Stablecoins Explained: What They Are and How They Work

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Ihssan El Medkouri

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Ihssan El Medkouri

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Ihssan is a dedicated Content Editor at Crypto News, where she excels in producing well-researched, insightful content. She has made notable contributions to the cryptocurrency industry, including...

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September 9, 2024 22:31 EDT

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Stablecoins are cryptocurrencies designed to maintain a fixed value. They are typically pegged to a fiat currency like the US dollar. Unlike traditional cryptocurrencies, stablecoins offer price stability, making them ideal for payments, remittances, and as a store of value. Examples include USDT, USDC, and DAI.

Types of Stablecoins

There are different types of stablecoins — fiat-collateralized, crypto-collateralized, commodity-backed, and algorithmic. Understanding each type helps you choose the right one for your needs, as they offer varying levels of stability, risk, and use cases.

Fiat-Collateralized Stablecoins

Fiat-collateralized stablecoins are pegged to traditional currencies like the US dollar, euro, or yen. For each stablecoin issued, the issuer holds an equivalent amount of fiat in reserve, maintaining stability in value. Well-known examples include USDT and USDC. They are frequently used in exchanges and DeFi platforms due to their reliability.

Transparency and regular audits are crucial for these stablecoins. Issuers must provide verifiable evidence of their reserves through third-party audits to uphold credibility. Here’s a snapshot of USDC’s reserves composition as an example:

Fiat-collateralized stablecoins are generally more centralized compared to other types. The collateral is held in regulated institutions, which can pose risks such as government intervention or fund freezes. While offering legal clarity, this centralization contrasts with the decentralized ethos of other stablecoins.

Commodity-Collateralized Stablecoins

Commodity-collateralized stablecoins are real-world asset (RWA) coins as they are backed by physical assets like gold, silver, or oil. Their value is tied to these commodities, offering a stable store of value and protection against inflation, since these commodities often increase in value when inflation rises. They let you gain exposure to commodities without handling or storing the physical assets.

For these stablecoins, transparency and secure custody are key. Issuers must prove they have the assets stored safely, typically through regular audits. This builds trust and ensures the stablecoin’s backing is reliable.

As an example, here’s a monthly report of PAXG’s proof of gold reserves:

Crypto-Collateralized Stablecoins

Crypto-collateralized stablecoins are backed by other cryptocurrencies instead of traditional money or physical assets. Because the value of these cryptocurrencies can be volatile, these stablecoins often need over-collateralization, i.e., more crypto backing than the stablecoin’s value. For example, to mint $100 worth of stablecoins, you might need to deposit $150 in crypto to account for volatility.

The screenshot below shows the proof of reserves, with a reserve ratio consistently above 100%. This indicates that the stablecoin is over-collateralized and has more assets backing it than the total value of issued tokens.

These stablecoins are decentralized, which means they aren’t controlled by any single entity. This offers greater resistance to censorship and external interference.

However, it also means they can be slower in reacting to problems and need more complicated management. Decentralized organizations typically handle governance, which can make decisions more democratic but potentially slower.

Algorithmic Stablecoins

Algorithmic stablecoins maintain their value through algorithms and smart contracts rather than being backed by traditional assets. These algorithms automatically adjust the supply of the stablecoin in response to changes in demand to maintain a stable price, typically pegged to a fiat currency like USD.

For example, if the stablecoin’s price rises above its peg, the algorithm increases supply by issuing more tokens, which lowers the price. Conversely, if the price falls below the peg, the algorithm reduces supply by buying back tokens or burning them, which raises the price.

Unlike crypto-collateralized stablecoins, which rely on over-collateralization, algorithmic stablecoins depend on the effectiveness of their algorithms and market mechanisms to maintain stability. However, they can be more volatile and riskier, as seen with the failure of TerraUSD (UST), which lost its peg due to flaws in its algorithmic design.

Developers are working to improve algorithmic stablecoins by refining algorithms, adding stabilization mechanisms, and exploring hybrid models. These efforts aim to reduce volatility, increase reliability, and pave the way for broader adoption.

Lastly, algorithmic stablecoins can be centralized or decentralized. Centralized versions rely on a single entity to manage the algorithm; decentralized models use smart contracts and community governance, promoting transparency but potentially increasing complexity and risk.

How Do Stablecoins Work?

