A Beginner’s Guide to stablecoin: Definition, how they work and types

Stablecoins, an emerging form of digital currency, are rapidly gaining traction in the cross-border market due to their ability to offer fast, cost-effective, and transparent payment solutions. Their emergence signifies a significant shift in global payment dynamics, with increasing adoption as the preferred method for remittances, payments, and cross-border transactions.

This growing prominence is underscored by major players like Visa and Mastercard, who are now utilizing stablecoins for settlement purposes. With the stablecoin industry boasting a market supply of $150 billion, it has firmly established itself as a cornerstone of the digital economy. Notably, in sub-Saharan Africa, stablecoins have emerged as the most widely exchanged cryptocurrency, accounting for over 40% of transactions in both 2022 and 2023.

But first, let’s get to understand what stablecoins are and how they work.

What are stablecoins?

Stablecoins are digital currency attached to a stable asset such as Fiat currency, i.e., USD, to maintain its price value. This means for every stablecoin in the transaction, there is an equal value of backing of the same in reserve. Unlike digital currencies such as Bitcoin or Ethereum which are volatile, stablecoins are engineered to maintain a steady value, making them attractive for global transactions.

So, how do they work?

Stablecoins operate by tying their value to a stable asset or a combination of assets, to maintain a steady price relative to a specified reference point, often a fiat currency such as the US dollar. This anchoring mechanism ensures that stablecoins experience minimal fluctuations in price. To uphold this stability, various methods are employed, including collateralization, where the issuer of the stablecoin holds reserves of the underlying asset to support its value. Additionally, algorithms or smart contracts may be utilized to regulate the supply of stablecoins in response to market demand, ensuring that the peg remains intact.

Transactions involving stablecoins take place on blockchain networks, allowing for rapid and transparent transfers across borders without the need for intermediaries like banks. Users can easily send and receive stablecoins, enjoying advantages such as low transaction fees and quick settlement times. Furthermore, the transparency and immutability inherent in blockchain technology instill confidence in users regarding the integrity of their transactions.

Stablecoins offer a reliable bridge between traditional finance and the world of digital assets, facilitating efficient and secure value transfer on a global scale.

Types of Stablecoins

How then do stablecoin maintain their peg? Well, this is highly dependent on the stablecoin’s backing. Here are the different types of stablecoins that exist:

1. Fiat-backed stablecoins

These stablecoins are directly pegged to a fiat currency like the US dollar. These stablecoins maintain a 1:1 ratio with the US dollar, ensuring each token holds the same value as one dollar. Redeeming these stablecoins for dollars is straightforward, typically done on a one-to-one basis.

The stability of these stablecoins is upheld by the issuing company, which holds reserves in dollars equivalent to the total number of stablecoins in circulation. These reserves are closely monitored, regulated, and audited by independent custodians to ensure compliance with necessary standards.

2. Commodity backed stablecoins

Commodity-backed stablecoins represent a departure from the reliance on fiat currencies seen in traditional stablecoins. Instead, they derive their stability from tangible assets such as precious metals, oil, or agricultural products. These stablecoins are crafted to offer stability and security by aligning their value directly with that of the chosen commodity.

Take, for instance, a stablecoin named “Gold token.” Each Gold token is backed by a precise quantity of physical gold securely stored within vaults. This reserve backing ensures that the value of each Gold token remains linked to the prevailing market value of gold. This direct correlation between the stablecoin and the underlying commodity serves as a foundation for stability and trust in the digital asset. As the price of gold fluctuates in the market, the value of each GoldToken adjusts accordingly, offering users a stable and reliable means of exchange and store of value.

3. Algorithmic stablecoins

This type of stablecoin operates on a dynamic algorithm rather than relying on traditional asset backing. Instead of being tied to a specific commodity, it derives stability from its supply, which is regulated by a computer program. Through this algorithm, the stablecoin tracks the value of a reference currency such as the US dollar, and adjusts its circulating supply accordingly.

Utilizing this algorithm, the stablecoin’s supply can be increased or decreased based on fluctuations in demand and the coin’s market value. For example, if the stablecoin’s value exceeds one US dollar, the algorithm will increase the supply, thus bringing the price back down. Conversely, if the value falls below one dollar, the algorithm will decrease the supply to create scarcity and drive the price upward.

4. Crypto-collateralized coins

These stablecoins are backed by cryptocurrencies, a unique approach in the realm of stablecoin design. Recognizing the inherent volatility of cryptocurrencies, these stablecoins adopt an over-collateralization strategy. This means that the value of the cryptocurrencies held in reserve exceeds the value of the stablecoins issued. Typically, this over-collateralization is set at a level where the reserve’s value is 150% of the stablecoin’s worth, providing a cushion against market fluctuations.

An example of this is the Dai stablecoin, which relies on Ethereum and other cryptocurrencies as collateral. This approach aims to maintain stability by ensuring that even if the value of the backing cryptocurrencies experiences a significant decline, the stablecoin’s value remains relatively stable, thereby mitigating the risk for holders.

5. Hybrid Stablecoin

Hybrid stablecoins blend various strategies to bolster their stability and durability, drawing on a mix of collateralization methods. For instance, they may rely partly on fiat currency and partly on cryptocurrencies for backing. This diversified strategy not only strengthens the stablecoin but also reduces the risks tied to any single backing approach. By melding aspects of centralized and decentralized systems, hybrid stablecoins strive to achieve a harmonious balance between security, transparency, and adaptability.

Which is the best stablecoin?

That depends. There are many factors to consider such as unique features, stability, method of backing, trust in the issuer, regulatory compliance, ease of use, transparency, adoption in the digital asset ecosystem, and its use case. But based on Market capitalization, Tether (USDT) takes the lion’s share followed closely by USD Coin (USDC) and Dai (DAI).

Whichever stablecoin you choose, the Kotani Pay Stablecoin settlement solution is tailor-made for businesses operating in the global payment industry. Through the utilization of stablecoins, we empower businesses to expand their capabilities and optimize cost savings. With support for multiple currencies across Africa, our solution facilitates seamless settlement processes, enabling your business to transact conveniently and easily.