A “stablecoin” is a type of cryptocurrency token with a value intended to track that of a real-world asset – typically a fiat currency like dollars or euros.
There are broadly two main types of stablecoin:
Asset-linked stablecoins are where a stablecoin issuer maintains a “reserve” of a currency off-chain in a bank or other custodian to directly back the value of the stablecoin. The issuer then issues a tokenized form of the asset on-chain at a 1:1 ratio. An example of this is the stablecoin USD Coin issued by the company Circle.
Algorithmic stablecoins, on the other hand, aren’t directly backed by anything at all, but attempt to create a token price that nonetheless naturally tracks a given stable asset as closely as possible.
They do this using algorithms, sometimes utilizing a price feed from an oracle to set the price target for the algorithm. Often the algorithm may increase or decrease the supply of the stablecoin itself. In some cases there exists a “balancing” token that can be minted or be redeemed for the stablecoin; the balancing token is intended to absorb any price fluctuations and thus allow the stablecoin to remain stable. TUSD and Luna are an example of a stablecoin and balancing token pair.
Algorithmic stablecoins are one of the hottest areas of research within DeFi, and many new models are being developed and experimented with.
Stablecoins are often touted as being one of the keys to developing a strong DeFi ecosystem as they are a haven from the wild price fluctuations seen in general cryptocurrencies. They provide all the benefits of permissionlessness, trustlessness, and fast settlement times of crypto, but without the wild price fluctuations. They are thus frequently used as a valuable trading position, or for developing real-world use cases for denominating payments or contracts.