How do stablecoins work? A guide to stablecoin cryptocurrencies
Stablecoins are cryptocurrencies whose price is pegged to another asset. We explain them in terms that are easy for beginners to understand.
By Sankrit K
Cryptocurrencies have been around for a few years now, but there has been a recent surge in their popularity.
This is partly due to the volatility of markets, which can see currencies rise and fall in value by huge percentages in a very short time. This makes cryptocurrency very appealing to those who hope to realize large profits in short periods but also very risky. For example, Bitcoin rose by over 300% in just 5 years and then lost over 70% of its value in just over a year.
This volatility is also the reason why most cryptocurrencies are not used for everyday commerce.
Stablecoins are designed to avoid this volatility and provide a less volatile alternative to other cryptocurrencies.
In this article, we will explore what stablecoins are, how they work, and why they play a significant role in decentralized finance.
What are stablecoins?
Stablecoins are cryptocurrencies whose price is pegged to another asset such as the US Dollar or Euro. Even though the price of a stablecoin is pegged to an external asset, it still remains relative to other crypto assets.
For instance, the value of a stablecoin token like USDT or USDC that is designed to always be equal to the value of one US dollar will still fluctuate with respect to other currencies and crypto assets like EUR or BTC.
How do stablecoins work?
There are several ways that stablecoins aim to maintain stability, but the most common method is by pegging the price of the stablecoin to another asset, such as the US dollar, gold, or even oil.
This way, even if the value of Bitcoin or other cryptocurrencies fluctuates significantly, stablecoins will still maintain their relative price stability.
This makes them ideal for use in transactions because you can worry less about the market price going up or down. For example, you could use stablecoins to buy goods and services in the real world, without having to convert back into dollars first. This allows you to save on transaction fees, withdrawal fees, and more.
While investing in cryptocurrencies can yield positive returns, there are several reasons why one might choose to hold on to stablecoins instead. For instance, you could park your funds in fiat money-backed stablecoins (more on these below) in a bear market to avoid volatility associated with many other crypto assets.
Another common use case is for international trade. If you're a business owner looking to buy goods from overseas, then using a stablecoin can eliminate the need to convert your currency into the local one first, saving you time and money. You may however still need to convert your stablecoin into the local currency, unless the counterparty accepts stablecoins as payment.
What are stablecoins used for?
As digital currencies continue to evolve, stablecoins are becoming an increasingly important part of the cryptocurrency landscape. But what are stablecoins used for exactly?
Holding value on-chain
For cryptocurrency investors, stablecoins offer a less volatile option to park their funds. This is especially useful during periods of high market volatility when the prices of most digital assets can fluctuate rapidly.
Stablecoins, however, allow users to take advantage of the stability of fiat currencies without ever going off-chain.
International payments
One of the major hurdles in international payments (remittances) is the need to first convert to fiat and then deal with the various taxes and fees that come with it. This process can be expensive.
With stablecoins, users can quickly transfer value across borders without first converting to fiat. This can make the process much faster and smoother.
Further, the transparency and security of public blockchains like Ethereum mean that there is no need to trust a third party with your funds.
Collateral for loans and credit
Cryptocurrency assets can also be used as collateral for loans and credit. However, the volatile nature of crypto can present a risk to lenders.
With stablecoins, however, lenders may have more confidence that they will receive the same amount of value that was loaned out, regardless of market conditions.
This use case is already being seen with some of the leading stablecoins, such as Dai (DAI) and USD Coin (USDC).
Commodity trading
Trading commodities is a complex and expensive process. From storing the physical commodity to transporting it, there can be several logistical hurdles involved.
With stablecoins, however, users can trade in commodities without having to worry about the complexities of storing and transporting them. Storing a digital file is undoubtedly easier than carrying a bar of gold in today's day and age.
Hedge against hyperinflation
Stablecoins allow anybody in the world to own a stable currency no matter where they live. This can be especially useful if someone is from a country facing hyperinflation.
Citizens of countries like Argentina, Venezuela, and Zimbabwe can hold stablecoins and use them to make international payments.
