Crypto-Backed Stablecoins: Backed by other cryptocurrencies, these stablecoins are typically over-collateralized to guard against extreme price fluctuations. Crypto-backed stablecoins might hold as much as 150% of their market cap to ensure sufficient liquidity. Examples of crypto-backed stablecoins include BUSD, DAI, and MUSD.
3. Commodity-Backed Stablecoins: Though less common, these stablecoins use commodities as collateral – most often gold, but also silver, oil, and real estate. Examples of commodity-backed stablecoins include PAXG and XAUT.
4. Algorithmic Stablecoins: Algorithmic stablecoins may seem more complicated in that they’re not backed by “real-world” assets. Rather, they’re controlled by smart contracts. To ensure a steady 1:1 connection, tokens are minted (added to circulation) or burned (removed from circulation). Examples of algorithmic stablecoins include FORTH, RAI, and UST.

Primarily, the purpose of stablecoins is to provide cryptocurrency holders the option to sell a coin or token and then hold their funds without being required to immediately convert to USD or another cryptocurrency.

Nonetheless, stablecoins present an opportunity to turn a profit. Investors do this by way of what is called arbitrage.