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What Is A Stablecoin: Comprehensive Guide for Beginners

Cryptocurrency prices experience significant changes over short periods, unlike traditional assets. The price movement in crypto is also easily influenced by market demand, sentiment, regulatory developments, adverse news, and technological progress.

This volatile nature created a demand for a unique digital asset class that will maintain a stable value at all times. Stablecoins emerged and became a steady anchor in the stormy seas of the crypto market. But what exactly are they, and how do they maintain a relatively constant value?

In this comprehensive guide, we discuss stablecoins, uncovering their mechanisms, use cases, and their role in reshaping the future of digital finance.

What is a stablecoin?

A stablecoin is a cryptocurrency (token) whose market value is attached to another stable asset, such as fiat currency, precious metals, oil, or securities. Stablecoins can be used for both investing and payment of goods and services. For example, a bitcoin can change its value up to 50% in six months, while stablecoin USDT is always worth $1 (although the value can fluctuate by fractions of several cents).

A stablecoin is a fixed-rate cryptocurrency whose market value is pegged to a stable asset (gold, traditional currency).

Stablecoins are necessary to create a stable and reliable environment, increase cryptocurrency adoption, and reduce the speculative nature of digital assets. They provide the best of both worlds, combining the security and decentralization of cryptocurrencies with the stability of fiat currencies.

Key facts

  • Stablecoins are cryptocurrencies whose market value is tied to some traditional asset.
     
  • As a medium of exchange, stablecoins are more valuable than volatile cryptocurrencies like Ether and Bitcoin.
     
  • Stablecoins can be pegged to a fiat currency, such as the US dollar, or the price of a commodity, such as gold.
     
  • Stablecoins maintain price stability by holding reserve assets as collateral or using algorithmic formulas to control supply.
     
  • Regulators often scrutinize stablecoins due to the $128 billion market's rapid growth and its potential to disrupt the broader financial system.
     

Types of stablecoins 

Stablecoins are classified into four types: Fiat-collateralized, Crypto-backed, non-collateralized, 

What are fiat-collateralized stablecoins?

Fiat-backed stablecoins are a category of stablecoins that derive their value from traditional fiat currencies, such as the US Dollar (USD), Euro (EUR), or British Pound (GBP). These stablecoins maintain a stable value by pegging their value directly to a specific fiat currency on a one-to-one basis.

How fiat-backed stablecoins work

Issuers of fiat-backed stablecoins hold an equivalent amount of the underlying fiat currency in reserve to back the stablecoin tokens in circulation. This collateralization ensures that the stablecoin maintains its pegged value.

Redemption mechanism
Users can usually redeem or exchange the stablecoin for the underlying fiat currency at a 1:1 ratio. This mechanism provides confidence in the stablecoin's value and ensures its stability.

Transparency and auditing
Reputable issuers of fiat-backed stablecoins often undergo regular audits by independent third parties to verify that the amount of fiat held in reserve matches the number of stablecoins in circulation.

Regulatory compliance
Issuers of fiat-backed stablecoins typically operate within the bounds of relevant financial regulations, like complying with anti-money laundering (AML) requirements.

Use cases
Fiat-backed stablecoins serve as a reliable medium of exchange, a unit of account, and a store of value. Traders often use them as a haven during periods of high market volatility.

Examples
Examples of popular fiat-backed stablecoins include Tether (USDT), USD Coin (USDC), and TrueUSD (TUSD), among others. Each of these stablecoins is pegged to the value of the US Dollar.

What are Crypto-backed stablecoins?

Crypto-collateralized stablecoins are a type of stablecoin that derive their value from a reserve of cryptocurrencies rather than traditional fiat currencies. Unlike fiat-backed stablecoins pegged to a specific fiat currency, crypto-backed stablecoins use a combination of smart contracts and blockchain technology to maintain their stability.

How crypto-backed stablecoins typically work

Instead of holding fiat currency reserves, crypto-backed stablecoins are backed by a pool of other cryptocurrencies, often called collateral. The collateral value is typically higher than the value of the stablecoins in circulation.

Smart contract mechanism
Smart contracts govern the issuance and redemption of crypto-backed stablecoins. These contracts automatically adjust the amount of stablecoins in circulation based on the value of the collateral. If the value of the collateral decreases, the smart contract may require additional collateral to be added to maintain the stablecoin's value.

