What are Stablecoins and How do They Work?

tl;dr

• Stablecoins are digital assets designed to maintain a stable value by pegging themselves to a specific reserve asset, usually a fiat currency.
  
  
• They provide stability and reduce exposure to market volatility in the crypto space.
  
  
• Stablecoins can be fiat-backed, cryptocurrency-backed, or algorithmic.
  
  
• Stablecoins are important in the DeFi ecosystem as they mitigate the risks of price volatility and provide a stable store of value.

• Popular stablecoins include Tether (USDT), USD Coin (USDC), Binance USD (BUSD), Djed, DAI, FRAX, and USDD.

An Introduction to Stablecoins

Stablecoins have emerged as a crucial component within the cryptocurrency ecosystem, addressing the inherent volatility associated with traditional cryptocurrencies like Bitcoin and Ethereum. These digital assets are designed to maintain a stable value by pegging themselves to a specific reserve asset, typically a fiat currency like the US dollar. By doing so, stablecoins provide stability and facilitate seamless transactions and value storage within the crypto space.

The first stablecoin to gain widespread recognition and adoption was Tether (USDT), which was launched in 2014. Tether quickly became popular due to its 1:1 peg with the US dollar, providing stability and acting as a reliable bridge between the traditional financial system and the crypto world. Following Tether's success, numerous other stablecoins entered the market, each with its unique features and underlying assets.

What are Stablecoins? 

The primary objective of stablecoins is to mimic the value of a specific reserve asset, typically a fiat currency like the US dollar, the euro, or the British pound. By doing so, stablecoins offer stability and reduce the exposure to market volatility prevalent in other cryptocurrencies. This stability makes stablecoins more suitable for everyday transactions, store of value, and even as a unit of account within the crypto ecosystem.

Moreover, stablecoins have evolved beyond fiat-backed pegs and can now represent other assets like commodities or precious metals. For instance, some stablecoins are backed by gold reserves, offering users exposure to the price movements of the precious metal while maintaining a stable value. These asset-backed stablecoins provide additional diversification opportunities and cater to users seeking stability while still participating in the crypto market.

There are several types of stablecoins, each with its own mechanism for maintaining price stability. The most common types include fiat-backed stablecoins, cryptocurrency-backed stablecoins, and algorithmic stablecoins.

Fiat-backed stablecoins are pegged to a specific fiat currency and are backed by reserves held in traditional bank accounts. These stablecoins aim to maintain a 1:1 ratio with the underlying fiat currency, ensuring their value remains stable.

Cryptocurrency-backed stablecoins, on the other hand, are collateralized by other cryptocurrencies. These stablecoins use a reserve of digital assets, such as Bitcoin or Ethereum, to back their value. 

Algorithmic stablecoins, rely on algorithmic mechanisms to control their supply and maintain a stable value. 

How do Stablecoins Work?

Stablecoins are a class of digital assets designed to maintain a stable value, providing a reliable and less volatile alternative to traditional cryptocurrencies. They achieve this stability through various mechanisms depending on the type of stablecoin.

Fiat-Backed Stablecoins

These stablecoins are backed by reserves of fiat currency held in traditional bank accounts. They aim to maintain a 1:1 peg with the underlying fiat currency, meaning that for every stablecoin in circulation, an equivalent amount of fiat currency is held in reserve. This ensures that the stablecoin's value remains stable and can be redeemed at any time for the underlying fiat currency. 

Examples of fiat-backed stablecoins include Tether (USDT) and USD Coin (USDC).

Cryptocurrency-Backed Stablecoins

These stablecoins are collateralized by other cryptocurrencies. The stablecoin issuer holds a reserve of cryptocurrencies, such as Bitcoin or Ethereum, which serves as collateral for the stablecoin's value. The collateralized cryptocurrencies are usually overcollateralized, meaning that the value of the collateral is higher than the stablecoin's total supply. This ensures that even if the price of the collateral fluctuates, the stablecoin remains stable. 

Examples of cryptocurrency-backed stablecoins include DAI.