Did you know? You can pay with stablecoins
Types of stablecoins
There are several types of stablecoins, each with its own advantages and disadvantages. Stablecoins are primarily differentiated based on what collateral they are backed with.
The four types of stablecoins are:
- Fiat-backed stablecoins
- Crypto-backed stablecoins
- Commodity-backed stablecoins
- Algorithmic stablecoins
What are fiat-backed stablecoins?
Fiat-backed stablecoins are cryptocurrencies that are pegged to the value of a traditional currency, such as the US dollar, in an attempt to maintain a value of one stablecoin equaling one unit of the underlying fiat currency.
The collateral backing fiat-backed stablecoins can include cash, government bonds, crypto assets, precious metals, secured loans, and other investments. As a result, these stablecoins are typically controlled by central entities. These centralized bodies also have the power to freeze or blacklist addresses to prevent them from using the tokens.
Most fiat-backed stablecoins are often collateralized in about a 1:1 ratio. USDC and USDT are popular examples of fiat-backed stablecoins.
What are crypto-backed stablecoins?
Crypto-backed stablecoins are cryptocurrencies that are backed entirely by other cryptocurrencies. The most popular example of a crypto-backed stablecoin is Dai, which is backed by collateral on MakerDAO that includes USDC, ETH, and BTC.
But how can cryptocurrency-backed stablecoins be stable when cryptocurrencies are not?
The answer lies in the tokens' balancing mechanisms. DAI, for instance, is over-collateralized, a mechanism designed to maintain the stablecoin’s price even if the collateral value drops greatly. More information on this can be found in their whitepaper.
Wrapped tokens, like Wrapped Ether (wETH) or Wrapped Bitcoin (WBTC), function in a similar manner as stablecoins, because they are backed in a 1:1 ratio. For example, the value of one wETH is pegged to one ETH.
What are commodity-backed stablecoins?
Commodity-backed stablecoins are backed by a physical commodity like gold, silver, real estate, or oil. Each commodity-backed stablecoin attempts to maintain a value equal to a certain amount of that commodity.
The advantage of these stablecoins is that they're backed by an actual asset but are more liquid than the asset itself. You may not be able to sell a barrel of oil stored at home instantaneously, but you could sell its equivalent cryptocurrency.
Stablecoins like Tether Gold (XAUt) and Paxos Gold (PAXG) also allow users to redeem the tokens for the actual asset when they comply with certain guidelines and regulations.
What are algorithmic stablecoins?
Algorithmic stablecoins are digital assets that use algorithms to maintain a pegging to a specific asset, a basket of assets, or another currency.
Algorithmic stablecoins will automatically adjust supply and demand in an attempt to maintain a stable price. This type of token is often used as collateral in financial contracts or as a way to store value.
Oftentimes, algorithmic stablecoins will have built-in mechanisms to burn coins or mint new tokens in order to stay pegged. This minting and burning mechanism, coupled with price volatility, create an arbitrage opportunity, which incentivizes all traders involved to keep the price stable.
Beanstalk (BEAN) is an example of an algorithmic stablecoin that uses a credit-based stability model to maintain its peg.
Each of the above four types falls into one of three additional buckets:
- Collateralized stablecoins
- Over-collateralized stablecoins
- Non-collateralized stablecoins
What are collateralized stablecoins?
Collateralized stablecoins are cryptocurrencies that aim to provide stability by pegging their value to an asset, such as the US dollar.
In order to achieve this goal, collateralized stablecoins issue tokens that can be redeemed for the underlying asset (e.g. USD) at a 1:1 ratio. This means that if the price of the stablecoin falls below the value of the US dollar, holders can simply redeem their tokens and receive cash equal to the current dollar value.
What are over-collateralized stablecoins?
An over-collateralized stablecoin is a cryptocurrency that is backed by a reserve of other assets. The reserve assets can be either government-issued currency or other cryptocurrencies.
The ratio of the value of the collateral to the value of the stablecoin is typically greater than 1:1. This means that if the value of the underlying asset falls, the stablecoin will still maintain its value at $1.
