Everything You Need to Know About Stablecoins: How They Work and Their Advantages
Among the vast array of cryptocurrencies, there are tokens that occupy a distinct place in the portfolios of traders and investors: stablecoins. These coins are pegged to fiat currencies, which allows them to maintain a stable price and be less susceptible to the volatility of the crypto market. They provide greater opportunities for risk management, portfolio management, and the creation of flexible trading strategies. In this article, we will explain what stablecoins are, how they work, and how they differ from one another.
What Are Stablecoins?
A stablecoin (from the English words stable and coin) is a cryptocurrency whose value is pegged to a fiat currency or another real asset. These coins are often referred to as “digital dollars,” “digital euros,” or “digital gold.”
Key Characteristics of Stablecoins:
- Pegged Price: The price is linked to the value of a real asset (fiat currency).
- On-chain Transactions: Ability to perform on-chain transactions like any other cryptocurrency.
- Compatibility: Works with crypto wallets, dApps, and DeFi tools.
There are dozens of stablecoins on the market, pegged to various assets, each differing in management models and mechanisms for maintaining a stable price. To understand which type of coin is best used in different situations, let’s delve into some technical details.
Why Are Stablecoins Needed?
Initially, the crypto market traded only cryptocurrencies and native tokens of projects. The market was characterized by low capitalization and high volatility. All trading pairs on exchanges consisted either of volatile assets or a combination of a volatile asset and fiat. If a trader wanted to lock in profits, they would have to exit from cryptocurrency into fiat.
Stablecoins emerged as a solution to these problems, allowing for:
- Profit Locking in Cryptocurrency: Fixing income in crypto without resorting to the services of CEX or exchange platforms.
- Increased Market Liquidity: Stablecoins constitute the majority of trading pairs on CEX and DEX.
- Launching Relatively Low-Risk DeFi Tools: Thanks to stable liquidity pools, staking programs, and farming, stablecoin holders can earn income with lower risk of impermanent loss.
Stablecoins have become the “dollars on the blockchain,” a bridge between fiat and cryptocurrency, eliminating the need to constantly use CEX for converting to stable fiat currency.
Popular Stablecoins
The most in-demand stablecoins in the market are dollar-pegged stablecoins, whose value is linked 1:1 to the US dollar. The most popular coins in this group include:
- USDT — A stablecoin launched by Tether, associated with the Bitfinex exchange. It is available on more than 10 networks and has the largest circulating supply in the market. Without exaggeration, it is the #1 stablecoin by trading volume.
- USDC — A stablecoin backed by the conglomerate Circle, which includes, among others, the Coinbase exchange and one of the largest miners, Bitmain. It positions itself as a fully transparent and reliable stablecoin and is a primary competitor to USDT. It is also available on several networks.
- BUSD — A stablecoin from Binance. It is available on the BSC and Ethereum networks. Its popularity is bolstered by the top exchange Binance, which offers reduced fees and other bonuses for BUSD holders. It is also the main stablecoin for the entire Binance Smart Chain ecosystem.
All of the above stablecoins are centralized, which may deter some crypto enthusiasts. However, judging by trading volumes, security is more important to the market than decentralization.
What Assets Are Stablecoins Pegged To?
In theory, issuers can tokenize any real asset to create a “stablecoin” pegged to a security, resource, or fiat currency. However, in practice, only a few types of stablecoins have become widespread in the market:
- Dollar-pegged: Coins pegged 1:1 to the US dollar. This category includes all of the coins mentioned above, as well as FEI, USDN, USDD, DAI, and others.
- Fiat-pegged: Stablecoins pegged to other fiat currencies. Examples include Binance GBP, Celo EUR, and Eurocoin from Circle. They operate on the same principles as dollar-pegged coins but track the price of other currencies.
- Precious metals: Stablecoins pegged to gold. These coins can reflect the market value of an ounce, gram, or another unit of precious metal. Gold-pegged stablecoins include XAUt, PAXG, DGX, and XAUR.
