How Do Stablecoins Work and Their Types Explained

Stablecoins are a type of cryptocurrency designed to maintain a stable value, usually pegged to a fiat currency or a commodity.

They were created to mitigate the volatility of traditional cryptocurrencies, allowing users to store value without the risk of price fluctuations.

Stablecoins work by maintaining a reserve of the underlying asset, such as US dollars or gold, to back their supply.

This reserve is typically held in a separate account, ensuring the stablecoin's value remains stable.

The most common type of stablecoin is the fiat-collateralized stablecoin, which is backed by a reserve of a fiat currency.

For example, the USDT stablecoin is pegged to the US dollar and backed by a reserve of actual US dollars.

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Stablecoins are cryptocurrencies that try to maintain a "peg" - the same market value as the external asset they represent.

Their goal is to stay pegged to the value of the currency they're tied to, like a dollar-based stablecoin aiming to stay at $1.

A dollar-based stablecoin will aim to stay pegged to $1, while a gold stablecoin aims to stay pegged to the market price of gold.

They can match the price of the currency they're pegged to consistently through collateralization with external assets or algorithmic mechanisms that adjust supply in relation to demand.

There are two main types of stablecoins: centralized and decentralized. Centralized stablecoins are issued by a single entity, such as Circle with USDC, and are backed by assets held in off-chain accounts with regulated financial institutions.

USDC, for example, can be redeemed for 1 USD, ensuring its 1:1 peg with the US dollar. Other centralized stablecoins include USDT, BUSD, TUSD, and USDP.

Decentralized stablecoins, on the other hand, are maintained by a community of users, such as MakerDAO with DAI, which has users lock up collateral into a smart contract to mint DAI as overcollateralized debt.

Algorithmic coins use a computer program to control the supply of the stablecoin and keep its value stable. This strategy is similar to how central banks maintain the value of a currency, but without the advantages of being the issuer of legal tender.

MakerDAO's DAI is a great example of an algorithmic coin, where users lock up collateral into a smart contract to mint the stablecoin. The smart contract then adjusts interest rates to encourage borrowers to pay back their debt or take out more stablecoin loans.

Algorithmic stablecoin issuers can't rely on the same level of credibility as central banks, as seen with the TerraUSD (UST) algorithmic stablecoin, which plunged in value in 2022. This highlights the risks associated with algorithmic coins.

The MakerDAO protocol has its own set of smart contracts that govern the system, which can be gamed, as seen in 2020 when losses of $8 million were incurred. This shows that even with decentralized systems, there can still be problems.

Ampleforth's AMPL is another example of an algorithmic stablecoin, which uses an elastic supply mechanism to maintain its peg to the Consumer Price Index (CPI) rate. This means that the total supply of AMPL is rebased daily to track the CPI rate.

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Stablecoins are a game-changer in crypto trading, solving the problem of volatility that makes it tough to use mainstream cryptocurrencies for real transactions.

Their stability allows them to be used as a functional currency within a crypto brokerage, making it easier to convert Bitcoin into a stablecoin like Tether, rather than into dollars.

Stablecoins are available 24/7, making them more accessible than cash obtained through the banking system, which is closed overnight and on weekends.

They can also be used with smart contracts, which are electronic contracts that are automatically executed when their terms are fulfilled.

The stability of stablecoins helps circumvent disagreements that could arise when dealing with more volatile cryptocurrencies.

Stablecoins require collateral to maintain their peg, and there are three main types of stablecoin collateral: fiat collateral, digital asset collateral, and commodity collateral. Fiat collateral is the most common type, with the US dollar being the most popular fiat currency used as backing.

Fiat-collateralized stablecoins, such as Tether (USDT) and TrueUSD (TUSD), maintain a reserve of a fiat currency as collateral, assuring the stablecoin's value. These reserves are regularly audited and are maintained by independent custodians.

Digital asset collateral, on the other hand, refers to the wide range of digital assets that natively exist on blockchain networks. MakerDAO's Dai (DAI) stablecoin is an example of a digital asset-collateralized stablecoin, backed by Ethereum (ETH) and other cryptocurrencies worth about 155% of the DAI stablecoin in circulation.