The advantage of over-collateralized stablecoins is that they are much less likely to experience sharp price swings than non-collateralized stablecoins. This makes them ideal for use in commerce and banking applications where price stability is essential. They are also more resilient to attacks from speculators who seek to destabilize the currency.
What are non-collateralized stablecoins?
Unlike traditional collateralized stablecoins that are backed by physical assets like gold or fiat currency, non-collateralized stablecoins are not backed by any assets. Instead, they rely on mechanisms like algorithmic price stabilization to maintain their value.
Non-collateralized stablecoins have become increasingly popular in recent years. Since they are not backed by any physical assets, there is always the risk of them becoming devalued or even collapsing.
Risks associated with stablecoins
As with any trade or investment, using stablecoins can pose some inherent risks that you should be aware of.
Money laundering and tax evasion
The very features that make stablecoins attractive to some, such as their anonymity and cross-border nature, also make them attractive to criminals for money laundering and tax evasion purposes.
This is a big concern for regulators who are already keeping a close eye on the stablecoin space. In fact, the US SEC has already shut down two digital asset exchanges for facilitating unlicensed securities transactions and money laundering.
Sometimes, a user may unknowingly engage in tax evasion by not reporting realized profits through stablecoin trades. Therefore, it is recommended that users keep track of all their trades and file their taxes accordingly and on time.
Theft and loss
Since stablecoins are digital assets; they are susceptible to hacking and theft, just like any other cryptocurrency. In fact, one of the leading stablecoins, Tether (USDT), has itself been hacked several times, with the attackers making off with millions of dollars worth of stablecoins.
Another big risk for users of non-custodial wallets is the loss of private keys. If you lose the private keys to your non-custodial wallet, there is no way to recover your funds. This is why it is extremely important to take all the necessary precautions to keep your private keys safe and secure.
Reliance on a central authority
One of the biggest concerns with stablecoins is their reliance on a central authority. This goes against the very ethos of cryptocurrencies, which are meant to be decentralized and free from third-party control.
With most stablecoins, a central entity holds the fiat or cryptocurrency reserves that back the value of the stablecoin. This means that there is a central point of control and failure.
If the central entity collapses or is hacked, the stablecoin could lose its value completely.
Lack of regulation
Another concern with stablecoins is the lack of regulation in the space. Currently, there are not many regulations governing stablecoins in most countries and they are treated differently depending on the country. This means there can be a lot of uncertainty surrounding their legal status and how they will be treated by regulators in the future.
However, there will be regulation in the near future in some parts of the world, and the number of regulations continues to grow.
Collapse of value
One of the most significant risks associated with stablecoins is the collapse of their value. This can happen for a variety of reasons, such as the loss of reserves, hacks, or even just a change in sentiment.
This risk is even greater for algorithmic stablecoins that are not collateralized. The collapse of Terra Classic USD (USTC) stablecoin as a result of a panic sell-off is an excellent example of this. Even USDC temporarily lost its peg in March 2023, after the collapse of Silicon Valley Bank.
If the value of a stablecoin collapses, it could have a ripple effect across the entire cryptocurrency market. This is because stablecoins are often used for trading other cryptocurrencies. When a stablecoin collapses, this could lead to a sell-off in other cryptocurrencies.
This is why it is essential to be aware of the risks associated with stablecoins before investing in them.
Where can you buy stablecoins?
Stablecoins can help you grow your crypto portfolio. If you are very new to crypto and don’t know how to navigate this space, then starting your journey with MoonPay is the ideal option.
To get started, simply buy cryptocurrency via MoonPay using your credit card or any other preferred payment method.
With MoonPay, you can buy stablecoins like DAI, USDT, USDC, and more.
How to sell stablecoins?
MoonPay also makes it easy to sell stablecoins like USDT and USDC for fiat currency when you decide it's time to cash out your crypto.
Simply enter the amount of USDT, USDC, DAI, or another stablecoin you'd like to sell and enter the details where you want to receive your funds.
Swap stablecoins for more tokens
Want to exchange stablecoins like USDT and USDC for other cryptocurrencies like Ethereum and Bitcoin? MoonPay allows you to swap crypto cross-chain with competitive rates, directly from your non-custodial wallet.