The emergence of “oil” or “iron” stablecoins is hindered by the need to store the assets they are backed by and logistical issues. However, in theory, such tokens could appear in the crypto market.
How Stablecoins Differ from Each Other
From the previous section, we know that stablecoins can be pegged to various assets, but this is not the only difference. Different coins can also have different mechanisms:
- Collateral and Pegging Mechanism: This can be centralized or decentralized (algorithmic). Algorithmic stablecoins operate without an issuing company. We will explore the pegging mechanism in more detail below.
- Token Standard: This determines which network the coin can be traded on. Some stablecoins are tailored for specific networks, such as USDD for the Tron network, while others are multi-chain assets like USDT. When using the latter, it’s important to check which network you plan to buy or transfer tokens on.
The combination of these characteristics forms the diverse array of stablecoins currently available on the market. Below, we will take a closer look at the main types of stablecoins.
What Are Centralized Stablecoins and Who Manages Them?
Centralized stablecoins are issued and backed by an issuing company (or several companies) that fully manages the coin. These stablecoins use a simple backing mechanism:
- Issuer Funds: The issuer holds funds in a bank account or in other low-risk assets.
- Token Issuance: The company then issues a certain number of tokens on the blockchain at a rate of $1 and guarantees holders that they can redeem each token for $1, if necessary.
- Liquidity Assurance: The constant peg is ensured through liquidity guarantees and arbitrage: if the centralized stablecoin is trading below $1 on an exchange, users can buy it and sell it back to the issuer for $1.
This mechanism is straightforward and reliable but requires trust in the issuer. The stable price can only be maintained as long as the issuer guarantees they can redeem all issued tokens, which means they must have enough fiat and securities on their balance sheet.
Consequently, the reputation of the company and regular independent audits of its balance sheet play a significant role in centralized stablecoins.
Centralized stablecoins are fully managed by the issuer. They can choose to freeze wallets, increase or decrease the available supply of coins, or even refuse to fulfill their obligations to redeem tokens, leaving users with worthless tokens in their wallets.
Advantages and Disadvantages of Centralized Stablecoins
The main advantages of stablecoins, which allow them to capture new markets, include:
- High Liquidity: Since the token’s liquidity is guaranteed by the issuer and their assets, users always have the opportunity to sell the stablecoin at the price of the currency to which it is pegged, regardless of exchange prices and the number of available markets.
- Regulatory Compliance: Issuers are subject to the regulations of the countries in which they operate, providing investors with legal tools to protect their rights. This is especially important for institutional investors and increases trust in the issuer and the coin as a whole.
- Multi-Chain Compatibility: Many centralized stablecoins are launched across multiple networks and can be easily converted through bridges, DEXs, and CEXs, expanding opportunities for traders and investors.
Disadvantages:
- Issuer Risk: Theoretically, there is a chance that the issuer could go bankrupt, refuse to conduct audits, or simply stop redeeming users’ tokens. Tether is an influential player, but it is not the US Federal Reserve, and USDT is not the same as USD; therefore, investors cannot be completely sure of the token’s liquidity.
- Censorship Vulnerability: This is the flip side of regulatory compliance. Stablecoin issuers will comply with regulatory requirements, which could potentially lead to blocking transactions, tracking, user verification, and other unwelcome scenarios.
- Limited Supply: The supply of a stablecoin is always limited by the issuer’s balance. It is challenging for one or even several companies to accumulate enough assets to provide a sufficient volume of stablecoins in the market. This potentially limits the scalability of the coin.
As the weaknesses of centralized coins undermine the core values of the cryptocurrency community (requiring trust and being subject to regulation), decentralized or so-called algorithmic stablecoins have emerged in the market.
What Are Algorithmic Stablecoins?
