What are stablecoins?

Are there cryptocurrencies that aim to maintain a stable value, i.e., without price volatility? This is precisely the meaning of stablecoins: coins whose price is pegged to the dollar or the euro or, in general, to fiat currencies. Let’s find out what stablecoins are in circulation, how they work, and what stablecoins are from the point of view of government regulation. 

Stablecoins: what they are and how they work

Stablecoins are cryptocurrencies that aim to replicate the value of a fiat currency (such as the euro or US dollar) through a mechanism called pegging. Price constancy is maintained through value reserves (in crypto or fiat) or supported by special algorithms: both stability systems attempt to counter the volatility characteristic of cryptocurrencies by managing the supply of the specific stablecoin.

Stablecoins seek to combine the 3 basic functions of trust currencies and the peculiarities of the technology from which they originate namely the blockchain. From this, we can understand stablecoins as cryptocurrencies that aspire to be units of account, stores of value, and means of exchange while enjoying the characteristics of transparency, immutability, traceability, and security of the peer-to-peer network of a blockchain. 

These stable cryptocurrencies allow global payments to be made relatively fast at any time because they are managed in a decentralised and seamless manner, precisely through the blockchain. Furthermore, stablecoins act as a bridge between the classical economy and the crypto world because:

As anticipated, there are several ways to ‘peg‘ these cryptocurrencies to the price of another currency, so let’s find out how many of the types of stablecoins are and how they specifically work. 

What are stablecoins: reserves and algorithms

In addition to knowing what stablecoins are, it is also important to understand how many forms they exist in. This way, you can exploit their advantages and consider their limitations. In general, stablecoins can be divided along centralised and decentralised lines, or according to their anchoring: stablecoins pegged to fiat currencies, cryptocurrencies, or managed by algorithms.

There are stablecoins dependent on centralised entities: although in opposition to the cryptocurrency ideal, this setup is a useful compromise to bring liquidity into the distributed world of the blockchain. Suffice it to say that Tether (USDT) and USDCoin (USDC) occupy the third and sixth positions by market capitalisation, respectively. The crypto Tether (USDT) is issued by the eponymous Tether Ltd, based on a reserve with a value equal to the number of USDT in circulation; similarly, the supply of the crypto USDC is managed by the Centre consortium, formed by the company Circle and the exchange Coinbase. Liquid money deposited electronically in bank accounts is the preferred collateral to support the price of $1. For this very reason, the composition of the reserves is a matter of debate for both stablecoins.

In other words, Tether and Centre should always keep enough cash to guarantee the conversion of tokens into fiat currency. Does each USDT and USDC correspond 1:1 to one US dollar? The reserves, being private, are not transparent. Still, USDT and USDC publish monthly third-party audits that are supposed to be independent: accounting reports analysing the nature of the funds. These reports have shown in the past the presence of US government debt (treasury bills/securities) and corporate bonds (corporate bonds), as well as cash: in each case, assets controlled by private and sovereign entities; the second reason why USDT and USDC are called centralised stablecoins.

The price of a fiat-backed stablecoin corresponds to the conversion ratio with the underlying collateral. Ideally, each USDT or USDC should be traded for $1, but the peg may be lost. In this case, the peg should be recovered through arbitrage: holders will be incentivised to sell their USDT or USDC to make a profit if the price is above unity. Conversely, they will buy stablecoin at the downside if the price is below $1. In a nutshell, arbitrage changes the circulating supply of tokens to balance the price: the value of stablecoins fluctuates around $1, depending on the scarcity of supply. 

Tether (USDT) and USDCoin (USDC) cryptos are mainly issued as ERC-20 tokens, built on Ethereum, but both stablecoins are multichains: other blockchains support them, in fact they also exist on Polygon, Avalanche, Algorand and Solana, for example (you can find full lists in the official website: www.circle.com/en/multichain-usdc

Crypto-backed stablecoins use other cryptocurrencies as collateral: they issue tokens based on reserves in Ethereum or Bitcoin, for instance. This makes them much more decentralised, as cryptocurrencies are independent of the control of states and governments. This composition may seem absurd to you: how is it possible to issue stable tokens based on highly volatile cryptocurrencies?

First, the anchoring mechanism provides for over-collateralisation: in practice, cryptocurrencies worth more than $1 are required to generate a crypto-backed stablecoin unit. This allows the crypto DAI, a cryptocurrency-anchored stablecoin, to defend the unit price. Specifically, to create new DAIs, cryptocurrencies are deposited in ‘Vaults‘, reserves usually based on ratios of 1:1.5. In a nutshell, to generate $100 of DAI, you will have to deposit at least $150 worth of collateral: this mitigates the volatility of cryptocurrency funds.

Overcollateralisation is combined with a second anti-volatility mechanism, called the liquidation ratio: when the value of collateral falls below a certain threshold, it is automatically sold to keep the DAI price stable; this level generally corresponds to the Vault Ratio.