Here are some examples of stablecoin collateral types:

Crypto-collateralized stablecoins, like MakerDAO's Dai, are also overcollateralized to ensure stability. This means that the value of cryptocurrency held in reserves exceeds the value of the stablecoins issued.

Fiat-collateralized stablecoins are the most common type of stablecoin, and they use fiat currencies like the U.S. dollar as collateral. Tether (USDT) and TrueUSD (TUSD) are popular examples of fiat-collateralized stablecoins, backed by U.S. dollar reserves and denominated at parity to the dollar.

These reserves are maintained by independent custodians and are regularly audited, which is a crucial aspect to consider. As of late June 2024, Tether (USDT) was the third-largest cryptocurrency by market capitalization, worth more than $112 billion.

Fiat-collateralized stablecoins maintain a reserve of a fiat currency, assuring the stablecoin's value. This is in contrast to other types of stablecoins that use digital assets or commodities as collateral.

Here are some key features of fiat-collateralized stablecoins:

Commodity collateral refers to the many commodities, such as metals, crops, and energy sources, that exist in the world. These commodities exist off-chain and require a form of redemption mechanism to maintain their peg.

Precious metals like gold are the most popular form of commodity collateral. Protocols such as Cache.gold and Pax Gold offer users tokenized gold that can be redeemed for an equivalent amount of gold.

Some stablecoins, like Tether Gold (XAUt), are backed by gold reserves held by an unnamed custodian in Switzerland. This ensures that the stablecoin's value is fixed to the market value of gold.

Commodity-backed stablecoins generally hold the commodity using third-party custodians or by investing in instruments that hold them. This provides an added layer of security and stability to the stablecoin's value.

Here are some examples of commodity-backed stablecoins:

Stablecoins continue to come under scrutiny by regulators, given the rapid growth of the $162 billion market and its potential to affect the broader financial system.

Regulators are proposing rules that focus on stablecoins that are deemed systemically important by regulators, those with the potential to disrupt payment and settlement transactions.

The International Organization of Securities Commissions (IOSCO) suggested that stablecoins should be regulated as financial market infrastructure alongside payment systems and clearinghouses.

Politicians in the U.S. are increasing calls for tighter regulation of stablecoins, with Senator Cynthia Lummis (R-Wyoming) calling for regular audits of stablecoin issuers in November 2021.

A bill to create a regulatory framework for stablecoins was introduced in 2024 by Senators Lummis and Kirsten Gillibrand, which would prohibit anyone from issuing a stablecoin unless they were a registered non-depository trust or a depository institution with authorization to issue them.

In Europe, the Markets in Crypto Assets Regulation, which took effect in 2023, essentially bans algorithmic stablecoins and requires all other stablecoins to have assets held in custody by a third party.

Reserves must be liquid and have a 1:1 ratio of assets to coins under this regulation.

Stablecoins don't usually get the same attention as other cryptocurrencies, but a few are among the most popular by market capitalization. As of August 2024, Tether (USDT) has a market capitalization of $116 billion.

Tether is one of the most popular stablecoins, followed by USD Coin (USDC) with a market capitalization of $35 billion. Dai (DAI) also makes the list with a market capitalization of $5 billion.

TerraUSD, an algorithmic stablecoin, was another popular option until it lost its peg to the dollar in May 2022. Its price plummeted lower after the decline in crypto markets and loss of confidence in the stablecoin.

Here are the top 3 most popular stablecoins as of August 2024:

Stablecoins are cryptocurrencies that try to keep their value stable by pegging it to something external. This could be a currency like the US dollar or the price of a commodity like gold.

Stablecoins are more useful as a medium of exchange than volatile cryptocurrencies because their value doesn't fluctuate as much. This makes them more reliable for everyday transactions.

Stablecoins achieve price stability in two main ways: by holding reserve assets as collateral, or through algorithms that control the supply of the coin. This helps to keep the value stable and predictable.

Here are some common things that stablecoins are pegged to:

Regulators are keeping a close eye on stablecoins because of their rapid growth and potential impact on the broader financial system. The market for stablecoins has grown to over $162 billion, which is a significant amount of money.