Each type of stablecoin works differently. It’s what sets them apart. They achieve stability through different mechanisms, depending on their type. For example, fiat-collateralized stablecoins are backed by real-world currencies held in reserve. This ensures that each token can be redeemed for an equivalent amount of fiat.

Commodity-collateralized stablecoins are backed by physical assets, like gold or oil. This provides stability through the value of the commodities. Meanwhile, crypto-collateralized stablecoins are backed by other cryptocurrencies and often need over-collateralization to mitigate the volatility of their backing assets.

Finally, we have algorithmic stablecoins. They don’t rely on collateral, but use algorithms and smart contracts to control the supply. The aim is to maintain their peg by controlling token circulation.

Examples of Stablecoins

Since the first stablecoin, BitUSD, was launched in 2014, various stablecoins have emerged. Each type has unique features and drawbacks. In this section, we’ll explore some of the best stablecoins to buy, their protocol, minting mechanism, and use cases.

Tether (USDT)

Tether, also known as USDT, is one of the most widely used stablecoins in the market. It’s backed by a mix of fiat currencies and other assets. USDT keeps its value by pegging its price to the US dollar. This makes it popular for trading and as a store of value.

USD Coin (USDC)

Issued by Circle and Coinbase, USD Coin (USDC) is also widely used. Just like Tether, its value is pegged 1:1 to the US dollar. USDC has become a trusted stablecoin due to its regular audits and transparency, making it perfect for both retail and institutional investors.

Dai (DAI)

Dai (DAI) is issued by the MakerDAO protocol. It’s designed to maintain its value pegged to the US dollar. What sets it apart from other stablecoins is its backing currency. Instead of being backed by one currency, Dai is supported by a mix of currencies, such as ETH and USDC.

Its decentralized nature makes it more popular among DeFi users; it provides stability without relying on any centralized entity.

PayPal Stablecoin (PYUSD)

PayPal USD (PYUSD) is a fiat-backed stablecoin issued by PayPal. It’s designed to offer a seamless way to make crypto payments and transfers online. It’s also backed 1:1 by US dollar reserves.

PAX Gold (PAXG)

PAX Gold (PAXG) is a commodity-backed stablecoin tied to the value of physical gold. Each PAX Gold token represents one fine troy ounce of gold stored securely in LBMA-approved vaults.

The LBMA is a globally recognized authority in the precious metals market, and its approval signifies that the vault meets strict criteria for security, auditing, and transparency.

PAXG allows users to gain exposure to gold without dealing with the complexities of physical ownership. It serves as a bridge between the traditional gold market and blockchain, providing the benefits of digital assets while maintaining the stability of gold.

Stablecoin Regulations

Regulators are monitoring stablecoins because of their growing use in the financial world. Since stablecoins are pegged to traditional assets, regulators want to ensure they are correctly backed and transparent to protect investors.

Different regions are working on frameworks to address various concerns, from financial stability to consumer protection. Let’s explore these regulations:

United States

The Responsible Financial Innovation Act proposes a national framework for regulating stablecoins. This bill requires issuers to maintain high-quality liquid assets equal to 100% of the value of the stablecoins they issue, ensuring full backing at all times.

Additionally, the Clarity for Payment Stablecoins Act aims to establish a clear compliance framework for stablecoins. This act outlines the legal authority for issuing stablecoins, the necessary regulatory oversight, and their classification.

Under these proposed regulations, stablecoins would be regulated by state and federal bank authorities and primarily be issued by depository institutions, avoiding classification as commodities or securities.

United Kingdom

Legislation passed in 2023 gives HM Treasury the authority to regulate fiat-backed stablecoins. This includes overseeing their use for payments, issuance, and custody processes.

The Financial Services and Markets Act 2023 enables the regulation of potentially systemic stablecoins similar to traditional payment systems, with supervision from the Bank of England and the Payment Systems Regulator.

Additionally, the FCA has proposed applying existing regulatory standards to stablecoin activities, requiring issuers to maintain stable, liquid, and well-managed backing assets.

European Union

In the EU, the Markets in Crypto-Assets Regulation (MiCAR) came into effect in June 2023. It introduced two categories of regulated stablecoins: Asset-Referenced Tokens (ARTs) and E-Money Tokens (EMTs).

Issuers must maintain reserves to back their stablecoins and adhere to detailed rules regarding asset composition, liquidity, and management.