Over-collateralization
Crypto-backed stablecoins use an over-collateralization ratio to ensure stability and account for potential market fluctuations. This means that the value of the collateral must be higher than the value of the stablecoins in circulation.

Liquidation instrument
If the value of the collateral falls below a certain threshold, the smart contract may automatically liquidate a portion of the collateral to maintain the stability of the stablecoin.

Decentralized governance
Some crypto-backed stablecoins operate on decentralized platforms, where a community of token holders decides on collateral requirements and other parameters through a decentralized governance mechanism.

Examples
Examples of popular crypto-backed stablecoins include DAI (collateralized with various cryptocurrencies on the Ethereum blockchain) and sUSD (collateralized with the Synthetix network's native token, SNX).

Crypto-backed stablecoins offer a decentralized and algorithmic approach to achieving price stability within the cryptocurrency ecosystem. They provide an alternative to fiat-backed stablecoins and have found use cases in decentralized finance (DeFi) platforms and other blockchain-based projects.

What are algorithmic stablecoins?

Non-collateralized stablecoins, or algorithmic stablecoins, are stablecoins that do not rely on holding a reserve of collateral to maintain their stability. Instead, they use algorithmic mechanisms and smart contracts to manage the supply and demand of the stablecoin to stabilize its price.

How non-collateralized/algorithmic stablecoins work

Non-collateralized stablecoins use sophisticated algorithms and smart contracts to manage the stablecoin's supply and keep its price stable.

Seigniorage shares
Users of non-collateralized stablecoins may hold tokens representing a share in the network's seigniorage. Seigniorage is the difference between the value of the stablecoins in circulation and the cost of creating them. Holders of these tokens may participate in governance decisions and receive rewards.

Market dynamics 
The algorithm considers various market factors, such as the current price of the stablecoin, trading volume, and demand. Based on these factors, it may trigger mechanisms to mint new stablecoins or implement measures to reduce the supply.

Elastic supply

Non-collateralized stablecoins have an elastic supply, meaning the total number of stablecoins in circulation can expand or contract as needed to maintain price stability. This contrasts with collateralized stablecoins, which are backed by a fixed amount of collateral.

Examples 

Examples of non-collateralized stablecoins include Ampleforth (AMPL) and Terra's failed stablecoin algorithm, which utilizes a dual-token system (LUNA and Terra) to stabilize the value of the Terra stablecoin.

What are commodity-backed stablecoins?

Commodity-backed stablecoins are a type of stablecoin that derive their value from a reserve of physical commodities, such as precious metals (e.g., gold or silver) or other tangible assets. 

These stablecoins are designed to offer stability by pegging their value to the price of the underlying commodity.

How commodity-backed stablecoins work

Issuers of commodity-backed stablecoins hold a reserve of the chosen physical commodity. The stablecoin's value is directly tied to the value of this commodity. For instance, if a stablecoin is backed by gold, one unit of the stablecoin is intended to be equivalent to a specific weight of gold.

Redemption mechanism 
Users can usually redeem or exchange the stablecoin for the underlying commodity at a predefined conversion rate. This ensures that the stablecoin maintains its value relative to the chosen commodity.

Storage and custody
The physical commodity used to back the stablecoin needs to be stored securely. This often involves using specialized custodial services or vaults to ensure the integrity and safety of the collateral.

Examples of commodity-backed stablecoins include PAX Gold (PAXG), backed by physical gold, and Tether Gold (XAUt), collateralized by gold held in a Swiss vault.
 

Why stablecoins are important?

Adopting cryptocurrencies as a direct replacement for fiat currency requires stability because a volatile currency can reduce the holder's purchasing power. Overall, stablecoins play a crucial role in expanding the utility and adoption of cryptocurrencies by providing a reliable, stable unit of value within the digital economy. We have compiled a list of advantages that the stablecoin market provides.

1. Stable prices

Stablecoins offer a more secure option for those looking to avoid the substantial price swings associated with other digital assets by being pegged to a widely recognized asset like a fiat currency (e.g., USD, EUR). This stability provides a reliable store of value, making stablecoins less susceptible to the extreme price fluctuations common in other cryptocurrencies.

