A stablecoin is a cryptocurrency with a value pegged to another asset’s price. If functioning correctly, a stablecoin pegged to the U.S. dollar should always be valued at $US1.
One type of stablecoin is issued by a financial entity that holds collateral backing for each unit of stablecoin, and the other uses derivative strategies to ensure the crypto asset maintains the value of the underlying government currency.”
Collateralised stablecoins. Collateralised stablecoins maintain a pool of collateral to support the coin’s value. An equal amount of collateral is taken from the coin’s reserves whenever someone redeems their tokens in exchange for the backing. Tether (USDT), which is pegged to the U.S. dollar, is probably the most recognisable stablecoin, although people question the reliability of its reserves.
Algorithmic stablecoins. These stablecoins use algorithms to control their supply and thus maintain their price peg. An example is TerraUSD (UST), which was initially pegged at $1 by creating and destroying a sister coin called Luna. Every time TerraUSD was bought or sold, a respective amount of its sister token, Luna, was created or destroyed.
This strategy worked great until it didn’t. When panic caused people to cash in their TerraUSD in a mass exodus, TerraUSD de-pegged from its $1 price and slid to near zero, along with Luna. In TerraUSD’s defence, the same panic caused Tether to slip from $1 per coin to $0.94 per coin.
However, this was a great opportunity for savvy investors, who could buy $1 for 94 cents and cash it in immediately, receiving 6 cents profit for every dollar.
