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What are stablecoins?

September 15, 2022
10 min
What are stablecoins?
Intermediate
You will learn

    Can cryptocurrencies have a stable value, i.e. without price volatility? This is precisely the goal of stablecoins: coins whose price is pegged to the dollar or the euro, or in general to any fiat currency. Let’s find out what stablecoins are in circulation, how they work and delve into how stablecoins are being considered from the point of view of government regulation.

    Stablecoins: what they are and how they work

    Stablecoins are cryptocurrencies that reproduce the value of a fiat currency (such as the euro or US dollar) through a mechanism called pegging. Price stability is maintained through value reserves (in crypto or fiat) or by support through special algorithms. Both of these stability systems counteract the volatility characteristic of cryptocurrencies by managing the supply of the specific stablecoin.

    Stablecoins seek to combine the 3 basic functions of fiat currencies and the peculiarities of the technology from which they originate, namely the blockchain. From this basis we can get a grasp of stablecoins for what they are: cryptocurrencies that aspire to be units of account, stores of value and means of exchange ; all the while enjoying the characteristics of transparency, immutability, traceability and security of the peer-to-peer network of a blockchain.

    Stablecoins allow for global payments to be made at any time in a relatively fast manner. This is because they are managed in a decentralised and seamless way, precisely due to their blockchain-based nature. Furthermore, stablecoins act as a bridge between the classic economy and the crypto world because:

    • Although they are cryptocurrencies, their value corresponds 1:1 to traditional currencies, such as the euro or the dollar.
    • They simplify mental calculations, using the same unitary logic as fiat currencies, thus allowing easier access to services on blockchain.

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

    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.

    Stablecoins: what are they and which are the main types?

    Stablecoins pegged to fiat currencies: USDC and USDT

    There are stablecoins dependent on centralised entities. Although in opposition to the ideals of cryptocurrencies, this set-up is a useful compromise to bring liquidity into the distributed world of the blockchain. Suffice it to say that Tether (USDT) and USDCoin (USDC) respectively occupy the third and fourth places in terms of overall market cap. The Tether (USDT) crypto is in fact issued by the eponymous Tether Ltd, on the basis of a reserve with a value equal to the number of USDT in circulation. In a similar sense, the supply of the USDC crypto is managed by the Centre consortium, formed by the Circle company and the Coinbase exchange. Liquid cash deposited electronically in bank accounts would, of course, be 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 of these centralised stablecoins.

    In other words, Tether and Centre should both keep enough cash to guarantee the conversion of tokens into fiat currency at all times. Does each USDT and USDC really correspond 1:1 to one US dollar? The reserves are private, and are therefore not transparent. However, both USDT and USDC publish monthly third-party audits that are supposed to be independent: accounting reports analysing the nature of the funds. In the past, these reports have shown the presence of US government debt (treasury bills/securities) corporate bonds (corporate bonds), as well as cash. In each case, these assets are controlled by private and sovereign entities. This is 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 it is also possible that the peg is lost. In this case, it is recovered through arbitrage. If the price is higher than the unit, holders will have an incentive to sell their USDT or USDC to make a profit. Conversely, they are likely to buy the stablecoin if the price is lower than the dollar. In a nutshell, arbitrage changes the circulating supply of tokens so as 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. However, both stablecoins are multichain: other blockchains also support them. For example, they also exist on Polygon, Avalanche, Algorand and Solana (you can find full lists here and here).

    Stablecoins pegged to cryptocurrencies: DAI

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

    Firstly, 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 DAI crypto, a cryptocurrency-anchored stablecoin, to maintain the unitary price. Specifically, to create new DAIs, cryptocurrencies are deposited in ‘Vaults‘,  which are 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  the cryptocurrency funds.

    Over-collateralisation 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 in order to keep the price of DAI stable. This level generally corresponds to the Vault Ratio.

    The issuance of the DAI stablecoin is managed entirely by smart contracts (the Vaults). Since the codes are searchable, this increases the transparency and reliability of the protocol. The creation of DAI takes the form of a ‘loan‘. In order to get their deposited cryptocurrencies back, debtors need to pay a variable stability fee. In a nutshell, when the price of DAI falls below $1, the stability fee is lowered to incentivise loan repayments. The returned DAIs are then ‘burned‘, so as to reduce the circulating supply and recover the peg. Conversely, when DAI’s value exceeds $1, the stability fee is raised to reduce demand and therefore lower its value.

    These anti-inflationary measures are actively managed by a decentralised autonomous organisation called MakerDAO. All MKR governance token holders can vote on such decisions and more, thus administering the functioning of DAI. The dependence on a DAO confirms the decentralised nature of the DAI stablecoin.

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

    Algorithmic Stablecoins

    Algorithmic stablecoins are the most recent and innovative example of unit-value stable cryptocurrencies. However, their peg mechanism does not rely on reserves. An algorithm automatically manages the circulating supply of the stablecoin to maintain the peg.

    This logic is based on the concept of scarcity. If necessary, the algorithm decreases the availability of the stablecoin so as to increase the price of the corresponding token and vice versa. This activity is called seigniorage and it’s already a common procedure for central banks. However, it becomes decentralised when it is dependent on the votes of a DAO. Through governance processes,the algorithm’s operation can be decided by the votes of the holders.

    The absence of reserves and collateral leaves algorithmic stablecoins in the domain of code. Pure technology that, although programmed and unbiased, has yet to be adequately tested. The Terra-Luna project’s UST stablecoin is an example of this. Its algorithm proved to be flawed, which then led to failure. Algorithmic stablecoins are an interesting alternative to reserve-based anchoring, but they need further study and research in order to create a stable solution.

    Stablecoin CeFi: CBDC and Regulation

    Especially in the aftermath of the LUNA-UST crash, Centralised finance (CeFi) has become more interested in the topic of stablecoins: in terms of regulation, as well as alternative solutions.

    Cryptocurrencies are by nature independent from the control of an authority and are therefore extremely difficult to regulate. They do not meet the traditional definition of  a ‘currency’, so it is complex to regulate their exchanges. However, the European Parliament is in the process of ratifying the MiCA (Markets in Crypto Assets) bill. It has already been passed but will need to be enforced from 2024. The bill has also set standards for stablecoins, such as requirements for reserves and daily flows.

    In addition, some governments are experimenting with issuing a digital version of their legal tender fiat currencies: so-called Central Bank Digital Currencies. CBDCs could be a competitor for centralised stablecoins as they are similar to the latter: created by private entities, based on traditional currencies and with a goal of making the global economy more accessible and inclusive.

    For now, CBDCs are in an experimental or research phase. Those that exist are based on private blockchains, so-called ‘permissioned’ DLTs. Centralising control makes solutions simpler and more scalable, but also sacrifices the values of privacy, decentralisation and transparency of cryptocurrencies.

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

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