A stablecoin is a cryptocurrency whose value is pegged to a fiat currency. For example, the most popular stablecoin by volume as of 2023 was Tether (USDT), which is pegged 1-to-1 to the USD (United States Dollar).
Stablecoins come in two categories: a stablecoin supported with reserves, and an algorithmic stablecoin.
Reserve Stablecoin. The first category maintains its peg because the cryptocurrency issuer keeps a sum of reserves equal to the value of cryptocurrency in circulation. So, if all cryptocurrency holders wanted to redeem simultaneously, the issuer would have sufficient reserves to complete the exchange.
For example, if a stablecoin is pegged 1-to-1 to the USD, and the current market has 50,000,000 coins outstanding for a $50,000,000 market cap, the issuer would need at least $50,000,000 in reserves to support the peg. The issuer’s balance sheet shows $60,000,000 of cash, cash equivalents, and other liquid assets, and the issuer has no liabilities. The issuer has sufficient reserves to support the $50,000,000 of cryptocurrency in circulation.
However, what if we looked at the issuer balance sheet and noticed the issuer only has $35,000,000 of assets, and the company has substantial debts owed to third-party banks and other creditors? The issuer does not have sufficient assets and reserves to support all of the cryptocurrency in circulation. If all cryptocurrency holders wanted to redeem simultaneously, the issuer would be unable to meet those requests. This causes the peg to fall apart, and the market price of the stablecoin collapses.
Algorithmic Stablecoin. The algorithmic stablecoin uses technology to constantly add or remove coins from the supply to maintain a specific valuation. The algorithmic stablecoin is viewed as less stable and riskier than the first category, which maintains actual reserves.