Understanding How Stablecoin Works
Stablecoins have become increasingly important in the rapidly growing decentralized finance (DeFi) sector, which allows for peer-to-peer transactions without intermediaries. Tether and USD Coin are among the most valuable stablecoins in the cryptocurrency market. However, when considering the use of cryptocurrency, it is important to understand that not all stablecoins are the same, and they can carry varying degrees of risk. Additionally, the regulatory landscape for stablecoins is constantly evolving. Therefore, it is essential to have a good understanding of how stablecoins operate before investing in them.
Here are some things to know about how stablecoins work.
What are Stablecoins?
Stablecoins are digital assets whose value is pegged against an external conventional asset such as the U.S. dollar or gold to maintain a stable price.
Stablecoin reduces price volatility by backing its value against a conventional asset. The backing asset could be a combination of currencies, a single fiat currency, or other valuable assets. They are aimed at creating a stable and reliable environment to increase cryptocurrency adoption and negate digital assets’ speculative nature by offering the best of both worlds — security, and decentralization of cryptocurrencies.
How Stablecoins Work
Stablecoins are a form of cryptocurrency that is gaining popularity in the crypto market. They are digital tokens that are minted on a blockchain and can be bought, sold, and traded on various cryptocurrency exchanges like any other cryptocurrency. Stablecoins are designed to have a stable value that is pegged to an external asset like fiat currency or commodities such as gold.
To maintain their value and ensure trust in the system, most stablecoins are backed by a reserve of external assets. This means that for every stablecoin in circulation, there is an equivalent amount of external assets held in reserve. The external assets serve as a guarantee for the stablecoin’s value, ensuring that it can be redeemed at any time for its pegged value.
Types of stablecoins
One important aspect to understand about stablecoins is that they are digital currencies that exist within the blockchain ecosystem. Stablecoins are typically identified by the collateral structures that support them, and four distinct types of collateral structures serve as the basis for different types of stablecoins.
Fiat-collateralized Stablecoins
Fiat-collateralized stablecoins are cryptocurrencies that are pegged to the value of a traditional currency, such as the US dollar. This means one stablecoin always equals one unit of the underlying fiat currency.
The collateral is either a cash reserve or its equivalent. As a result, these stablecoins are typically controlled by central entities. These centralized bodies also have the power to freeze or blacklist addresses to prevent them from using the tokens.
Most fiat-backed stablecoins are collateralized at a 1:1 ratio, meaning that the stablecoin is fully backed by an equivalent amount of the underlying fiat currency. Some examples of popular fiat-collateralized stablecoins include USDC and USDT.
Commodity-backed Stablecoins
Commodity-backed stablecoins are a type of cryptocurrency that is backed by a physical commodity such as gold, silver, real estate, or oil. The purpose of these stablecoins is to provide investors with a more reliable investment option in the cryptocurrency market.
Commodity investors find commodity-backed stablecoins appealing as it enables them to invest in commodities such as gold without having to deal with the complexities of sourcing and storing it themselves. An example of such a stablecoin is Tether gold (XAUT), which is backed by a reserve of gold held in a vault in Switzerland. The value of one XAUT is equivalent to one ounce of gold.
Crypto-backed Stablecoins
Crypto-backed stablecoins are a type of cryptocurrency that is backed by other cryptocurrencies. However, since the backing asset can be volatile, these stablecoins are typically overcollateralized to ensure their stability. This means that the value of the stablecoin is tied to an underlying cryptocurrency asset that is worth more than the stablecoin’s face value.
For instance, a $1 crypto-backed stablecoin might be linked to an underlying crypto asset worth $2. If the underlying cryptocurrency loses value, the stablecoin has a built-in cushion that helps it maintain its value at $1. Therefore, it’s important to monitor the performance of the underlying crypto asset behind the stablecoin, as these assets are generally less stable than fiat-backed stablecoins.
One of the most popular examples of a crypto-backed stablecoin is Dai, which is backed by collateral on MakerDAO.