Algorithmic Stablecoins

These stablecoins rely on algorithmic mechanisms to control their supply and maintain a stable value. They do not require direct backing by any reserve asset. Instead, their supply is adjusted algorithmically based on predefined rules in response to changes in demand. For example, if the stablecoin's price is above the target value, the algorithm may increase the supply to decrease the price, and vice versa. 

Seigniorage-style stablecoins, such as Ampleforth (AMPL), are examples of algorithmic stablecoins

Why are Stablecoins Important in the DeFi Ecosystem? 

Stablecoins are essential in the DeFi ecosystem as they mitigate the risks of price volatility, providing users with a stable store of value. They enable participants to engage in various DeFi activities without the fear of significant losses due to sudden market swings. Stablecoins also enhance trading efficiency by serving as a medium of exchange with precise pricing and facilitating seamless transactions within DeFi protocols.

Moreover, stablecoins contribute to the liquidity of DeFi platforms by acting as a bridge between volatile cryptocurrencies and real-world assets. This liquidity attracts more participants and increases the overall functionality of DeFi protocols. Stablecoins also play a crucial role as collateral in lending and borrowing protocols, providing a reliable and standardized form of collateral that can be easily managed and assessed for risk.

Stablecoins promote interoperability within the DeFi ecosystem, allowing users to transfer value and assets between different DeFi applications. This seamless transferability enhances the efficiency and usability of the ecosystem, enabling participants to navigate and utilize various protocols with ease.

Additionally, stablecoins play a significant role in the emerging concept of "Hard cash" DeFi. Some DeFi protocols offer users the ability to earn interest on their crypto holdings by supplying liquidity, and stablecoins are often used as the payment currency for these interest earnings. This feature attracts users looking for more stable returns on their investments while benefiting from the advantages of DeFi.

Stablecoin Benefits & Risks

The primary benefit of stablecoins is their ability to maintain a stable value, typically pegged to a specific asset like a fiat currency or a basket of assets. This stability makes stablecoins a reliable medium of exchange and a store of value, enabling users to transact and hold assets without being exposed to the price volatility of other cryptocurrencies.

Fast and efficient transactions are another advantage of stablecoins. They are built on blockchain technology, allowing for quick and low-cost transfers globally, making them well-suited for cross-border transactions and remittances.

Stablecoins also promote financial inclusion by providing access to a stable currency for individuals in regions with volatile local currencies or limited banking infrastructure. This can empower users with access to global financial services and opportunities.

However, stablecoins are not without risks. One significant risk is the potential for de-pegging, where the stablecoin's value deviates from its intended peg. A notable example is Terra, a stablecoin that experienced a de-pegging event in November 2022. Due to insufficient reserves and an insecure algorithmic architecture, the price of Terra deviated from its peg. The project collapsed in price and dooming Terra and its sister project Luna.

Regulatory concerns also pose risks to stablecoins. The increased scrutiny from regulators and central banks could result in stricter regulations, affecting the operation and viability of stablecoin projects.

Counterparty risks are another consideration, as stablecoins often rely on custodians or issuers to hold and manage the reserves backing the stablecoin. If these custodians face financial difficulties or operational failures, it can impact the stability and value of the stablecoin. For instance, the collapse of Silicon Valley Bank on March 12, 2023, briefly caused USDC to depeg. However, USDC quickly recovered within a day and restored its value.

Stablecoin Use Cases

Stablecoins have emerged as a valuable asset class within the cryptocurrency ecosystem, serving various important use cases. They provide price stability, making them suitable for payments and remittances, especially in regions with limited banking infrastructure. Stablecoins enable fast and cost-effective cross-border transactions, offering a reliable alternative to traditional payment methods.

In the realm of DeFi, stablecoins play a pivotal role. They provide liquidity to DeFi protocols, allowing users to engage in lending, borrowing, yield farming, and decentralized trading. Stablecoins act as a stable intermediary for crypto-to-crypto swaps, enabling traders to mitigate market volatility by temporarily parking their funds in a stable asset.

