Definition: stablecoins are cryptoassets pegged to a national currency, a basket of currencies or another asset.
Reading Time 7 Minutes
Reading Time 7 Minutes
Created on 20.11.2023
What is a stablecoin?
Stablecoins are one of the major developments in cryptoassets. Aiming to provide a stable digital currency with a relatively constant value and, as a result, to reduce the risk of price fluctuations in blockchain-based applications, their popularity has grown enormously over recent years. This article explores how they work, which different types are available and what their benefits are.
Anyone considering investment in cryptoassets will come across stablecoins sooner or later. Just like Bitcoin, stablecoins are cryptos, too – but with a few key differences.
What is a stablecoin?
Unlike classic cryptos, stablecoins are pegged cryptocurrencies. Pegged because they’re linked to an asset. Most stablecoins are pegged to a “stable” reserve asset, such as the US dollar or gold. In the first instance, this means that one single stablecoin is theoretically equivalent in value to one US dollar. In principle, any asset can be used as a basis for stablecoins. However, most stablecoins are pegged to fiat currencies – which is what currencies such as the US dollar and euro are called in the crypto world. The various types of stablecoins are explained in the article “What types of stablecoins are available?”.
Stablecoins are more stable than classic cryptos such as Bitcoin
Stablecoins were created to minimize volatility compared with unpegged cryptocurrencies such as Bitcoin. Unlike many other cryptos whose prices fluctuate sharply, stablecoins are “stable”. That’s also where the name “stablecoin” comes from. This stability is achieved by pegging the crypto to an asset or combination of assets.
How do stablecoins work?
Stablecoins link the worlds of traditional investment and digital cryptos
Stablecoins bridge the gap between the digital world of cryptos and the traditional financial sector, where transactions are executed in US dollars or euros. Stablecoins enable payments to be made with an asset equivalent in value to a fiat currency using blockchain infrastructure.
What types of stablecoins are available?
We now know that stablecoins are pegged to assets. Assets don’t necessarily always mean currency. There are different types of stablecoin, depending on which type of asset they’re pegged to.
Stablecoins pegged to fiat currencies
With fiat-pegged stablecoins, the stablecoin’s value is usually directly (1:1) equivalent to that of a fiat currency, such as the US dollar. This means that the cryptoasset is subject to the same fluctuations as the underlying national currency. Fiat-pegged assets are considered the most stable type of stablecoins.
Stablecoins pegged to commodities
Other stablecoins are backed by commodities such as gold. Stablecoins pegged to commodities are usually based on a fixed ratio between the stablecoin’s value and the value of a certain quantity of gold. This ratio can vary depending on the specific structure of the pegged stablecoin.
For gold, there are different approaches: some stablecoins are structured so that one coin is exactly equivalent in value to one gram of gold. This means that the stablecoin’s value is directly linked to the current gold price. So the value of one stablecoin is always the same as that of one gram of gold. By contrast, other stablecoins pegged to gold are structured so that their value is equal to a predefined value in gold. That means the actual amount of gold received when trading stablecoins depends on the current gold price.
The exact ratio and type of asset-backing can vary from stablecoin to stablecoin and depends on the issuer. This type of stablecoin is also considered relatively stable, as it is backed by physical assets.
Crypto-backed stablecoins
Not all stablecoins are backed by fiat currencies or commodities such as gold – some are pegged to other cryptocurrencies. Crypto-pegged stablecoins also track the prices of fiat currencies, but they are backed by cryptocurrencies. As a general rule, they are over-backed to offset the effect of price fluctuations to underlying cryptos.
The advantage of these stablecoins is that the underlying value of fiat-pegged stablecoins isn’t controlled by a central authority that investors must place their trust in. However, the investment entails greater risk, as the underlying price compensation mechanism may fail due to the underlying algorithm. The best-known example of a crypto-backed stablecoin is the DAI (see more below).
Algorithm-based stablecoins
In addition to asset-backing with fiat currencies, gold or cryptocurrencies, there’s also a fourth option. This type of stablecoin is based on an algorithm linked to a physical currency. They are not completely backed by collateral and rely on an algorithm to maintain their 1:1 linked price. In line with the principle of supply and demand, automated buy and sell algorithms ensure price stability. In principle, this type of stablecoin works a bit like a central bank – but in an automated and decentralized way. If the market causes the price to rise above the targeted underlying value (e.g. 1 US dollar), the algorithm places more coins on the market, artificially increasing supply. This is designed to bring the price back down to 1 US dollar.
These are the three best-known stablecoins
Tether (USDT)
Tether (USDT) is one of the most well-known stablecoins. It’s pegged to the US dollar and traded at a ratio of 1:1. This means that every USDT stablecoin has an equivalent value of 1 US dollar.
USD Coin (USDC)
Just like Tether, USD Coin (USDC) is pegged to the US dollar at a 1:1 ratio. USDC was introduced in 2018 to enable goods and services to be paid for in cryptocurrency in future. The underlying US dollars are held in accounts that are publicly audited by the accountancy firm Grant Thornton on a regular basis. So USD Coin isn’t just backed by a fiat currency, it’s also audited and transparent.