The issuance of the stablecoin DAI is managed entirely by smart contracts (the Vaults): the codes are searchable, increasing the transparency and reliability of the protocol. The creation of DAI takes the form of a ‘loan‘: debtors will have to pay a variable stability fee to get their deposited cryptocurrencies back. In a nutshell, when the price of DAI falls below $1, the stability fee is lowered to incentivise the repayment of the loan; the returned DAIs are ‘burned‘ to reduce the circulating supply and recover the peg. Conversely, when DAI exceeds $1, the stability fee is raised to reduce demand and lower its value. 

A decentralised autonomous organisation, MakerDAO, actively manages these anti-inflation measures. All MKR governance token holders can vote on these and other decisions, thus administering DAI’s functioning. The dependence on a DAO confirms the decentralised nature of the DAI stablecoin.

The crypto DAI is exclusively an ERC-20 token supported by the Ethereum blockchain, but it can be generated by depositing different cryptocurrencies besides ETH, WBTC (Wrapped Bitcoin), USDC, and many others. 

Algorithmic stablecoins are the most recent and innovative example of unit-value stable cryptocurrencies. Their peg mechanism, however, has no reserves: an algorithm automatically manages the circulating supply of the stablecoin to maintain the peg.

This logic is based on the concept of scarcity: the algorithm, if necessary, decreases the availability of stablecoin to increase the price of the corresponding token and vice versa. An activity called seigniorage, since time immemorial used by central banks, but, in this case, decentralised if dependent on the votes of a DAO: through governance processes, the functioning of the algorithm could be decided by the votes of the holders.

The absence of reserves and collateral leaves algorithmic stablecoins to the domain of code: pure technology that, although programmed and unbiased, has yet to be adequately tested. The Earth-Moon project’s UST stablecoin is an example of this: its algorithm proved flawed enough to lead the entire network to failure. Algorithmic stablecoins are an interesting alternative to reserve-based anchoring, but further study and research are needed to create a stable solution.

Stablecoin CeFi: Regulation and CBDC

Centralised finance (CeFi) and market regulators, especially after the LUNA-UST crash, have become interested in the stablecoin in terms of regulation and alternative solutions. 

Cryptocurrencies, by nature independent from the control of authority, are extremely difficult to regulate. They need to meet the traditional definition of ‘currency’, so it is complex to regulate their exchanges. The European Parliament, however, has ratified the MiCA (Markets in Crypto Assets) law from 2022 onwards, of which a first block entered into force on 30 June 2024. 

The arrival of European Regulation No. 2023/1114 of 31 May 2023 on Crypto-Activity Markets (MiCA) marked a milestone for stablecoins in the entire European Economic Area (EEA).

MiCA defines stablecoins in two main categories: ART tokens (Asset-Referenced Token) and EMT tokens (E-money Token), for which specific requirements are outlined in Articles 16 and 48 of the Regulation. In addition, the Italian government approved a Legislative Decree on 25 June 2024 to adapt the national regulatory framework to the MiCA Regulation, ensuring coordination with the sector provisions in force in Italy, particularly with the TUB and the TUF.

The entry into force of the MiCA, albeit partial, represented an important turning point for this type of cryptocurrency and for the organisations, centralised and otherwise, that issue them. Today, the only actor to have adapted is the Centre mentioned above consortium. Thus, the only stablecoins recognised by the European Union are USDC and EURC, which were born from the collaboration between Circle and Coinbase.

These two digital assets are both e-money tokens (EMT), and anyone who owns them can redeem them for the same amount of fiat money on a 1:1 basis.

The discourse changes if we focus on USDT, DAI, and PAXG, which are three very different but comparable stablecoins from a regulatory point of view. Tether, Paxos, and MakerDAO have yet to publish any official communication regarding their position on this issue, so it is impossible to determine which category their tokens belong to and whether they comply with the Regulation.

We, the Young Platform, are constantly monitoring the situation to update our users promptly on any news regarding stablecoin compliance.

To conclude this article, we must remember the Central Bank Digital Currencies (CBDC), the digital version of fiat currencies whose issuance has been experimented with by some g. CBDCs could represent a competitor for centralised stablecoins, being similar to the latter: created by private entities based on traditional currencies to make the global economy more accessible and inclusive.

CBDCs are currently in the experimental or research phase. Those that exist are based on blockchain or private, so-called ‘permission’ DLT: centralising control makes solutions simpler and more scalable. Still, it sacrifices the values of privacy, decentralisation, and transparency of cryptocurrencies.

It’s the same dilemma that spawned DeFi: to understand what stablecoins are, one has to move away from the technical level and get back to the values of the crypto world. Is a stablecoin a cryptocurrency if it is centralised and based on fiat currencies? What are true crypto stablecoins, perhaps only decentralised ones? In any case, time will recognise the best stablecoin in the most widely used one: will USDT and USDC retain their dominance or will a new algorithmic solution provide more stability?