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What are stablecoins?

Stablecoins are an attempt to create a cryptocurrency that isn’t volatile, but how do they work?

Sep 19, 2021
Edward Wilson

Quick summary

Stablecoins are digital currencies pegged to real-world assets, like a currency or commodity. Achieving this peg varies between stablecoins. In the volatile cryptocurrency markets, stablecoins offer stability, making them ideal for DeFi and cross-border payments.  

Stablecoins are tokens that attempt to peg their market value to real-world assets. This can be currencies like the U.S. dollar or commodities like gold. 

What can you do with stablecoins?

Stablecoins offer an easy way to move from volatile cryptocurrencies to a stable digital currency. But, they have other use cases, and they are:

  • Decentralized finance (DeFi): Stablecoins allow users to earn interest, lend and borrow in DeFi
  • Programmable money: Stablecoins can perform coded instructions through smart contracts creating unique features and functions. 
  • Fighting hyperinflation: Stablecoins enable people and businesses in countries with high inflation to protect their money by moving it out of broken currencies into a stable digital currency. 
  • Global transactions: Transfers with stablecoins are cheap and quick, making them ideal for cross-border payments.  

What type of stablecoins are available?

There is more than one type of stablecoin available. To understand them and how they differ, let's explore:

Fiat-backed

The first type of stablecoin is directly backed on a one-to-one ratio by a fiat currency. That means for every stablecoin created, a custodian, like a bank, will have equal reserves of the fiat currency. These custodians get audited regularly, ensuring that the currency reserves are accounted for to maintain the 1:1 peg. 

Examples of fiat-backed stablecoins are: Tether (USDT), Circle (USDC) and Gemini dollar (GUSD).

Crypto-backed

Crypto-backed stablecoins are similar to fiat-backed stablecoins as they maintain their peg from their collateral. The difference with crypto-backed stablecoins is that the collateral isn’t fiat currency but cryptocurrency. 

Cryptocurrency is volatile, unlike most fiat currencies, meaning that crypto-backed stablecoins require over-collateralization. That means the amount of cryptocurrency needed to issue the stablecoin must be worth more than the amount created.  

For example, a crypto-backed stablecoin may need $2 of ETH for every $1 stablecoin created. If the price of the cryptocurrency falls, then more ETH needs to get added to maintain the peg. Otherwise, the ETH gets liquidated, paying back the debt created to issue the stablecoin.

The best example of a crypto-backed stablecoin is MakerDAOs DAI other examples include Alchemix USD (alUSD) and Magic Internet Money (MIM).

Algorithmic

Fiat and crypto-backed stablecoins use collateral to maintain their peg. However, algorithmic stablecoins exist without collateral. Instead, an algorithm manages the supply to keep the peg. If the price is above the peg, more stablecoins are issued to reduce the price. And, if the price is below the peg, then stablecoins are bought or removed to increase the price. 

Let’s go through an example of an algorithmic stablecoin pegged to the U.S. Dollar. In this example, the stablecoin is at $0.90. To bring this price back to the $1 peg, the number of tokens in circulation gets removed. That means the total amount of stablecoins gets reduced. But, holders of the stablecoin will keep the same percentage of the supply, meaning they don't lose out financially.   

Examples of algorithmic stablecoins are Fei protocol (FEI) and Ampleforth (AMPL)

Commodity 

Commodity-baked stablecoins are backed by commodities such as gold. 

These are currently less popular than the alternative stablecoins, though this is expected to change as the industry develops. 

The best example of a commodity-backed stablecoin is PAX Gold (PAXG) which represents one ounce of gold. 

Hybrid

Hybrid stablecoins combine more than one stablecoin in an attempt to secure the desired peg. Typically, if a stablecoin loses its peg, then the consequences can be disastrous for its holders. In comparison, a basket of stablecoins mitigates this risk. That’s because the other stablecoins will keep the stablecoin afloat.

Reserve (RSV) is an example of a hybrid stablecoin. 

The future of stablecoins

Stablecoins have exploded in growth with no signs of stopping as they’re the backbone of DeFi. But the way see them may change in the future. Currently, a stablecoin is pegged to real-world assets like the U.S. Dollar. But we are now seeing attempts to move away from U.S. Dollar dependency with ‘crypto native’ stablecoins, like RAI, which is backed by ETH. These ‘stablecoins’ are unpegged and are ‘volatile’. Whether they’ll be successful or not is still to be determined. One thing for sure, though, is that stablecoins will continue to innovate.

Further resources 

The Ethereum Foundations guide on stablecoins 

Introduction to stablecoins with Ryan Watkins of Messari -- a podcast by Between2Chains

A blog post on USDC by Fred Wilson

Fighting to be STABLE: the Evolution of Stablecoins

The State of Stablecoins in DeFi: A Deep Dive by DappRadar in The Defiant Newsletter

The rise of stablecoins -- a report by Coinmetrics 

The rise of stablecoins: charts documenting the rise of stablecoins produced by The Block 

Stablecoins: Bridging the Network Gap Between Traditional Money and Digital Value -- brought to you by GMO Trust by The Block Research

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