Stablecoins have become an essential part of decentralized finance (DeFi) used for trading, purchases, and more.
In this article we’ll cover:
- What a stablecoin is
- Why people may buy stablecoins
- How stablecoins are used
- How stablecoins work
What is a stablecoin?
Stablecoins are cryptocurrencies pegged to currencies like the US dollar or euro or assets like the price of gold.
Because they’re “tied” to the value of less volatile assets, stablecoins provide an alternative way for people to participate in crypto without having exposure to bitcoin and other tokens known for their potential wide price swings.
The main draw of stablecoins is that they provide the speed of crypto with the stability of dollars and other trusted assets.
Reasons why people may buy stablecoins
- Cash alternative. Stablecoins could minimize fluctuations in holdings since they stay pegged to a fiat currency or physical commodity, such as the US dollar or gold.
- Building and protecting wealth. People whose currencies have devalued through inflation may buy stablecoins as an alternative to their local currency.
- Payments. In areas where it’s difficult to get physical dollars, stablecoins could be a viable way to do commerce.
- Trading. Crypto exchanges often offer stablecoin pairs against dollars, bitcoin, ether, and other assets.
How stablecoins are used
Some of the most common use cases of stablecoins may include:
- Hedging against market volatility. The ability to pull funds out of volatile cryptocurrencies, especially during extreme market fluctuations, could be an attractive use case of stablecoins.
- Cheaper payments. Because stablecoins circumvent traditional banks and clearing houses, users may avoid many of the traditional fees associated with cross-border transfers.
- Faster payments. Bank payments usually take between 3–5 days while stablecoin payments could settle in a matter of minutes or hours.
Drawbacks of stablecoins
- Primarily centralized. Advocates of a fully decentralized financial system often criticize stablecoins because they’re controlled by centralized entities, meaning that they’re not truly trustless.
- Counterparty risk. When you buy a stablecoin, you’re trusting that the issuer will honor its promises and redeem your coins for the appropriate amount of fiat currency. If the entity controlling the stablecoin mismanages its reserves or becomes insolvent, you could lose money.
- Smart contract risk. If there’s a bug in the code governing the stablecoin, it could lead to loss.
- Lack of transparency. Some stablecoin companies skirt or ignore audit requests, meaning that users never really know if the necessary reserves to hold the peg are actually in place. Without audits, those funds can be embezzled or used for purposes other than collateralization.
Are all stablecoins backed by cash?
No. Some stablecoins are completely collateralized by cash, holding at least a 1:1 ratio in reserves to maintain their peg.
However, each stablecoin project manages peg maintenance and collateralization uniquely, so reviewing the documentation from the company can help you understand their process.
How stablecoins work
There are four kinds of stablecoins and each works a little differently.
- Stablecoin value is pegged to a fiat currency, like the US Dollar.
- Fiat reserves ensure a 1:1 collateralization ratio.
- Stablecoin value is pegged to a single commodity or index of commodities.
- Collateral reserves are tied to the commodity.
- Stablecoin value is pegged to another cryptocurrency, like BTC.
- Many crypto-backed stablecoins hold more collateral than needed, and in different currencies, to ensure peg.
- No collateral is required to start or operate a true algorithmic stablecoin.
- Relies on smart contract algorithms based on supply and demand.
It’s important to note that a stablecoins peg is not the same as its collateral currency.
The peg is the value the stablecoin is tying itself to, such as the US dollar. If a stablecoin is pegged to USD, that means that one unit of the stablecoin will equal one US dollar.
The collateral currency is what’s backing up the stablecoin; it’s the stored value that helps the stablecoin maintain its peg.
For example, a stablecoin could be pegged to the Euro, but be backed by various assets, such as fiat currency or gold, that essentially proves the value of the stablecoin.
Asset-backed stablecoins have real assets held in reserve as collateral for the stablecoin.
Many asset-backed stablecoins currently available are fiat-backed, using a fiat currency such as the US dollar. Other asset-backed stablecoins use commodities like gold or even other cryptocurrencies as their collateral.
Fiat-backed stablecoins are pegged to a traditional fiat currency, such as the US dollar or the Euro, and maintain their peg by using a one-to-one (1:1) collateralization ratio, meaning that for one stablecoin, there is one unit of the fiat currency held in reserve.
One of the primary criticisms of fiat-backed stablecoins is that the collateral must be held by a custodian, which means trusting a centralized organization.
A good example of a fiat-backed stablecoin is PAX USD:
Commodity-backed stablecoins use a physical asset, like gold, oil or real estate, as a peg for a digital currency. Asset-backed stablecoins that use commodities as collateral can be more volatile than stablecoins collateralized by fiat currencies.
Gold-backed tokens, for example, are fairly stable and offer the advantage of being able to hold the value of an asset like gold without needing to store and secure the physical gold coins or bars. Stablecoins backed by gold often use a measurement of the metal, such as one gram, as the peg for the stablecoin.
Some companies even take a blended collateral approach, using a mix of assets to back their stablecoins, similar to a precious metals index or using multiple fiat currencies.
You’re probably ahead of us at this point: Crypto-backed stablecoins are cryptocurrencies that hold their value at a 1:1 ratio to a different, more established, cryptocurrency.
Some cryptobacked stablecoins are overcollateralized, meaning they hold more reserves than needed, in order to minimize the risk of losing their peg.
This is why some crypto-backed tokens use a mix of multiple cryptocurrencies, or crypto and fiat currency, to collateralize the stablecoin. In the event that the pegged crypto has an extreme drop in value, the stablecoin can maintain value.
MakerDAO’s stablecoin DAI (which runs on multiple blockchains) is one of the most popular stablecoins available and makes use of this model.
MakerDAO made this change after ETH experienced a massive drop in 2020, creating extreme losses in DAI since it was pegged to ETH.
Since then, MakerDAO has implemented overcollateralization and uses multiple cryptocurrencies as reserves.
Many DeFi purists consider algorithmic stablecoins to be the pinnacle of dollar-pegged stablecoins, as they don’t require any centralization or reliance on an underlying reserve.
Algorithmic stablecoins are non-collateralized, which means that these stablecoins do not necessarily require any assets held in reserve in order to function. Instead, they use complex formulas in smart contracts to determine when to create or destroy tokens to maintain parity with the chosen peg, which is often one dollar.
Some of these stablecoins provide rewards when they are valued over their dollar peg, selling what’s called “seigniorage shares” to bring the token back down to the peg value.
Algorithmic stablecoins function as standalone central banks, burning existing tokens when the value falls below the fiat peg, and creating new tokens when the price goes higher than the tracked currency.
Are stablecoins the future of money?
Stablecoins have received a lot of attention in the last few years, and the jury is still out on what their place is in the future of finance. In some cases, stablecoins are the only option for people who need their crypto to maintain a stable value while being useful for everyday purchases.
A great example of this took place in Argentina in 2022 when economy minister Martin Guzmán resigned, sending the peso into further decline and driving the demand for stablecoins up. Argentinians bought stablecoins to hedge against devaluation of the peso.
Some fear that central banks may take over the role that decentralized networks play in stablecoins and issue currencies of their own. So-called “central bank digital currencies” (CBDC) would have all the capabilities of cryptocurrency without any of the privacy protections or pseudonymity that most crypto provides.
It’s hard to tell how long that adoption will take, so in the meantime, stablecoins fill a valuable need in the crypto ecosystem.
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Disclaimer: This information is provided for informational purposes only and is not intended to substitute for obtaining accounting, tax, or financial advice from a professional advisor. Some of the stablecoins mentioned above are not supported by Blockchain.com