Stablecoins: what they are and how they work

Stablecoins are blockchain-based cryptocurrencies that aim to keep a stable value, usually by pegging their value to a specific currency such as the US dollar. This lets you use them for transactions without the price volatility seen in many cryptocurrencies.

Most stablecoins are worth the same as the US dollar, but there are others that track different fiat currencies, such as the euro and the British pound.

Stablecoins are important in the crypto space because they make it possible to take advantage of the stability of traditional currencies. This is especially useful on smart contract blockchains such as Ethereum. Instead of having to move capital off-chain to trade, investors can more easily swap their crypto for dollar-pegged assets.

Growing demand for stablecoins in decentralized finance (DeFi) protocols has driven up their market value. This has happened through a variety of mechanisms, including stablecoins being used as collateral for loans on DeFi platforms.

This article explains the different categories of stablecoins (fiat-backed, overcollateralized and algorithmic) and gives examples of each. It also explains the advantages and risks of using them.

Let’s take a closer look at the 3 categories of stablecoins and the examples in each.

Fiat-backed stablecoins

Stablecoins are cryptocurrencies that keep a stable value and are usually pegged to a national currency, such as the dollar. This works because they are backed by an equivalent amount of that national currency. The best-known ones are issued by centralized providers and are usually pegged to the dollar. However, there are others pegged to the euro, the Chinese yuan and the Mexican peso.

Issuers can easily increase the supply of fiat-backed stablecoins, as long as there are cash reserves behind them. This has led to the growth and widespread use of these cryptocurrencies.

One major advantage is that these coins can always be redeemed for the equivalent amount of the national currency, usually dollars. This keeps their value stable. For example, if one of these coins dropped below one dollar, traders could buy it cheaply and redeem it at a profit.

Although all of these coins work in a similar way, there are differences between their issuers and how secure they are.

USD Tether (USDT)

USD Tether (USDT) has the largest circulating supply of all stablecoins. It was created by Tether Limited Inc., which is owned by iFinex Inc., the operator of the crypto exchange Bitfinex.

USDT is supported on 12 different blockchains, including Ethereum, Avalanche, Polygon and others. In the US, Tether is supervised as a money services business, but it has not yet been approved by the New York Department of Financial Services. To show that USDT is fully backed, the company publishes assurance opinions and holds substantial funds.

Fears about what backs USDT’s price have raised concerns, with regulators scrutinizing the company. Despite these difficulties, USDT has managed to hold its value through redemptions.

In June 2022, Tether released a new attestation report carried out by BDO Italia, after its previous partner, MHA Cayman, came under investigation  in the United Kingdom over its audits of another company. More recently, the company promised to provide a full audit of its reserves following  criticism  from  the Wall Street Journal .

USD Coin (USDC)

USD Coin (USDC) is the second-largest stablecoin. USDC is managed by Centre, a consortium that includes Circle (the company that founded the coin), Coinbase and Bitmain. It is supported on many different blockchains.

Although it isn’t as popular as USDT, Circle has obtained operating licenses in many countries. In the US, it is authorized to issue digital currency and holds licenses in specific states. It also has licenses in the United Kingdom and Bermuda.

USDC is considered trustworthy because of its transparency and regulatory compliance. During periods of market volatility, it is often seen as the “gold standard” for investors who want to park their value in stablecoins.

To show that it is backed by cash, Circle publishes monthly attestation reports from the leading accounting firm Grant Thornton LLP. Despite its commitment to transparency, it has drawn the attention of regulators. In 2021, it was investigated by the SEC.

Binance USD (BUSD)

Binance USD (BUSD) is the third-largest stablecoin by circulating supply. It is issued by the crypto exchange Binance in partnership with Paxos Trust Company, LLC. While USDT and USDC are available on many blockchains, BUSD is currently available only on the Ethereum and Binance BNB networks. Even so, BUSD has grown successfully, as Binance converted deposited stablecoins into BUSD, making it the main stablecoin on its exchange. BUSD is regulated by the New York State Department of Financial Services, and its issuers state that they hold reserves in cash and cash equivalents, ensuring it can be redeemed for dollars. However, Binance has faced compliance and regulatory problems, which could affect BUSD’s future under US regulation.

Conclusion on fiat-backed stablecoins

Fiat-backed stablecoins are considered safe to hold because of their liquidity and dollar backing. USDT, USDC and BUSD all have freeze or blacklist functions written into their contracts, which means the companies that issue them can freeze or even seize funds directly from users’ wallets. This ability may worry some people, since it goes against the decentralized nature of crypto. Even so, the convenience of using these coins usually outweighs the concerns. Still, users should be aware of this risk before deciding to use them.

Overcollateralized stablecoins

Overcollateralized stablecoins are not backed directly by money, but by a pool of different assets whose value must always exceed that of the stablecoins in circulation. To achieve this, a smart contract protocol on the blockchain is used. Within it, users deposit assets as collateral and can borrow up to a certain percentage of their value in stablecoins. This keeps the coins secure.

When someone takes out a loan in these stablecoins, they pay a small interest rate. To stay safe, the protocols use mechanisms that automatically sell the user’s assets if their value falls below a threshold. This keeps the system stable, and the stablecoins are always backed by greater value.

While most of these stablecoins are pegged to the US dollar, their availability depends on user deposits. This makes them less capital-efficient and less liquid than fiat-backed stablecoins, but more decentralized.

