Stablecoins are digital assets built on the blockchain and are designed to maintain a value relevant to the asset they’re pegged to, most often at a price of $1. But why do they do this?
To keep their use and legitimacy as a payment method, stablecoins must have backing from fiat currency, or another asset of equal fair value. This collateral is used to provide stablecoin holders with the opportunity to redeem the tokens for US dollars or the assets that can then be used in the real world.
The most popular stablecoins, like USDC and Tether, are off-chain assets, meaning they’re backed by collateral that is held in reserve. Both of these stablecoins make use of the US dollar as collateral.
Stablecoins that are backed by assets like other cryptocurrencies are considered to be on-chain assets. Instead of being backed by fiat cash or traditional assets, the collateral takes the form of a smart contract which allows you to obtain tokens of equal representative value.
While collateral structures can vary between stablecoins, they each have the same mission: to stabilise the system and to smooth out volatility.