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What Are Stablecoins and Why Do They Exist?

As the name suggests, stablecoins are designed to remain stable. Essentially, stablecoins are dollars in digital form. Except that’s not necessarily always true because stablecoins can be algorithmically tied to any fiat currency, including Euro, Sterling, and others, as well as other form of assets like gold.

In the volatile cryptocurrency market, stablecoins have become a safe haven of stability, and have gained high popularity among investors. By virtue of being non-profit oriented, they are predictable, and hence why stablecoins rank among the top 10 of all cryptocurrencies by market capitalization.

Now let’s take a look at how stablecoins work…

What are the mechanics of a stablecoin?

Stablecoins generally work the same way across the board: they are blockchain-based cryptocurrencies that traders can buy, sell, and trade on exchanges just like any other cryptocurrency. Stablecoins can be stored in wallets or cold storages just like they would with Bitcoin or any other cryptocurrency.

Strictly speaking, a stablecoin is a cryptocurrency pegged to the price of a dollar or other fiat currencies, precious metals, or another valuable asset. The price of a stablecoin mirrors the price of the asset to which it was meant to peg to; for instance, a US dollar stablecoin will, theoretically, always trade at $1.

In order to achieve credibility, most stablecoins are backed by a reserve of external assets of some type, whether it’s a cache of fiat currency, commercial notes, commodities like gold, or debt instruments in order to maintain their integrity. Generally, the company or protocol behind a stablecoin will have reserves equivalent or more to the number of stablecoins in circulation. This means that at any given time, each stablecoin holder may choose to redeem the stablecoin with the issuer for one dollar or the associated pegged asset.

There are four types of stablecoins:

These four different types have their own way of fixing the value of the stablecoin to maintain a stable figure:

1. Fiat-backed
2. Cryptocurrency-backed
3. Commodity-backed
4. Algorithmic

Fiat-backed stablecoins:

By far the most popular type of stablecoin; it is backed in a 1:1 ratio by physical fiat currency housed in vaults of the token issuer. A centralized authority oversees a stablecoin and ensures that sufficient cash or cash-equivalents are held in reserve.

The benefit of fiat-backed stablecoins is that they have proven to be trustworthy overtime. The concept of fiat-collateralized cryptocurrencies is simple to grasp, and consumers are aware of how they hold their value. However, not all fiat-backed stablecoin issuers are sufficiently transparent. Some issuers are routinely criticized for not being audited frequently enough. Although the opposite is also true, with some issuers being heralded by the community to be extremely transparent.

On the other hand, fiat-backed stablecoins are not decentralized by nature, and often are subject to public scrutiny and regulations. Such fiat-backed stablecoins as Tether (USDT) and USD Coin (USDC) are the most popular cryptocurrencies in the world, taking the 3rd and 5th position by market capitalization.

Cryptocurrency-backed stablecoins:

This category of stablecoins is backed by other cryptocurrencies — or more specifically, over-collateralized cryptocurrency debt positions. They function entirely on the blockchain, and their collateralization method is open to all; hence, they are the most transparent type of stablecoin as the reserves are recorded on the public ledger to be viewed by anyone.

MakerDAO, for example, is one of the most widely adopted cryptocurrency-backed stablecoins. Users can interact with MakerDAO through smart-contracts to deposit Ether (ETH) to the protocol to mint (or issue) the DAI stablecoin. This is essentially a loan by MakerDAO to the user where the deposited ETH is used as collateral. If the loan value reaches a certain threshold relative to the collateral (i.e. when ETH loses value), the smart-contract will self-execute and sell the ETH to cover its own principal — in order to maintain the integrity of its stablecoin.

Commodity-backed stablecoins:

Although not very popular, commodity-backed stablecoins do exist. Their value is pegged to the value of commodities like precious metals, industrial metals, or oil. The distinctive feature of such stablecoins is that their price is not pegged to a unit of fiat currency like the other categories.

The goal of such stablecoin is to allow retailers ease of access to trade commodities in a permissionless manner. Tether Gold (XUAT) is an example of a commodity-backed stablecoin. The currency is backed by a reserve of gold held inside a vault in Switzerland. One XAUT represents and tracks the price of one ounce of gold.

Algorithmic stablecoins:

Unlike the other categories, algorithmic stablecoins are not backed by any real-world asset, fiat, or cryptocurrencies. In fact, they are not backed by any assets at all. They rely entirely on supply and demand forces.

Here’s how it works: let’s say the stablecoin is trading above $1, this means there is high demand for the token. To return the price back to $1, the algorithm mints extra supply — thus, lowering the value until the token reaches $1. On the other hand, when the stablecoin is trading below $1, the algorithm burns the supply — thus, increasing the value until the token reaches $1. This is essentially how TerraUSD (UST) functions against the LUNA token.

Closing Thoughts

In the wildly volatile world of cryptocurrencies, stablecoins offer a way for investors to achieve stability in their own portfolios. Stablecoins act as a neutral ground or a liquidity trading pair against the various cryptocurrencies. They are popular because they offer predictable and constant form of value. There are more than a handful of stablecoin options on the market, which vary by the way their value is maintained. There is no single best stablecoin, but rather, the choice of choosing between the options should depend on the profile and purpose of the user. Different options offer different security levels, transparency levels, and stability levels. The ultimate choice on which option is best will depend on the profile of the end-user.