Stablecoins also serve as a store of value and a hedging tool, attracting investors seeking a safe haven during periods of market turbulence. They offer stability and price predictability, allowing users to protect their capital and navigate market fluctuations. Additionally, stablecoins facilitate the tokenization of real-world assets and their integration into smart contracts, enhancing liquidity and enabling frictionless transfer and fractional ownership. Moreover, stablecoins are well-suited for micropayments and digital commerce, providing a stable unit of account for seamless and instant transactions in online marketplaces, gaming platforms, and content subscription services.

Popular Stablecoins

Tether or USDT

Tether (USDT) is a popular and widely used stablecoin in the cryptocurrency market. Launched in 2014, Tether was one of the first stablecoins to introduce the concept of pegging its value to a specific fiat currency, initially the US dollar. Tether is designed to provide stability and act as a digital representation of traditional currencies, facilitating seamless transactions within the crypto ecosystem.

Tether operates on various blockchain networks, including Ethereum, Tron, and others, utilizing protocols such as ERC-20 and TRC-20. This enables USDT to be easily integrated into DApps, smart contracts, and cryptocurrency exchanges.

One of the key benefits of Tether is its liquidity and wide acceptance within the crypto industry. USDT is used as a trading pair for many cryptocurrencies and acts as a bridge between crypto and traditional finance. Its stable value relative to the US dollar makes it a preferred choice for traders seeking to hedge against market volatility or maintain a stable store of value.

USD Coin or USDC

USD Coin (USDC) is a widely recognized and trusted stablecoin in the cryptocurrency market. Developed by Circle in collaboration with Coinbase, USDC was launched in 2018 to provide a stable and transparent digital currency pegged to the US dollar. As an ERC-20 token built on the Ethereum blockchain, USDC leverages the security, efficiency, and interoperability of the Ethereum network. Since 2018, USDC has expanded to various additional blockchains.

Read the In-depth guide, What is USDC? To learn all about the stablecoin.

USDC is designed to maintain a 1:1 ratio with the US dollar, meaning that for every USDC token in circulation, there should be an equivalent amount of US dollars held in reserve. This commitment to full collateralization is achieved through regular attestations and audits by leading accounting firms, ensuring transparency and trustworthiness.

‍

USDC has gained significant adoption and popularity due to its robust regulatory compliance measures and adherence to established financial standards. It has obtained licensing and regulatory approvals in multiple jurisdictions, enhancing its credibility and trustworthiness among users and institutions.

Binance USD or BUSD

Binance USD (BUSD) is a stablecoin introduced by Binance, one of the world's largest cryptocurrency exchanges, in collaboration with Paxos. Launched in September 2019, BUSD is designed to provide a stable and reliable digital asset pegged to the value of the US dollar. As a regulated and audited stablecoin, BUSD aims to combine the benefits of the crypto market with the stability of traditional fiat currencies.

BUSD operates on the Binance Chain, a blockchain platform developed by Binance, which offers high performance, low transaction fees, and interoperability with other Binance Chain-based tokens. BUSD is also available on the Ethereum network as an ERC-20 token, allowing users to access a wider range of decentralized applications and services.

Furthermore, BUSD benefits from the wide acceptance and liquidity of the Binance exchange, making it readily accessible for trading and conversion to other cryptocurrencies. Its integration with Binance's extensive ecosystem allows users to seamlessly move funds between BUSD and other supported digital assets.

Djed

Djed is the native overcollateralized stablecoin on the Cardano blockchain, developed by IOG and powered by COTI. Introduced as part of the broader Cardano ecosystem, Djed aims to provide a stable and reliable digital asset within the decentralized finance (DeFi) space.

Unlike traditional stablecoins that rely on a centralized authority or reserve, Djed operates in a decentralized manner. It leverages smart contracts on the Cardano blockchain to ensure transparency and trust in the stability and value of the stablecoin.

The reserve coin for Djed is called SHEN, which is backed by ADA, the native cryptocurrency of the Cardano blockchain. The reserve ensures the stability of Djed by collateralizing SHEN with a significant amount of ADA.

