What is a Stablecoin?

Imagine you have a digital version of the money in your bank account, but instead of being held at a traditional bank, it exists on the internet. This digital money is called a stablecoin, and it is designed to always be worth the same amount - just like a regular dollar, euro, or any other currency.

For instance,, if you have 1 USDC (a popular stablecoin), it will always be worth 1 U.S. dollar. Unlike Bitcoin, which can rise and fall in value daily, stablecoins don’t have wild price swings because they are backed by real-world assets like cash in a bank, government bonds, or even gold.

How Do Stablecoins Work? A Simple Breakdown

Stablecoins are designed to hold a stable value, unlike Bitcoin and other cryptocurrencies that experience price swings. They achieve this stability in different ways—by being backed by real-world assets or using automated systems to regulate their supply.

In order to understand this better, let’s explore the three main types of stablecoins and how they function.

Fiat-Backed Stablecoins (The Most Common Type)

To begin with, fiat-backed stablecoins are the simplest and most widely used type.

What It Is:
Fiat-backed stablecoins are tied to traditional money, like the U.S. dollar (USD), euro (EUR), or other government-issued currencies.

How It Works:
For every 1 stablecoin issued, the company behind it holds 1 real dollar (or equivalent) in a bank account or government bond. This ensures that you can always redeem the stablecoin for actual money.

Examples:

USDT (Tether) – One of the most widely used stablecoins, pegged to USD.
USDC (USD Coin) – Issued by Circle and backed 1:1 by U.S. dollar reserves.
BUSD (Binance USD) – Issued by Binance, though it faced regulatory challenges in 2023.

Pros:
✔️ Highly stable and widely accepted in crypto trading and payments.
✔️ Easy to understand, essentially digital dollars.
✔️ Backed by real-world assets, reducing volatility.

Cons:
⚠️ Requires trust in the issuing company (Are the reserves really there?).
⚠️ Governments could regulate or restrict their use.

Crypto-Backed Stablecoins (Backed by Other Cryptocurrencies)

On the other hand, some stablecoins do not rely on traditional currencies but instead use cryptocurrency reserves to maintain their value.

What It Is:
Rather than being backed by cash, crypto-backed stablecoins are secured by other cryptocurrencies like Ethereum (ETH) or Bitcoin (BTC).

How It Works:
Since crypto prices fluctuate, these stablecoins are "overcollateralized"—meaning more crypto is held in reserve than the actual stablecoins issued.

For example, to mint $1 DAI stablecoin, you might need to deposit $1.50 worth of ETH in a smart contract.
If ETH’s price drops, the system automatically liquidates some of the reserve assets to keep the stablecoin stable.

Examples:

DAI – Backed by a mix of cryptocurrencies, managed by the MakerDAO system.

Pros:
✔️ Doesn’t rely on banks or fiat money, fully decentralised.
✔️ No government control over reserves.
✔️ Can be used in DeFi (Decentralized Finance) without intermediaries.

Cons:
⚠️ More complex and harder to understand than fiat-backed stablecoins.
⚠️ If crypto prices drop too much, the system can collapse (requires active risk management).
⚠️ Less widely used for payments compared to fiat-backed stablecoins.

Algorithmic Stablecoins (Controlled by Code, No Reserves)

Finally, there is a completely different approach to stablecoins—one that doesn’t rely on holding reserves at all.

What It Is:
Algorithmic stablecoins aren’t backed by any assets but use smart contracts (automated programs on the blockchain) to control supply and demand—similar to how central banks adjust money supply.

How It Works:

If the stablecoin price goes above $1, the system mints new coins to increase supply and bring the price back down.
If the price drops below $1, the system burns coins (reducing supply) to push the price back up.
Some systems use a secondary token to balance the price.

Examples:

FRAX – A hybrid algorithmic stablecoin.
TerraUSD (UST) – Once a major algorithmic stablecoin, but it collapsed in 2022 when the balancing system failed, wiping out billions of dollars.

Pros:
✔️ Doesn’t require banks or collateral—fully decentralized.
✔️ Theoretically scalable and more efficient than fiat-backed stablecoins.

Cons:
⚠️ Extremely risky—if confidence is lost, the whole system can crash.
⚠️ No real asset backing, meaning if demand drops, it can spiral out of control (as seen with TerraUSD).
⚠️ Governments and regulators are skeptical about their stability.

Why Do People Use Stablecoins?

Faster & Cheaper Transactions
– Sending money with a stablecoin is like sending an email—it’s fast and doesn’t require banks. It can take seconds instead of days.
Protection from Inflation & Banking Issues
– In some countries, stablecoins help people store their money in a currency that doesn’t lose value over time. If a local currency is unstable, people can hold stablecoins instead.
Easier International Payments
– If you want to send money to another country, stablecoins allow you to do it instantly and with lower fees than traditional banks or services like Western Union.

How Are Stablecoins Different from Bitcoin?

Stablecoins = Always the same price (like digital cash)
Bitcoin = Price changes all the time (like stocks)

People often use stablecoins for everyday transactions, while Bitcoin is seen more as an investment.

Why Are Governments and Banks Talking About Stablecoins in 2025?

Governments and major companies like PayPal, Visa, and banks are starting to use stablecoins in payments and savings. Some governments even want to create their own versions, called CBDCs (Central Bank Digital Currencies), to compete with private stablecoins.

However, regulators are also debating how to control them, as stablecoins could challenge traditional banking systems.

Recent Developments with stablecoin:

Legislative Progress: The U.S. Senate Banking Committee advanced the GENIUS Act, a bipartisan bill establishing a regulatory framework for stablecoins. This legislation aims to legitimise stablecoins, encouraging mainstream adoption while addressing consumer protection and financial stability concerns.
Financial Institutions' Involvement: Major banks and fintech companies, including Bank of America, PayPal, and Stripe, are entering the stablecoin market. Their involvement signifies a shift towards integrating stablecoins into traditional financial systems, potentially reshaping cross-border payments and enhancing transaction efficiency. Financial Times
Regulatory Discussions: The House Financial Services Committee held hearings focusing on stablecoins, highlighting their potential to improve payment systems. Witnesses emphasised the need for a balanced regulatory approach to foster innovation while ensuring financial stability. Axios

These developments underscore the growing significance of stablecoins in the financial landscape, reflecting a trend towards broader acceptance and integration into mainstream finance.

Summary

Stablecoins are digital assets that remain stable in value, either by being backed by fiat money, cryptocurrencies, or controlled by algorithmic mechanisms. They are widely used for fast transactions, international payments, and protecting against inflation. As a result, governments, banks, and regulators are taking them seriously, indicating that stablecoins will likely be part of the future financial system.

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