Stablecoins: How Do They Work?
A deep dive into stablecoins that exist on the market and how they work at the fundamental level.
In recent years, stablecoins have become a crucial component of the cryptocurrency ecosystem as a solution to the volatility issues that affect most traditional cryptocurrencies like Bitcoin.
While they are being used all across the ecosystem, they have found their biggest utilization in DeFi. Simply put, DeFi, or decentralized finance, is a new class of products that utilizes the power of blockchain technology to automate transactions eliminating the need for a middleman such as a bank or a broker.
With the stability of a traditional low-risk asset and the flexibility of a cryptocurrency, stablecoins are the perfect case of the best of both worlds in the crypto ecosystem. Even so, not all stablecoins are the same. Different stablecoins use different mechanisms to keep their values stable, and the risks vary depending on which one you choose.
In this article, we’ll discuss some basics to get you started with stablecoins.
What Are Stablecoins?
Stablecoins are a class of crypto assets that aim to provide price stability. They do this by being pegged to external, generally stable, asset classes such as fiat currency. Stablecoins can also work by utilizing algorithms to adjust supply and demand.
This enables them to provide a less risky alternative for storing funds and facilitating payments on the blockchain. But the meltdown of TerraUSD in May 2022, raises the question of whether all stablecoins can guarantee price stability.
How Do Stablecoins Work?
Most stablecoins are pegged to the value of either a fiat currency, such as the US dollar, or a specific commodity, such as gold. Being pegged means that their price is fixed. One stablecoin pegged to the US dollar should be worth one dollar.
To maintain this price peg, stablecoins usually set up a reserve of a single asset or basket of assets responsible for backing the stablecoin, a process known as asset backing. A fiat-backed stablecoin like USDC, for instance, might have $1 million in US dollars in its reserve to act as collateral for $1 million in USDC. In this case, the USDC is backed 1:1.
Should a USDC holder choose to cash out their tokens, an equal amount of the underlying fiat asset, the US dollar, is deducted from the reserve and transferred to the user’s bank account.
Types of Stablecoins
The stability of stablecoins relies on a few basic mechanisms. From these mechanisms, we get the various types of stablecoins, which include fiat-backed stablecoins, crypto-backed stablecoins, commodity-backed stablecoins, and algorithmic stablecoins.
Fiat-backed stablecoins make up the most popular and secure stablecoins. They keep reserves in fiat currencies like the US dollar and usually have one dollar in reserve, either in cash or cash equivalents, for every token in circulation.
Stablecoin reserves are maintained by central entities such as central banks and governments, which conduct regular audits of entities offering stablecoin products and collaborate with regulators to ensure compliance. Users must go through Know Your Customer (KYC) and Anti-Money Laundering (AML) checks to buy stablecoins directly from these issuing entities.
These procedures entail gathering personal information from users, including a copy of their government-issued ID. Most entities offering stablecoin products are exchanges like Coinbase and Gemini, which offer their fiat-backed stablecoins.
Fiat-backed stablecoins include:
- USDC (Coinbase)
- GUSD (Gemini)
- BUSD (Binance)
Crypto-collateralized stablecoins, as the name implies, are backed by other cryptocurrencies (usually ETH). They use smart contracts to secure assets as collateral, contrary to fiat-backed stablecoins, which rely on a central entity to manage the reserve. As such, they can be thought of as a more decentralized version of fiat-backed stablecoins
A crypto-backed stablecoin can be issued to launch one asset on a different blockchain as is the case with Wrapped Bitcoin (WBTC), a stablecoin backed by Bitcoin issued on the Ethereum blockchain.
Crypto-backed stablecoins can also be used to track the value of a fiat currency via blockchain balancing mechanisms that use the stablecoins’ backing to ensure price stability. In this case, a stablecoin is overcollateralized to cushion it from the volatile cryptocurrency market.
When a stablecoin is overcollateralized, it means that the assets backing it are worth more than the market value of the stablecoins. The stablecoin’s stability is further strengthened by regular audits and monitoring tools.
Let’s take MakerDAO’s DAI token at a 200% collateralization ratio as an example. To borrow $100 worth of DAI you would need to collateralize $200 worth of your ETH. This collateralization allows ETH to maintain its peg even when the market becomes extremely volatile. The higher the ratio, the more ETH must fall in value before DAI loses parity with the US dollar.
Commodity-backed stablecoins are backed by physical assets such as precious metals, oil, and real estate reserves. Essentially, these stables are blockchain representations of the commodities backing them.
Commodity-backed stablecoins are centralized, which makes them unappealing to some investors, but it is also the reason why they are less volatile. Also, the commodities used to back these stablecoins can and will fluctuate in price, potentially causing them to lose value.
On the plus side, commodity-backed stablecoins make it simpler to invest in assets that were previously inaccessible to small investors and asset classes that may be unavailable on a local level. For instance, obtaining and storing a real-life bar of gold is difficult and costly in many areas.
Examples of gold-backed stablecoins include Tether Gold (XAUT) and PAX Gold (PAXG).
Algorithmic stablecoins rely on complex algorithms to keep their value stable. They act as central banks, defending their currency’s peg in the market. If an algorithmic stablecoin is pegged to 1 USD and the price rises above the peg, the algorithm buys assets and sells them when the price falls below the peg.
An algorithmic stablecoin will release more tokens into the supply to bring the price down if the token’s price exceeds that of the fiat currency it is pegged to and cut the supply to bring the price back up if the price falls below the fiat currency’s price.
Ideally, the number of tokens you hold changes while their value remains the same. However, as the groundbreaking collapse of TerraUSD demonstrated, algorithmic stablecoins require sufficient demand to remain valuable.
What Are the Best Stablecoins?
Like with any other investment, research is crucial when deciding the right stablecoin. A good stablecoin must be backed by a credible asset reserve. It also needs to have a high trading volume to function as a liquid medium of exchange.
These two factors, when combined, form the foundation for trusting the stability of a stablecoin. To be safer, stick to fiat-backed stablecoins from major exchanges, as they offer the most transparency into their reserves and carry the least counterparty risk.
Here’s a list of some stablecoins you can invest in during volatile cycles in 2023. (Not Financial Advice)
- USD Coin (USDC)
- Binance USD (BUSD)
- Magic Internet Money (MIM)
- Reserve Rights
- PAX Gold (PAXG)
- Tether Gold (XAUT)
- Neutrino USD (USDN)
- Decentralized USD (USDD)
- Frax (FRAX)
- Stablecoins are a class of crypto assets that aim to provide price stability. They do this by being pegged to external, generally stable, asset classes such as fiat currency.
- Stablecoins combine the stability of a traditional low-risk asset and the flexibility of a cryptocurrency to provide a less risky alternative for storing funds and facilitating payments on the blockchain.
- There are four types of stablecoins namely: fiat-backed stablecoins, crypto-backed stablecoins, commodity-backed stablecoins, and algorithmic stablecoins.
- Fiat-backed stablecoins from major exchanges are the safest choice of stablecoins as these entities provide the most insight into their reserves and come with the least counterparty risk.
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Information in the article does not, nor does it purport to, constitute any form of professional investment advice, recommendation, or independent analysis.