The Djed protocol employs an over-collateralization mechanism, where the value of the reserve coin (SHEN) is set at 400-800% of the stablecoin supply (DJED). This over-collateralization ratio provides a cushion against price volatility and ensures the stability of Djed even in turbulent market conditions.

DAI

DAI is a decentralized stablecoin that operates on the Ethereum blockchain. Developed by MakerDAO, DAI is designed to maintain a stable value relative to the US dollar. Its decentralized nature makes it an attractive option for users seeking a stable digital asset within the DeFi ecosystem.

Unlike traditional stablecoins that rely on a centralized reserve or collateral, DAI achieves its price stability through an innovative mechanism called the Collateralized Debt Position. Users can generate DAI by depositing digital assets, primarily ETH, into a CDP as collateral. The value of the collateralized assets exceeds the value of the DAI issued, ensuring that DAI remains backed by sufficient collateral at all times.

The smart contracts governing DAI automatically adjust the supply based on market conditions and demand. If the price of DAI deviates from its peg, various mechanisms come into play to incentivize users to stabilize the price. For instance, if DAI trades above its target price, users are encouraged to mint new DAI by depositing more collateral, increasing the supply and bringing the price back down. Conversely, if DAI trades below its target price, users are incentivized to purchase and burn DAI, reducing the supply and pushing the price back up.

FRAX

FRAX is a decentralized algorithmic stablecoin that aims to maintain a stable value relative to the US dollar. It operates on the Ethereum blockchain and is designed to provide a stable and reliable digital asset within the DeFi ecosystem.

The primary mechanism used by FRAX is the FRAX Redemption Contract, which allows users to redeem FRAX for its underlying collateral, which is typically a combination of stablecoins and cryptocurrencies. When the price of FRAX deviates from its peg, the protocol incentivizes users to either mint new FRAX tokens by providing collateral or redeem FRAX for its underlying assets, thereby adjusting the supply and stabilizing the price.

The FRAX protocol incorporates an innovative concept called the "Fractional Algorithmic Bank." The FAB dynamically adjusts the collateralization ratio based on market conditions, allowing for a flexible and responsive stabilization mechanism. This approach allows FRAX to maintain stability while providing liquidity to users.

USDD

USDD, launched on May 5, 2022, is a stablecoin designed to maintain a 1:1 peg with the U.S. dollar. It operates on the TRON, Ethereum, and BNB Chain blockchains and is governed by the TRON DAO Reserve. Unlike traditional stablecoins that rely on collateralization, USDD utilizes an algorithmic approach called seigniorage shares to ensure stability.

USDD's collateralization differs from that of other stablecoins like UST. It is backed by a diversified basket of assets including TRX, BTC, and USDC, which collectively secure over 200% of the value of USDD in circulation. This means that each USDD token is backed by more than twice its face value. The mint-and-burn mechanism enables users to exchange 1 USDD for 1 USD worth of TRX when the price of USDD is below 1 USD, and vice versa. This ensures that the stablecoin remains closely tied to the U.S. dollar, preventing it from de-pegging.

Final Thoughts

The future of stablecoins appears promising as they continue to play a vital role in the evolving landscape of decentralized finance (DeFi) and the broader Web3 ecosystem. While it is true that some stablecoins, like Terra, may encounter challenges or even fail, and others may face increased regulatory scrutiny, the overall trajectory suggests that stablecoins will thrive and evolve.

Stablecoins have proven their value by addressing the volatility concerns associated with traditional cryptocurrencies, providing a reliable medium of exchange and store of value within the decentralized realm. Their ability to maintain a stable peg to a fiat currency, such as the U.S. dollar, enables users to transact and engage with digital assets without exposure to extreme price fluctuations.

As the Web3 space continues to expand and mature, stablecoins are likely to become even more integral to its growth. They serve as a bridge between the traditional financial system and the decentralized world, facilitating seamless transactions, lending and borrowing, liquidity provision, and other financial activities. The stability they offer fosters confidence among users and encourages broader adoption of DeFi applications.