How stablecoins work will depend on the type, whether its reserve-backed, algorithmic, or backed by other cryptocurrencies.
The first type functions like paper money. Instead of being backed by gold reserves in a central bank, it is backed by one-for-one currency reserves that they are pegged to which in this case, are U.S. Dollars.
A good example of this type of stablecoin is Tether (USDT). Even without any public proof, the 2.5 billion USDT coins that are in circulation are backed by dollars.
Algorithmic stablecoins on the other hand, are controlled by an algorithm. There is software that controls the supply of the stable token, increasing and decreasing it to maintain its peg.
Cryptocurrency-backed stablecoins, as the name suggests, use cryptocurrency as collateral instead of fiat money. Done on a blockchain, it removes third parties from the equation.
The problem with this type of stablecoin, however, is that the cryptocurrency introduces a source of volatility that makes a stablecoin less stable than it is supposed to. As a solution, more collateral than a 1:1 basis is introduced into the transaction. For example, for a guaranteed $100 worth of a stablecoin, a larger amount of $150 worth of ether (Ethereum) must be deposited first.
Stablecoins are commonly used as a liquidity tool for cryptocurrency exchanges. Many exchanges are wary of anything related to cryptocurrency because of its volatility, but stablecoins offer a solution to the problem.
Stablecoins are a new class of cryptocurrency that offer steady valuations and price stability. It is designed to retain its purchasing power with little to no impact from inflation.
In order to maintain steady valuations, stablecoins are tied to price stable assets like gold or the U.S. dollar. Different methods are used to achieve price stability for different stablecoins.
For now, there are three broad categories of stablecoins. But there are other stablecoin proposals at work and may be introduced sometime in the future.
This type of stable coin uses a particular amount of a standard fiat currency as collateral. To issue crypto-coins, for example, U.S. dollars, gold, or oil can be used as collateral.
A central entity is responsible for the collateral and will issue a token representing the money they hold. The ratio of the number of crypto-coins issued is also 1:1 against the fiat currency it is pegged to. This is why fiat collateralized is the most straightforward method of stablecoin creation and operation.
Apart from a central entity or custodian that holds the collateral–fiat currency or commodity, this type of stablecoins require operational processes to ensure that valuations of collateral are maintained up to the mark. Processes include frequent audits and valuations.
Fiat collateralized stablecoins however, have their share of problems. For this type of stablecoin to be successful, users have to trust the central entity that holds the money or collateral.
In the case of Tether, trust is not exactly working out well. This is especially true with allegations about insolvency and accusations that this particular stablecoin is being used to drive up price of Bitcoin on exchanges.
Crypto-collateralized stablecoins depend on the cryptocurrency value that they use as collateral to maintain a stable target price against certain assets. Unlike fiat-collateralized stablecoins, which are simple but centralized, crypto-collateralized stablecoins are used in a much more decentralized approach, as they are backed by cryptocurrency reserves.
In essence, these types of stablecoins work quite similar to their fiat counterparts. The only difference is, the collateral is not considered as assets in the real-world, but rather another cryptocurrency. They are extremely volatile. Thus, they are often over-collateralized (there is a huge rate of capital involved) to account for the price volatility of the underlying crypto collateral.
Also, in the crypto-collateralized stablecoins system, a bulk of cryptocurrencies account for the price stability achieved by a particular stablecoin. While using these stablecoins is good for everyday situations, holding long term could be risky. There is still no account that this method has already been rigorously tested in real markets.
One more major issue with using crypto-collateralized stablecoins is that if your crypto assets go through significant value depreciation, the loans you have taken out will be automatically liquidated.
Unlike crypto-collateralized stablecoins, non-collateralized stablecoins are cryptocurrencies with stable prices and are not backed by collateral. Their implementation involves a system or an algorithm that contracts and expands the coin supply depending on the coin value. Basically, the non-collateralized stablecoin approach is based on the Quantity Theory of Money, which implies that “there is a direct relationship between the quantity of money in an economy and the level of prices of goods and services sold.” This means that the coin supply will depend directly on the prices of the stablecoins. For example, if a coin’s value is above $1.00, the supply would increase. On the other hand, if the value drops to less than $1.00, the supply would decrease. These activities create upward and downward pressure on the coins’ value, as needed.
Overall, stablecoins are likely to evolve over the years. The market around these coins would become more and more competitive, with gradually rising interest in cryptocurrency.