How Do Stablecoins Work?

Cryptocurrencies are highly volatile, and the current market situation is only emphasizing their notorious reputation. But crypto space also offers an alternative – tokens that don’t fluctuate in price but comply with all other aspects of cryptocurrencies. These so-called stablecoins are built upon another coin’s blockchain and function as utility tokens. 

Why doesn’t the price of stablecoins change?

Stablecoins avoid volatility by one of the two methods – collateralization or smart contract. 

When we speak about stablecoin being pegged to the US dollar, this means that in theory each stablecoin is collateralized or backed up by one USD. In the case of Tether (USDT) with the current market cap of roughly $83 billion, this means that the Tether company holds $83 billion of fiat reserves as collateral for their stablecoin. 

Fiat collateralization

Fiat collateralization has its downsides. The money reserves are at risk of potential embezzlement or theft. What is more, transparency of collateralization is weak, because it’s extremely hard to prove that a company really holds the necessary funds to back the stablecoin in question. These stablecoins are also inherently centralized because they need a trusted custodian to store their fiat reserves. 

Despite these issues, fiat collateralization has proven to be one of the safest and most stable models so far. 

Crypto collateralization

Stablecoins are pegged to another cryptocurrency, making this model completely decentralized. Due to the volatility risk of the used crypto coin, this system needs to ensure over-collateralization. This means that every stablecoin there needs to be pegged to more than one USD worth of cryptocurrency. Crypto collateralization offers faster and less expensive liquidity and is completely transparent. On the other hand, this model is quite complicated and thus less appealing for implementation and adoption. It is also less stable than fiat collateralization and could crash in case of bigger price drops in the market. This is the case of this week’s TerraUSD crash.

Non-collateralization or smart contract 

Algorithmically pegged stablecoins run on smart contracts which can easily be audited and are thus 100% transparent but are much more volatile. There are three algorithm models used in non-collateralization: Rebase / Debase, Empty Set Dollar and Seigniorage Supply, and Fractional Algorithm Stablecoin.

Seven of the most used stablecoins in the market

• Tether (USDT) – Ranked third on the CoinMarketCap, this stablecoin is pegged at 1-to-1 with a matching fiat currency and is backed 100% by Tether’s reserves.
• True USD (TUSD) – One of several TrustToken’s stablecoins that is pegged 1-to-1 to USD. 
• USD Coin (USDC) – Product of Circle and Coinbase collaboration, this stablecoin is fiat-backed and issued by regulated and licensed financial institutions that maintain full reserves of the equivalent fiat currency. 
• Binance USD (BUSD) – Binance’s stablecoin is backed 1-to-1 by USD, approved by the New York State Department of Financial Services (NYDFS), and issued in partnership with Paxos.
• Gemini Dollar (GUSD) – Regulated and 1-to-1 USD-backed stablecoin issued by Gemini.
• DAI (DAI) – An Ethereum-based stablecoin that is crypto-collateralized by a mix of other cryptocurrencies and managed by the Maker Protocol and the MakerDAO. 
• TerraUSD (UST) – Crypto-collateralized by its sister cryptocurrency token TerraLuna (LUNA). It’s also the topic of the week as it broke its stability and fell to 30 cents.

Why do companies decide to create stablecoins?

Each company has its own interest when it comes to building its own stablecoin. Some companies charge a certain fee for trading their coin, while others use it as the company’s marketing tool. Stablecoins can indeed attract more users to trading platforms and facilitate the transition of funds within and in between exchanges. 

Just how stable is a stablecoin?

We can conclude that stablecoins are an excellent medium of exchange. They represent the best of both worlds; they inherit some of the most powerful properties of crypto, like immutability, transparency, security, fast transactions, privacy, and low fees while also keeping the trust and stability of real-life fiat currency. Because of these characteristics, they ease trading and facilitate mass crypto adoption. 

Just like they inherit the best of both worlds, stablecoins also include the worst of traditional and crypto finances. Being a cryptocurrency, they offer no insurance in case of price downfall or any collateralization issue. And since they need outside governance to ensure that the peg holds, many believe that they are not really decentralized.  

It has been proven many times before that it is extremely hard and costly to maintain the peg which is why many stablecoins have failed in the past. A similar story has been unfolding in front of us in the last couple of days and only time will tell what the true reason for the prominent TerraUSD downfall was. But all of these are growing pains in the short run.

The main question for the long run is if there will still be a need for stablecoins once cryptocurrencies achieve a higher market cap and become less volatile. Only time will tell.

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