Overall, 2023 and 2024 have brought significant progress in stablecoin regulation across major markets. These developments focus on consumer protection, financial stability, and integrating stablecoins into existing financial systems with clearer rules and oversight.

Should You Invest in Stablecoins?

Investing in stablecoins can be an attractive option for many people thanks to their unique features and stability. However, like any other investment, stablecoins come with their own set of benefits and risks that are important to understand before diving in.

In this section, we’ll explore the advantages and potential drawbacks of investing in stablecoins to help you make an informed decision.

Benefits of Investing in Stablecoins

Stablecoins offer several advantages that can make them an attractive investment option, including:

• Reduced Volatility: Stablecoins aim to maintain a stable value, providing a safe haven from the volatility of other cryptocurrencies.
• Easy Transactions: They facilitate seamless transactions and can be used for payments and transfers like traditional money.
• Liquidity: Stablecoins often offer high liquidity, allowing quick and easy access to funds without significant price fluctuations.
• Integration: They are widely accepted across various platforms, exchanges, and DeFi protocols.

Drawbacks and Risks of Stablecoins

While stablecoins offer benefits, such as reduced volatility and easier transactions, they also come with several drawbacks and risks that you should be aware of, such as:

• Lower Returns: Earning interest on stablecoins may not be as lucrative as investing in more volatile assets, since they usually offer lower returns than altcoins.
• Regulatory Risks: Changes in regulations could affect the value or use of stablecoins, as regulators are paying closer attention to them.
• Centralization Issues: Fiat-backed stablecoins depend on central authorities, which can create trust and transparency problems.
• High Costs: Crypto-backed stablecoins often need to be over-collateralized, leading to higher costs and inefficiencies.
• Algorithmic Risks: Algorithmic stablecoins might struggle to maintain their value during market extremes, leading to instability.
• Transparency Concerns: Some stablecoins may not be transparent about their reserves or backing.
• Security Threats: Like all digital assets, stablecoins are at risk of hacking and security breaches, which can endanger your funds.

Final Thoughts on Stablecoins

Stablecoins are key players in the crypto world because of their stability and utility. They are increasingly used for trading, decentralized finance, and as a store of value. However, they also face scrutiny and regulatory challenges.

To address these challenges, developers are tirelessly working on improving transparency, security measures, and robust mechanisms.

To learn more about stablecoins, watch or read our exclusive interview with Conor Ryder, Head of Research at Ethena, who digs deep into the stablecoin trilemma, the differences between stablecoins and synthetic dollars, and stablecoin use cases.

FAQs

What’s the role of stablecoins in the cryptocurrency ecosystem?

Stablecoins play a crucial role by providing stability with little to no volatility, which helps protect crypto traders from market swings. They are also widely used for global payments and remittances, making transactions more efficient and accessible across borders.

What are the most popular stablecoins?

The most popular stablecoins are Tether (USDT), USD Coin (USDC), Dai (DAI), First Digital USD (FDUSD), PayPal USD (PYUSD), USDD (USDD), Frax (FRAX), Tether Gold (XAUT), TrueUSD (TUSD), PAX Gold (PAXG).

What does it mean when a stablecoin “depegs”?

When a stablecoin “depegs,” its value deviates from its intended peg, such as the US dollar. This can occur due to market fluctuations, loss of backing reserves, or instability in underlying mechanisms.

What is the difference between stablecoins and synthetic dollars?

Stablecoins are typically backed by real assets or collateral to maintain a stable value. Synthetic dollars, like those created through decentralized finance protocols, simulate the value of fiat currencies but are not directly backed by physical assets. Examples include USDe, sUSD, and mUSD.

References

• PAXOS: Examination of Management Assertions
• CEX: Proof of Reserves Audit Report
• Circle: Reserves Composition
• CoinDesk: A Timeline of the Meteoric Rise and Crash of UST and LUNA
• US Congress: S.2281 – Lummis-Gillibrand Responsible Financial Innovation Act
• US Congress: H.R.4766 – Clarity for Payment Stablecoins Act of 2023
• UK HM Treasury: Update on plans for the regulation of fiat-backed stablecoins
• UK Public General Acts: Financial Services and Markets Act 2023
• European Securities and Markets Authority (ESMA): Markets in Crypto-Assets Regulation (MiCA)
• Forbes: Top Stablecoins Coins Today By Market Cap