Algorithmic stablecoins are cryptocurrencies whose value and backing are maintained not through centralized control but automatically via mathematical algorithms. They emerged as a response to the limitations of centralized stablecoins, aiming to eliminate the need for a single entity to manage liquidity and backing.
During 2020-2021, algorithmic stablecoins were marketed as next-generation assets and a “savior” for the cryptocurrency market from centralized structures that require trust. However, following the collapse of Terra and its associated stablecoin, $UST, in spring 2022, investor confidence in algorithmic coins waned, while centralized counterparts began to increase supply and expand into new ecosystems.
Types of Algorithmic Stablecoins
Algorithmic stablecoins can be categorized into several subtypes based on the algorithms employed. To maintain stable pricing and backing, these coins can utilize:
- Overcollateralization: This requires a deposit of cryptocurrency as collateral at a specific collateralization ratio to issue the stablecoin. A well-known example is $DAI, where to obtain $DAI, a deposit of cryptocurrency worth 150% is needed. Thus, to issue 1 DAI, one must lock up cryptocurrency valued at $1.50. This collateral guarantees the liquidity of the stablecoin.
- Rebase: This algorithm manages the coin’s value by automatically decreasing or increasing the number of tokens in circulation.
- Example: If the price of the token falls below $1, the algorithm automatically burns a certain number of tokens, pushing the price upward. Conversely, if the price increases, the algorithm issues new tokens, raising the supply and lowering the price.
- Seigniorage: This mechanism manages price through arbitrage. It involves a combination of a stablecoin and a base token required for its minting.
- Example: $UST and $LUNA. If a user wants to acquire $UST, they must buy $LUNA and then burn that $LUNA to mint an amount of $UST corresponding to the market value of $LUNA. For instance, if LUNA is worth $100, they can mint 100 $UST.
Additionally, it is possible to use combined algorithms or semi-centralized management, where the asset is partially backed by fiat reserves.
The Future of Stablecoins
Since the emergence of the first centralized stablecoins, this asset class has continuously evolved. Several trends are shaping the development of stablecoins:
- Expansion into New Networks and Ecosystems: Market makers and developers have recognized the importance of stablecoins for ecosystem liquidity, leading them to integrate their projects with stable assets in various ways. Major tokens like USDT are launching tokens in new networks, while smaller ecosystems, such as Near, are developing their own stablecoins.
- Regulation: Issuers of centralized stablecoins must comply with the jurisdictions in which they are registered, affecting the coins themselves. For example, after the U.S. Treasury imposed sanctions on several wallets associated with TornadoCash, Circle froze these addresses, effectively locking the USDC held there.
- Search for New Mechanisms of Backing and Maintaining Pegs: The decline in trust towards centralized issuers amid increasing regulation and the collapse of the algorithmic $UST have prompted developers to seek new governance and backing models. A potential new mechanism is being implemented in crvUSD, a stablecoin from the decentralized exchange Curve, although technical details are yet to be disclosed.
Simultaneously, non-government stablecoins may pose competition to Central Bank Digital Currencies (CBDCs) and, following their release, could be viewed as a threat to monetary sovereignty. This might prompt regulators to impose restrictions and bans on stablecoins, putting the future of this asset class at risk in the medium term (~5 years). The issuance of CBDCs by the ECB and the Federal Reserve (the digital euro and digital dollar) will reveal regulators’ true intentions.
Conclusion
Stablecoins are a class of cryptocurrencies whose prices are pegged to fiat currencies or other real assets. Depending on the mechanism for maintaining value and formation, stablecoins can be categorized into:
- Centralized stablecoins
- Algorithmic stablecoins
Stablecoins can be transacted across various blockchains and managed by both decentralized autonomous organizations (DAOs) and traditional companies. Regardless of the governance model, stablecoins represent an essential asset class in the market, as they facilitate the creation of thousands of trading pairs and allow traders to secure profits without exiting the market. Furthermore, stablecoins serve as a bridge between fiat currencies and the cryptocurrency market.