A stablecoin is a type of cryptocurrency that is backed by fiat currency, gold or some other type of reserves to ensure price stability. Stablecoins attempt to merge the benefits of leading cryptocurrencies like bitcoin or ether (frictionless payments and cryptographic security) and fiat currencies (relative price stability).
The most widely used stablecoin is USD Tether (USDT), which works using blockchain technology. While transfers are publicly available on the blockchain like Bitcoin, their value is not determined by supply and demand and USDT tokens are not created through a process of mining.
New USDT tokens can only be created by Tether Limited through fiat deposits into their reserve of US Dollars (which is supposed to back up the number of USDT in existence). Each USDT represents a claim on $1 in this reserve at a 1-to-1 conversion rate.
The benefit of stablecoins is that traders can exit positions in cryptocurrency and keep their money on exchanges to easily re-enter the market. If a trader withdraws using fiat currency, it might take a few days before the money hits their account and the bank will also charge a fee. Coins like USDT also allow traders to hedge against the volatility of cryptocurrencies like bitcoin or ether.
An increasing number of new entrants reflects growing interest in a stable cryptocurrency. For instance, many exchanges have started to offer their own stablecoins (including Coinbase’s USDC and Gemini’s GUSD). These tokens all represent the US Dollar as an asset on the Ethereum blockchain using the ERC-20 standard and are backed by a reserve of US Dollars.
There are also alternatives that are collateralised with cryptocurrency, such as MakerDAO’s DAI stablecoin. Each unit of DAI (pegged to the US Dollar) is created through the use of smart contracts on the Ethereum blockchain where a user deposits ETH as collateral to generate DAI. Unlike USDT and other stablecoins, they do not rely on a reserve of US Dollars or fiat currency but instead on the market dynamics of Ethereum's ETH.