Stablecoins are a type of cryptocurrency designed to hold a steady value, unlike other major cryptocurrencies like Bitcoin (BTC) or Ethereum (ETH), which are known for their price swings.
Stablecoins aim to keep their value fixed by linking it to assets like fiat currencies, commodities, or other financial instruments. They achieve this through various methods, depending on the type of stablecoin.
There are three primary categories of stablecoins:
- Fiat-backed stablecoins
- Crypto-backed stablecoins
- Algorithmic stablecoins
Traders often use stablecoins to shield themselves from the volatility of the crypto market without needing to convert their assets back to traditional money.
As of 2023, there are numerous stablecoin projects, but a few dominate the market. A recent study showed that stablecoin transaction volume exceeded that of major payment networks like Visa, highlighting their rising popularity worldwide.
Why Are Stablecoins Important?
Stablecoins are valuable for crypto users who want to minimize exposure to the market’s ups and downs without leaving the crypto ecosystem entirely.
They also act as a link between traditional finance and decentralized finance (DeFi). Stablecoins pegged to currencies like the US Dollar or Euro enable fast, reliable, and low-cost cross-border transfers.
Popular stablecoins like Tether (USDT) and USD Coin (USDC) are often backed by reserves of fiat currencies, such as the US Dollar. Large holders can redeem their stablecoins for fiat from these reserves. When a redemption occurs, the issuer burns an equivalent amount of tokens. Conversely, when someone wants to convert fiat into crypto, the issuer mints new tokens and holds the fiat in reserve to maintain the pegged value.
In the DeFi space, stablecoins are widely used for lending, borrowing, and earning interest. Their price stability is crucial in DeFi protocols, where users need a dependable unit of value to manage financial activities and reduce risks like impermanent loss. However, if a stablecoin fails to maintain its peg, users in DeFi protocols could face losses.
How Do Stablecoins Work?
Stablecoins are designed to track the value of another asset, but they use different mechanisms to achieve this, each with its own set of risks. Understanding these mechanisms is key to choosing the right stablecoin for your needs.
Here’s a breakdown of how the main types of stablecoins operate.
Fiat-Backed Stablecoins
Fiat-backed stablecoins are tied to government-issued currencies like the US Dollar or Euro, often supported by “cash equivalents” such as treasury bills. These reserves are typically held in traditional financial institutions like banks.
The goal is to maintain a 1:1 peg with the currency they track. For example, for every token in circulation, the issuer holds an equivalent amount in fiat reserves. When more fiat is deposited, new tokens are minted; when tokens are redeemed, they are burned.
Tether (USDT), launched in 2014 by Tether Limited, was one of the first fiat-backed stablecoins. It remains the largest by market cap and is widely used globally. Tether also offers a Euro-pegged stablecoin called EURT. These stablecoins are managed by a central entity that oversees issuance and redemption. Many issuers conduct regular third-party audits to verify that their reserves match the circulating supply, building trust among users.
USD Coin (USDC), the second-largest fiat-backed stablecoin, was introduced in 2018 on the Ethereum blockchain. It has since expanded to support networks like Solana, Polkadot, and Tron.
Crypto-Backed Stablecoins
Crypto-backed stablecoins are supported by other cryptocurrencies rather than fiat.
They typically operate without a central authority, relying on open-source smart contracts. Users lock up crypto assets as collateral to mint new stablecoins, essentially taking out a loan. To account for the volatility of the collateral, these stablecoins are over-collateralized—meaning the value of the locked crypto exceeds the value of the stablecoins issued.
To retrieve their collateral, users must repay the stablecoins, plus any fees. The supply of these stablecoins is managed by smart contracts, which adjust based on market conditions, not by a single entity.
A leading example is DAI, created by MakerDAO, which is one of the most popular crypto-backed stablecoins.
Algorithmic Stablecoins
Algorithmic stablecoins use smart contracts to maintain their price peg, often with the help of a secondary token to balance supply and demand.
Some algorithmic stablecoins, known as rebase tokens, automatically adjust their supply to stabilize their price. If the price rises above the target (e.g., $1), the algorithm mints new tokens and distributes them to holders, increasing supply to lower the price. If the price drops below the target, tokens are burned to reduce supply and raise the price.
Other algorithmic stablecoins use a secondary token with a floating price. Holders can burn one token to receive the other at a fixed rate. For example, if the stablecoin’s price exceeds $1, users can exchange the secondary token for stablecoins, sell them, and profit until the price stabilizes. If the price falls below $1, users can burn stablecoins for the secondary token, reducing supply and supporting the peg.
Algorithmic stablecoins are considered the riskiest type due to their susceptibility to market manipulation. In 2023, the algorithmic stablecoin TerraUSD (UST) and its paired token Luna collapsed in a “death spiral.” A large sell-off of UST caused it to lose its peg, triggering a chain reaction that wiped out nearly $50 billion in market value in just days.
Risks of Stablecoins
While stablecoins aim to reduce volatility, they come with their own risks that can affect their value:
- Issuer Risk: The issuer might face legal, regulatory, or financial issues, leading to a depeg or inability to redeem tokens for collateral.
- Counterparty Risk: If the reserves are held by third parties (e.g., banks), those entities could fail, resulting in a loss of collateral.
- Technical Risks: Algorithmic stablecoins may suffer from bugs, exploits, or failures in their smart contracts, causing the peg to break.
Why Use Stablecoins?
Stablecoins are popular among users who want to avoid the volatility of other crypto assets while staying in the crypto ecosystem.
They’re also borderless, programmable, and easy to transfer at a low cost, making them ideal for global transactions.
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