What exactly is a stablecoin? Why is it so crucial to the crypto market?

Most people are often scared by price fluctuations when they first enter the encryption world. However, the emergence of stablecoins has changed everything — they are a special type of crypto asset that is pegged to the US dollar, euro, or other real assets, allowing you to freely switch between the convenience of Blockchain and the stability of TradFi.

What is the core purpose of the design of stablecoins? It aims to solve two problems: first, to make cryptocurrencies suitable for daily payments, and second, to provide traders with a hedging tool. Although Bitcoin and Ethereum are full of opportunities, their prices can fluctuate dramatically within 24 hours, which is a nightmare for merchants and coin holders.

Why Does the Market Need Stablecoins?

Imagine running a café with Bitcoin. On Monday, a customer pays with BTC, and you receive Bitcoin worth $5. But by Tuesday, it might only be worth $2.50, and your income is directly reduced. This is why stablecoins were created - they allow you to transfer value on the encryption network at a fixed price while retaining all the advantages of Blockchain.

For traders and investors, stablecoins are a lifesaver. They allow you to lock in profits and avoid risks without cashing out to the bank. You can quickly convert your positions into stablecoins during a market crash and wait for better buying opportunities, all of which happens on the Blockchain, completed in seconds.

Three Operational Modes of Stablecoins

fiat-backed stablecoin

This is the most direct way: each coin is backed by real US dollars or euros. For example, TrueUSD (TUSD) is supported by $1 in the bank for each token. You can exchange US dollars for TUSD at any time, and vice versa.

TrueUSD uses Chainlink's Proof of Reserve (PoR) mechanism, allowing users to independently verify that its reserves indeed exist in off-chain accounts. This transparency is crucial for trust in stablecoins.

encryption asset-backed stablecoin

This type of stablecoin is backed by other encryption assets, such as Ethereum. However, due to the extreme fluctuations in the crypto market itself, these stablecoins often require over-collateralization to maintain their peg.

Taking DAI as an example, this is the most well-known stablecoin in the MakerDAO ecosystem. Users need to deposit $150 worth of Ethereum to obtain $100 of DAI. This 1.5 times over-collateralization ratio ensures that even if the price of ETH drops, DAI still maintains a value of $1.

The operational mechanism of DAI is quite clever: when the price of DAI is below $1, holders are motivated to return it to the system to redeem collateral, thereby reducing supply and raising the price. When DAI is above $1, new DAI is created, increasing supply and causing the price to drop. All of this is executed automatically by smart contracts, completely transparently.

algorithmic stablecoin

Algorithmic stablecoins take a completely different approach—they do not have any reserves but rely on algorithms and smart contracts to adjust the supply. When the price falls, the system reduces supply by destroying tokens or incentivizing staking. When the price rises, new tokens are minted to stabilize the price.

This model sounds perfect, but in reality, it is the most difficult to maintain stability, and there are the most failure cases. It completely relies on the confidence of market participants and the network effect.

What has stablecoin brought you?

Daily payments become possible — You can transfer using stablecoin anywhere in the world, with very low fees and fast settlement. No banks are needed, no waiting for clearance, direct peer-to-peer.

Portfolio Risk Management — Allocating a portion of your portfolio to stablecoins is a smart way to reduce overall risk. Holding stablecoins during market peaks allows you to maintain firepower to buy on dips when other assets plummet.

All the advantages of Blockchain — Stablecoins live on the Blockchain, which means you have complete control over your assets without needing to trust any exchange or bank. You can send, receive, and store them with any compatible wallet.

Trading Flexibility — Traders can quickly switch between different coins, perform short selling or hedging, without having to withdraw to fiat accounts each time.

The Risks of Stablecoins You Must Understand

Pegging is not a permanent guarantee — While large stablecoins usually maintain their value well, the peg can break. If a stablecoin frequently deviates from its target price, it can quickly lose value. Several projects have collapsed due to this in history.

Transparency has gray areas — Not all stablecoins publish complete independent audit reports. Many only provide periodic attestations, which are issued by private accountants commissioned by the issuer, potentially leading to conflicts of interest.

Centralized Risk — Fiat-backed stablecoins concentrate reserves in the hands of a single entity, which may face regulatory, freezing, or bankruptcy risks. You must trust that the issuing institution truly holds the claimed reserves.

Governance Risk — Encryption-backed stablecoins are governed by the community through DAO. This means you either participate in voting or delegate decision-making to others. A poor governance decision could lead to system failure.

Real Case

DAI (MakerDAO) — This is the most mature decentralized stablecoin in the encryption field. Users collateralize assets such as ETH and wBTC to generate DAI, and the entire process is fully controlled by smart contracts. MKR token holders of MakerDAO hold the decision-making power of the protocol. DAI has been operating stably for many years, with a market value exceeding $5 billion, becoming the infrastructure of the DeFi ecosystem.

TUSD (TrueUSD) — This is the first stablecoin that uses on-chain verification mechanisms. Each TUSD is backed 1:1 by bank dollars and is verified in real-time through Chainlink's asset proof. This design offers the highest transparency standards in the industry.

Long-term Impact of Regulation

Global regulators are closely monitoring stablecoins. As stablecoins integrate characteristics of TradFi and encryption, some countries are even attempting to issue their own stablecoins. Depending on the laws of your country, stablecoins may be regarded as cryptocurrencies and subjected to the same regulations, or classified as financial products requiring special licenses.

Companies issuing fiat-backed stablecoins may need to obtain approval from financial regulators. This could enhance the compliance and security of stablecoins in the long term, but may restrict innovation in the short term.

Final Recommendations

Stablecoins have become an essential tool for any serious encryption investor. Whether for trading, storing value, or transferring funds, they offer unique value. But don't assume they are risk-free just because of their name—stablecoins are still crypto assets and carry technical, economic, and operational risks.

Before using any stablecoin, conduct thorough research on its collateral mechanism, issuing institution, and historical performance. Diversify your allocation of different types of stablecoins instead of putting all your funds into one project. Always do your homework, as you are ultimately the only one responsible for your decisions.