A stablecoin is a type of cryptocurrency where the value of the digital asset is supposed to be pegged to a reference asset, which is either fiat money, exchange-traded commodities (such as precious metals or industrial metals), or another cryptocurrency.
In theory, 1:1 backing by a reference asset could make a stablecoin value track the value of the peg and not be subject to the radical changes in value common in the market for many digital assets. In practice, however, stablecoin issuers have yet to be proven to maintain adequate reserves to support a stable value and there have been a number of failures with investors losing the entirety of the (fiat currency) value of their holdings.
Background
Stablecoins have several purported purposes. They can be used for payments and are more likely to retain value than highly volatile cryptocurrencies. In practice, many stablecoins have failed to retain their "stable" value.
Stablecoins are typically non-interest bearing and therefore do not provide interest returns to the holder.
Reserve-backed stablecoins
Reserve-backed stablecoins are digital assets that are stabilized by other assets. Furthermore, such coins, assuming they are managed in good faith and have a mechanism for redeeming the asset(s) backing them, are unlikely to drop below the value of the underlying physical asset, due to arbitrage. However, in practice, few, if any, stablecoins meet these assumptions.
Backed stablecoins are subject to the same volatility and risk associated with the backing asset. If the backed stablecoin is backed in a decentralized manner, they are relatively safe from predation, but if there is a central vault, it may be robbed or suffer loss of confidence.
Fiat-backed
The value of stablecoins of this type is based on the value of the backing currency, which is held by a third party–regulated financial entity. Fiat-backed stablecoins can be traded on exchanges and are redeemable from the issuer. The stability of the stablecoin is equivalent to the cost of maintaining the backing reserve and the cost of legal compliance, licenses, auditors, and the business infrastructure required by the regulator.
In this setting, the trust in the custodian of the backing asset is crucial for the stability of the stablecoin's price. If the issuer of the stablecoin does not actually possess the fiat necessary to make exchanges, the stablecoin can quickly lose value and become worthless.
The most popular stablecoin, Tether, initially claimed to be fully backed by fiat currency; this was proven to be untrue, and Tether was fined $41 million by the Commodity Futures Trading Commission for deceiving consumers. Instead, Tether only had enough fiat reserve to guarantee 27.6% of their stablecoin. Nevertheless, Tether still remains widely used.
Cryptocurrencies backed by fiat currency are the most common and were the first type of stablecoins on the market. Their characteristics are: Their value is pegged to one or more currencies (most commonly the US dollar, the euro, and the Swiss franc) in a fixed ratio; The value connection is realized off-chain through banks or other types of regulated financial institutions which serve as depositaries of the currency used to back the stablecoin; The amount of the currency used to back the stablecoin should reflect the circulating supply of the stablecoin.
Examples: TrueUSD (TUSD), USD Tether (USDT), USD Coin, Monerium EURe.
In January 2023, National Australia Bank (not Australia's central bank) announced that it would create by mid-2023 an Australian Dollar fiat-backed stablecoin called the AUDN, for streamlining cross-border banking transactions and trading carbon credits.
Commodity-backed
The main characteristics of commodity-backed stablecoins are: Their value is fixed to one or more commodities and redeemable for such (more or less) on demand; There is an implied or explicit promise to redeem by unregulated individuals, agorist firms, or even regulated financial institutions; The amount of commodity used to back the stablecoin should reflect the circulating supply of the stablecoin.
Holders of commodity-backed stablecoins can redeem their stablecoins at the conversion rate to take possession of the backing assets under whatever rules as to timing and amount are in place at the time of redemption. Maintaining the stability of the stablecoin is the cost of storing and protecting the commodity backing.