Algorithmic Stablecoins
Algorithmic stablecoins are digital assets that use algorithms to maintain a pegging to a specific asset, a basket of assets, or another currency. An algorithmic stablecoin relies on two types of tokens to function: a stablecoin and another crypto asset supporting the aforementioned stablecoin. Therefore, the algorithm or smart contract governs the relationship between them.
The advantage of using algorithms is that they can automatically adjust supply and demand to keep the price stable. This type of token is often used as collateral in financial contracts or as a way to store value.
Oftentimes, algorithmic stablecoins will have built-in mechanisms to burn or mint new tokens to stay pegged. This minting and burning mechanism, coupled with price volatility, create an arbitrage opportunity, which incentivizes all traders involved to keep the price stable. Some notable examples of algorithmic stablecoins are TerraUSD, Neutrino USD, and Frax.
Security Risks of Stablecoins
Because cryptocurrencies are largely unregulated, stablecoin providers don’t have to comply with industry standards. Here are some of the risks that investors face with Stablecoins.
- Market and liquidity risks: Stablecoins can be susceptible to runs, which occur when a sudden increase in redemption requests is triggered by events such as a drop in price, rumors of instability, or concerns about the quality of the underlying assets. This can lead to a “fire sale” of the assets that support the stablecoin, potentially causing additional outflows as investors worry that the issuer may not be able to fulfill future redemption requests in their entirety. This can be seen in the case of TerraUST where investors started selling off when there were rumors of instability.
- Smart contract risk: As most decentralized stablecoins live within smart contracts in protocols like Ethereum or Stellar, there’s a risk the algorithm which keeps the currency stable fails. Smart contracts could even be manipulated by a third party. Because “code is law”, updates to the network can have an impact on previous smart contracts — a huge hassle for decentralized projects.
- Reliance on a central authority: One of the biggest concerns with stablecoins is their reliance on a central authority. This goes against the very ethos of cryptocurrencies, which are meant to be decentralized and free from third-party control. With most stablecoins, a central entity holds the fiat or cryptocurrency reserves that back the value of the stablecoin. This means that there is a central point of control and failure. If the central entity collapses or is hacked, the stablecoin could lose its value completely.
- Lack of transparency: There are some issuers of stablecoins who don’t provide proof or information about their reserves, making it difficult to determine if they are adequately supporting their stablecoins. Since there are no industry requirements for audits or reporting, there is concern that these tokens may fail.
- Lack of precision: Stablecoins often deviate in value from their underlying pegs which can undermine confidence in their usefulness. This can be seen in Stablecoins like USDT, USDC frequently ranging between $0.98 — $1.02.
- Regulatory Risk: The lack of clear regulations for stablecoins creates significant uncertainty for both investors and issuers. As different jurisdictions treat stablecoins differently, it can lead to a patchwork of rules and guidelines. This regulatory inconsistency can make it difficult for stablecoin issuers to comply with various requirements in different jurisdictions, leading to increased risk.
Where can I buy stablecoins?
To buy stablecoins you will need to create an account with a crypto exchange or a web3 wallet where you can buy crypto directly. Some services may not be available in all locations, so be sure to check whether the options you want are available where you live. Exchanges like Binance, Kucoin or Coinbase may offer some stablecoins, but such centralized exchanges may list fiat-backed versions only. For more options, you could use a decentralized exchange to swap any existing tokens for most stablecoins.
The future of Stablecoins
The purpose of a stablecoin goes beyond being just a financial contract. It is the evolution of both conventional payment systems and traditional, volatile cryptocurrencies. It is a new form of digital money. Controlled algorithmically instead of by a central authority, and offers similar monetary benefits as fiat currencies. As inherently stable assets, stablecoins could open new doors to the mainstream adoption of digital assets in day-to-day life.
But because of the dangers inherent to stablecoins, governments are exploring new forms of regulation. Hence what we know about the stablecoin in blockchain technology might change in the nearest future.
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