2. Facilitates trading and transactions

Stablecoins serve as a reliable medium of exchange within the crypto space. Traders often use stablecoins to quickly move in and out of positions, avoiding the need to convert to fiat currencies, which can be time-consuming and costly.  Stablecoins are also versatile and can be used as collateral in decentralized finance (DeFi) applications.

3. Facilitates cross-border transactions

Stablecoins can enable seamless cross-border transactions. Their stable value and blockchain technology allow for swift and cost-effective international transfers, bypassing traditional banking systems and their associated fees and delays. 
Financial institutions such as Wells Fargo and JP Morgan are exploring using stablecoins as an efficient solution for settling international payments.

4. Enables financial inclusion

Stablecoins have the potential to bring financial services to unbanked or underbanked populations around the world. By providing a stable unit of account and a means of exchange, stablecoins can offer financial services to people excluded from traditional banking systems.

5. Combines privacy and security

Stablecoins can offer privacy and security comparable to traditional cryptocurrencies. Users can take advantage of blockchain technology's privacy features while enjoying the stability of a fixed-value asset.

6. Hedging against market volatility

Traders and investors often use stablecoins to hedge against other cryptocurrencies' volatility. When the market experiences turbulence, they can move their funds into stablecoins to preserve their capital.

During a bear market, traders can quickly convert their Bitcoin, Ethereum, or other crypto assets to stablecoin. Traders can also increase their crypto holdings by using comparison services and entering and exiting markets with stablecoins rather than converting them to fiat currency.

7. Smart contract functionality

Stablecoins built on blockchain platforms like Ethereum can be programmed using smart contracts. This enables them to be integrated into decentralized applications (DApps) and DeFi protocols, opening up a wide range of use cases beyond simple transfers.
 

Most popular stablecoins and their history

Since the dot-com boom, there has been a desire to digitize fiat and reduce its permissions. Entrepreneurs and institutions experimented with creating a digital dollar, and the journey began with the launch of BitUSD.

BitUSD: the first stablecoin

BitUSD debuted in 2014 as a token on the BitShare blockchain and was the first stablecoin. Created by Charles Hoskinson and Dan Larimer, the token was backed by BitShares' core token, BTS, and collateralized by various other cryptos, all of which were locked in a smart contract to act as collateral. 

BitUSD lost 1:1 parity with the US dollar in 2018 and has yet to recover. BitMEX's detailed analysis of BitUSD revealed the stablecoin's flaw: it was collateralized with an obscure, volatile, and unbacked asset, BitShare.

Tether (USDT)

Tether (USDT) is one of the most widely used stablecoins in the cryptocurrency market, known for its peg to the value of the US Dollar. 

Tether was launched in 2014 by Realcoin, which was later rebranded as Tether Limited. The goal was to create a stable cryptocurrency to maintain a 1:1 peg with the US Dollar.

2015 - Omni protocol: Tether was initially built on the Bitcoin blockchain using the Omni Layer protocol, which allowed the issuance of assets on the blockchain. Each USDT token represented a claim to one US Dollar held in reserve.

2017 - Expansion to Ethereum: In September 2017, Tether began issuing USDT tokens on the Ethereum blockchain using the ERC-20 standard. This expansion allowed Tether to leverage the capabilities of the Ethereum network.

2017-2018 - Controversies and auditing concerns: Tether faced scrutiny over its claims of being fully backed by US Dollars. Experts raised concerns about the lack of independent audits to verify Tether's reserves. Tether claims it does not disclose its audits because it does not want regulators to know how US dollars are converted into Tether.

2018 - Partnership with Deltec Bank: In November 2018, Tether revealed that it had established a banking relationship with Deltec Bank & Trust Limited, a Bahamas-based financial institution. Deltec confirmed that Tether had a sufficient amount of USD reserves.

2019 - Launch on additional blockchains: Tether expanded further by issuing USDT on various blockchain platforms, including Tron (TRC-20) and EOS (EOSIO).

2020 - Regulatory scrutiny: Tether and its affiliated company, Bitfinex, settled with the New York Attorney General's office over allegations that they covered up the loss of approximately $850 million in customer funds. As part of the settlement, Tether agreed to pay an $18.5 million fine and provide regular reports on its reserves.

