A “stablecoin” is a type of cryptocurrency whose value is pegged to another asset class, such as fiat currency or gold, to stabilize its price.
Cryptocurrencies like bitcoin and ether offer a number of benefits, and one of the most basic is that they don’t require trust in an intermediary institution to send payments, which opens up their use to anyone around the world. But one major drawback is that cryptocurrency prices are unpredictable and have a tendency to fluctuate, often wildly.
This makes them difficult for ordinary people to use. Generally, people expect to find out how much their money is worth a week from now, both for their safety and for their livelihood.
Cryptocurrency uncertainty is different from the generally stable price of fiat money, such as the US dollar, or other assets, such as gold. The value of a currency like the dollar does change gradually over time, but the day-to-day changes are often more drastic for cryptocurrencies, which rise and fall in value on a regular basis.
The following chart shows the price bitcoin vs. the US dollar (USD) is compared to another fiat currency, the Canadian dollar (CAD), to see how much each currency fluctuates in relation.
Stablecoins in a nutshell
Stablecoins try to cope with price fluctuations by tying the value of the cryptocurrency to another, more stable asset – usually fiat currency. Fiat is a government-issued currency that we normally use on a daily basis, such as the dollar or the euro.
Typically, the entity behind a stablecoin will set up a “reserve” where it securely stores the asset or basket of assets backing the stablecoin – for example, $1 million in an old-fashioned bank (the kind with branches and tellers and ATMs in the lobby) to reserve a million units of stablecoins.
This is one way digital stablecoins are pegged to real-world assets. The money in the reserve serves as collateral for the stablecoin – meaning every time a stablecoin holder wants to cash out their token, the same amount of any backed asset is taken from the reserve.
There are more complex types of stablecoins that are backed by other cryptocurrencies than fiat but are still engineered to track mainstream assets like dollars.
Maker, perhaps the most well-known stablecoin issuer to use this mechanism, accomplishing it through a service called “Dome” (formerly known as Collateralized Debt Position), which locks in the user’s cryptocurrency collateral. Then, once the smart contract knows that the collateral is guaranteed, the user can use it to borrow the newly minted one day, stable coin.
A third variety of stablecoins, known as algorithmic stablecoins, are not collateralized at all; instead, coins are burned or created to keep the coin value at the target price. Let’s say a stablecoin drops from a target price of $1 to $0.75. The algorithm will automatically burn a certain number of coins to generate more rarity, driving up the price of stablecoins. This type of stablecoin protocol is difficult to repair and has been try and fail several times last year. However, entrepreneurs keep trying.
Stablecoin collateral types
Using this framework, stablecoins come in a variety of flavors, and collateralized stablecoins use different types of assets as backers:
- Order: Fiat is the most common collateral for stablecoins. The US dollar is the most popular among fiat currencies, but the company is also exploring stablecoins that are pegged to other fiat currencies, such as BiLira, which is pegged to the Turkish lira.
- Precious metal: Some cryptocurrencies are tied to the value of precious metals such as gold or silver.
- Cryptocurrency: Some stablecoins even use other cryptocurrencies, such as ether, the native token of the Ethereum network, as collateral.
- Other investments: Tether’s USDT was once supposed to be backed 1-for-1 with the dollar but its collateral mix has shifted over time, and in a breakdown given in 2021, the company says nearly half of its reserves are in commercial paper, short-term corporate debt. It has not revealed the publisher of this paper but claim all are rated A-2 or higher (A-2 is the second best rating available to corporate borrowers from credit rating agencies such as Standard & Poor’s). circle USDC, similarly, lists unspecified “approved investments” next to accounts at federally insured banks (notably, it doesn’t say whether the accounts themselves are insured) in their monthly disclosure.
What are the most popular stablecoins?
To give you an idea of the experiments taking place in the stablecoin field, let’s take a look at some of them most popular stablecoins.
Shut up (formerly known as Libra) is a stablecoin in the works, originally conceived by the powerful and worldwide social media platform Facebook. While libra hasn’t launched yet, it has a bigger psychological impact than any other stablecoin.
Governments, especially China, are now exploring their own crypto-inspired digital currencies, partly because they fear silence will become a competitive threat because Facebook is a multinational company with billions of users from all over the world.
Initially, the Diem Association, a consortium formed by Facebook, said Diem would be supported by a “basket” of currencies, including the US dollar and euro. However, due to global regulatory issues, the association has back off from his original ambitious vision. Instead, it now plans to focus on developing several stablecoins, each backed by a separate national currency.
Its first stablecoin, the silent dollar, is expected to launch as early as January 2021.
tie (USDT) is one of the oldest stablecoins, launched in 2014, and the most popular to this day. It is one of the most valuable cryptocurrencies overall by market cap.
The main use case for USDT is moving money between exchanges quickly to take advantage of arbitrage opportunities when the price of a cryptocurrency differs across the two exchanges; traders can make money from this difference. But has found another application: Chinese importers stationed in Russia too using USDT to send millions of dollars of value across borders, bypassing China’s strict capital controls.
Tether Ltd. companies that issue USDT, are involved in 22-month legal battle with the New York Attorney General over allegations Bitfinex (Tether’s sister company) tried to cover up $850 million shortfall uses funds taken from Tether.
Finally, the case is established On February 23, 2021, Tether and Bitfinex were forced to pay $18.5 million and submit a quarterly report showing Tether’s stablecoin reserves for the next two years.
Launched in 2018, USD Coin is a stablecoin co-managed by cryptocurrency companies Circle and Coinbase through the Center Consortium.
Like tether before moving on to the collateral asset mix, USD Coin is pegged to the US dollar with an outstanding supply of nearly $26 billion. In 2023, Circle stated in a recent investor presentation that anticipate supply touched $190 billion.
On July 8, 2021, Circle announced plan to go public through $4.5 billion SPAC merger agreement with Concord Acquisition Corp. This news comes one month after Circle closed a $440 million a funding round involving big industry names such as FTX, Digital Currency Group (CoinDesk’s parent company) and Fidelity Management and Research Company.
Runs on MakerDAO protocol, day is a stablecoin on the Ethereum blockchain. Created in 2015, dai is pegged to the US dollar and backed by ether, the token behind Ethereum.
Unlike other stablecoins, MakerDAO intends for dai to be decentralized, meaning that there is no trusted central authority to control the system. On the other hand, Ethereum smart contract – who encode immutable rules – have this job instead.
However, there are still problems with this innovative model; for example, if a MakerDAO-enabled smart contract doesn’t work exactly as expected. Indeed, they are toyed with in 2020, causing a loss of $8 million.
Do stablecoins have drawbacks?
There are several drawbacks of stablecoins to keep in mind. Due to the way stablecoins are usually regulated, they have different difficulty points than other cryptocurrencies.
If the backup is stored in a bank or other third party, other vulnerabilities are opponent’s risk. This boils down to the question: Does the entity actually have the collateral it claims to be? It has become often ask submitted to Tether, for example, about whether it maintains true 1-1 support between USDT tokens and US dollars.
In a worst-case scenario, it’s possible that the reserves backing stablecoins turn out to be insufficient to redeem each unit, potentially shaking confidence in the coin.
Cryptocurrencies were created to replace the intermediary companies that are usually trusted with users’ money. Naturally, the intermediary has control over the money; for example, they can usually stop a transaction from happening. Some stablecoins add the ability to stop transactions back into the mix.
USD coins openly have a backdoor to stop payments if the coins are used illegally. Circle, one of the companies behind USDC, confirmed in july 2020 that it froze $100,000 of stablecoins by law enforcement order.