Dai (DAI)
Another well-known stablecoin is the Ethereum-based stablecoin Dai (DAI). This stablecoin’s price is also pegged to the US dollar. However, Dai isn’t pegged to a fiat currency, but instead maintains parity with the US dollar by relying on collaterals in the form of cryptocurrencies. The protocol – in this case the Maker platform – uses a system called Collateralized Debt Positions (CDP). CDPs are smart contracts under the Maker protocol where users can deposit their collateral (securities in the form of cryptos). In return, they receive new DAI tokens.
TerraUSD (UST) and LUNA: when the algorithm fails
We’ve learned that stablecoins are relatively stable because their value is pegged to a key currency, usually the US dollar. To ensure that this works, the algorithms behind the stablecoins must offset investors’ purchases by investing the same amount in dollars.
One example of this kind of algorithm-based stablecoin is TerraUSD (UST), which LUNA, the Terra network’s cryptocurrency, uses as collateral to peg its value to the dollar. Pegging to the US dollar worked well, because UST and LUNA could be exchanged at a fixed rate at any time.
However, things went out of kilter in May 2022. The stablecoin UST became unpegged from the US dollar. This was because the algorithm, which should have ensured pegging to the US dollar, proved susceptible to falls in demand in practice. The algorithm was actually supposed to increase demand for UST, but provided high, artificially maintained yields and relied on an emergency reserve pool.
This led to liquidations and a loss of trust, because the stablecoin almost completely collapsed, became unpegged from the dollar and slumped to a low of 26 cents. Extremely volatile conditions and problems with the UST/LUNA exchange ultimately led to the failure of the pegging mechanism. Despite rescue attempts and the liquidation of the reserve pool, the collapse couldn’t be staved off.
Advantages of stablecoins
Besides the question of how stablecoins work, the benefits provided by cryptocurrencies such as Tether and USDC is also of interest.
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As the name suggests, stablecoins are designed to ensure stability. Because they are pegged to fiat currencies, the value of stablecoins is coupled to a stable asset. This stability makes stablecoins calculable and suitable for use as a means of exchange.
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Stablecoins such as USDC are designed to be fast and efficient, making them an excellent choice for transactions. They’re based on blockchain technology, which enables secure and fast transactions. In contrast to conventional fiat currency transactions, which can take days, stablecoin transactions are executed almost immediately.
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Stablecoins’ transaction fees are lower than those of most conventional cryptos. That’s because they were designed as a means of exchange, and their transaction fees are generally lower than those of traditional cryptos such as Bitcoin.
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Stablecoins such as USDC are transparent, which means that users can track their transactions and see how their money is being used. This transparency is a major benefit, especially for companies and organizations that monitor their transactions and must comply with certain regulations.
Disadvantages of stablecoins
Stablecoins provide a more stable alternative to conventional cryptocurrencies such as Bitcoin or Ether. However, it’s also important to consider the potential downsides.
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As touched upon before, not all stablecoins are quite as stable as they might promise. That’s the case with non-fully-collateralized stablecoins. These are usually algorithm-based stablecoins. As most decentralized stablecoins are stored in smart contract protocols, there’s a risk that the algorithm intended to ensure currency stability may fail. For example, a sudden slump in demand can lead to the stablecoin collapsing, which is what happened with the TerraUSD crash.
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Another downside is that, so far, no notable stablecoins have been established in currencies other than the US dollar (e.g. EUR, CHF, GBP and JPY). The main reasons for this are the US dollar’s leading market position in the global economy and its role as one of the most-traded currencies on global financial markets. This means that stablecoins pegged to the US dollar have greater liquidity and a higher trading volume. For investors, this can mean a certain degree of stability that other currencies may not provide. However, the potential consequences of dependence on one single currency should also be fully considered. There’s a risk that market fluctuations or political developments in the USA could have a major impact on the US dollar and so too on the stablecoins pegged to it.
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Stablecoins are often centralized, which means that they’re issued and controlled by a central authority. This centralization can have downsides, as it makes stablecoins more vulnerable to fraud or hacker attacks.
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Stablecoins such as USDC are still relatively new, and their use is limited compared with well-known cryptos such as Bitcoin. This can be disadvantageous, as it restricts the liquidity of stablecoins, making them less usable for transactions.
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Stablecoins are not generally intended as an investment and provide limited opportunities for generating return compared with other cryptos.
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Stablecoins are often backed by a reserve of assets, exposing investors to a counterparty risk. If the company behind a stablecoin goes bankrupt or isn’t able to meet its obligations, investors risk losing their money. This risk could also exist if a fiat currency is used for collateral and suffers huge losses or disappears completely.
How stablecoins are used in practice
Stablecoins provide opportunities for various practical applications in the crypto world. These include:
- Decentralized financial services: stablecoins are often used in decentralized financial service protocols to counteract price volatility. For example, they can be used as stable units for credit or loans. Users can convert their cryptoassets into stablecoins to use them on decentralized financial service platforms.
- Execution of smart contracts: blockchain platforms such as Ethereum can use stablecoins to fulfil conditions and contracts. For example: payments will be made in stablecoins if certain conditions – stipulated in the smart contract protocol – are met.
Besides these and other practical applications, stablecoins provide investors with the option of holding assets in the crypto world, without missing out on certain benefits of fiat money or traditional assets. Stablecoins such as Tether and USD Coin have established themselves as a key component in the investment world and are playing an increasingly significant role. It’s advisable for (potential) investors to find out about the specific characteristics and risks of the stablecoins they’re considering and to invest only as much as they’re prepared to lose.