2021 - Market dominance: Tether remains the most widely used stablecoin in the cryptocurrency market, with billions of dollars in daily trading volume.

USD Coin (USDC)

USD Coin (USDC) is a widely used stablecoin in the cryptocurrency space. USD Coin was introduced in September 2018 by CENTRE — a consortium founded by Circle and Coinbase. However, Circle is the sole issuer of stablecoin tokens. Circle also owns the Poloniex exchange and has Goldman Sachs and Baidu as investors.

It was designed to be a stablecoin pegged to the US Dollar, with the aim of providing a reliable digital representation of fiat currency.

USD Coin was launched on the Ethereum blockchain. Initially, it was only available as an ERC-20 token, which operated on the Ethereum network.

Protocol

USDC is currently issued on multiple blockchains, but it was first introduced in 2018 on the Ethereum blockchain. Rising gas fees on the Ethereum network pushed the token's launch to other networks with lower fees. As a result, the coin was distributed across multiple networks, including Algorand, Solana, and Stellar.

In March 2021, USD Coin became one of the first stablecoins to be integrated into Visa's payment network. This allowed businesses to settle transactions using USDC, further increasing its utility.

Use cases

USDC can be bought and sold on Coinbase, Poloniex, Binance, and other exchanges such as Huobi. The stablecoin is also compatible with several decentralized finance protocols. Traders value USDC as a stable asset that helps them avoid market volatility.

USD Coin continues to evolve with ongoing efforts to enhance its interoperability and functionality across various blockchain networks. It remains a pivotal stablecoin in the cryptocurrency ecosystem.

In August 2021, USD Coin's market capitalization reached over $27 billion, solidifying its position as one of the leading stablecoins in the crypto market.

DAI Token

DAI, which debuted in 2017, is an Ethereum-based stablecoin with a fixed price of one US dollar. The MakerDAO lending system also makes use of the ERC-20 stable token. Self-executing smart contracts are used to keep the price of each stablecoin in check. If the price rises or falls, DAI tokens are created or burned to keep the price at one dollar.

Protocol 

The DAI protocol is an open-source platform that anyone can use to generate tokens against crypto collateral assets by depositing said crypto collateral via the Oasis app. DAI was initially launched with only Pooled Ether (PETH), obtained by depositing ETH into a smart contract. 

Use cases

DAI is a non-collateralized stablecoin created by the MakerDAO project — a decentralized platform on the Ethereum blockchain. In December 2017, DAI was officially launched on the Ethereum mainnet and designed to maintain its value at 1 US dollar by using over-collateralization and smart contracts.

In November 2019, MakerDAO introduced Multi-Collateral DAI (MCD), allowing users to collateralize assets beyond Ethereum. This expanded the range of assets that could back DAI.

Black Thursday and emergency shutdown

In March 2020, a significant market crash led to increased volatility in the cryptocurrency markets. This caused issues for MakerDAO, resulting in an emergency shutdown to protect the stability of DAI. 

Later that year, in November 2020, MakerDAO transitioned from MCD to Single-Collateral DAI (SCD), which allowed users to migrate their existing Collateralized Debt Positions (CDP)to the new system.

Since 2021, DAI has seen significant growth in adoption and usage. It became a widely used stablecoin in decentralized finance (DeFi) protocols and saw integrations across various platforms and exchanges. DAI remains a prominent stablecoin in the DeFi ecosystem.

The future of stablecoins

A stablecoin serves more than just as a financial contract. It represents the evolution of traditional payment systems and conventional, volatile cryptocurrencies.

However, governments are getting involved with new forms of regulation. The Biden administration stated in 2022 that they hope to regulate stablecoin issuers in the same way that banks are regulated.

To do that, issuers must insure their stablecoin reserves like traditional depository institutions do.

It would provide traders with some protection against price fluctuations and theft or issuer bankruptcy. Federal oversight and auditing would also apply to issuers. They'd also have to adhere to commercial entity affiliation restrictions and promote interoperability among stablecoins. 

Though the kinks are still being worked out, stablecoins have the potential to alter the global payment landscape significantly.