Keeping their value requires a process similar to that of fiat-backed stablecoins. However, instead of being exchanged manually, they can be swapped automatically through the protocol for the assets that back them. This strengthens the system’s solvency and ensures the coins hold their value.

DAI

DAI is a digital currency pegged to the dollar and backed by the Maker protocol on Ethereum. It works as a stable, collateral-backed asset and is the largest stablecoin of its kind in circulation. The main purpose of the Maker protocol is to let users borrow DAI using various assets as collateral.

This is possible because users can deposit cryptocurrencies such as ETH, BTC and other stablecoins as collateral to take out DAI loans. The loan-to-collateral ratio and the interest rate charged vary, and each type of collateral can have multiple vaults with different ratios.

Maker holders, known as MakerDAO, decide which assets can be used as collateral and what ratio should apply, and they have voting rights on these decisions, providing a degree of governance.

Although DAI is decentralized, there are concerns about the composition of its collateral. A large share of DAI is backed by USDC, which could create risk if Circle (the company behind USDC) runs into trouble. To address this, various solutions have been proposed, such as using real-world assets as collateral.

Overall, DAI is a dollar-pegged stablecoin managed by the Maker protocol. It is used for borrowing and relies on a range of assets as collateral.

GHO

GHO is managed by the team behind the decentralized lending protocol Aave. It is a stablecoin similar to the one from the DeFi protocol Curve Finance.

Like Maker, Aave is governed by a DAO structure, in which holders of the voting token (AAVE) can decide on community matters. GHO was first proposed in July 2022 and successfully passed a governance vote.

GHO works much like Maker’s DAI, using smart contracts for control and keeping its price stable through liquidations. However, GHO offers new features. Instead of requiring you to lock up one specific asset, it can use many different ones at the same time, as long as there is a lending market for them on the Aave platform.

GHO also introduces Facilitators, which are protocols that can mint and burn GHO tokens in a trusted way. There are other features too, such as discounted interest rates and expansion to Layer 2 networks.

These improvements help capital be used more efficiently on Aave and other DeFi applications, offering gas fee savings compared with the Maker protocol. Aave’s reputation in the DeFi world helps GHO gain popularity and compete with DAI, giving crypto users more choice.

Decentralized USD (USDD)

Decentralized USD (USDD) was created by the TRON Foundation. It was announced in May 2022 in response to the troubles of Terra’s UST stablecoin. USDD uses collateral mechanisms with underlying assets and algorithmic calculations to keep its peg to the dollar. USDD is available on several networks, such as TRON, BNB Chain and Ethereum, and can be traded on a number of exchanges.

To keep USDD’s value pegged to the dollar, algorithmic methods are used in combination with the TRON network. Arbitrageurs can take advantage of price differences to rebalance USDD’s value by swapping it for TRON’s TRX. USDD is also linked to the assets of the TRON DAO Reserve, which helps keep it stable.

While USDD is a decentralized coin, the TRON network and the TRON Foundation have significant control over the blockchain and its products. The governance mechanism and decision-making processes remain opaque.

Overall, USDD represents an attempt to build a stablecoin using a variety of collateral mechanisms and calculations, but it still has some gaps when it comes to decentralization and governance.

Conclusion on overcollateralized stablecoins

Overcollateralized stablecoins are stablecoins backed by more value than the amount issued. This creates a decentralized alternative to traditional fiat-backed stablecoins. Control of the network is shared among holders or a collective body such as a DAO. In the case of DAI and USDD, there are no restrictions such as freezes or blacklists in their rules. This guarantee appeals to people who worry that their crypto could be affected by centralized issuers such as Circle and Tether. However, this feature could have negative consequences, as governments step up crypto regulation and stablecoins face potential pressure from regulation or sanctions. Another problem is that many overcollateralized stablecoins depend on centralized stablecoins such as USDC, which runs contrary to the original idea of decentralization.

Algorithmic stablecoins

Algorithmic stablecoins keep a stable value thanks to algorithms. These stablecoins usually have some kind of reserve backing their value, but they don’t require equivalent amounts for redemption. Various methods are used to keep them stable, including swaps with other tokens or coins. Although they face challenges, some of them have managed to stay stable with collateral and offer a stable alternative during periods of high market volatility.

TerraUSD (UST)

TerraUSD (UST) was a digital currency that tried to keep a stable value, created by Terraform Labs. It ran on the Terra blockchain and was linked to LUNA, another cryptocurrency.

The way it worked was that holders could burn LUNA to mint UST, or the other way around, burn UST to get LUNA back. It relied on this buying and selling to keep UST’s value stable. But the process caused problems when UST’s value rose above the dollar and LUNA-UST trading created an imbalance.

This led to the collapse of UST and LUNA in May 2022. The imbalance between UST’s supply and demand set off a chain of events that led investors to lose confidence. Both coins lost value, and the collapse followed.

The main reason this stability broke down was inadequate support from Anchor Protocol. Users could earn high interest rates by depositing UST in Anchor, but this depended on subsidies from Terraform Labs, which put pressure on LUNA.

Essentially, the loss of investor confidence and the inadequate backing led to a chain of negative events that caused the collapse of UST and LUNA, wiping significant amounts off the crypto market cap.

IRON

IRON was created by Iron Finance. It launched on BNB Chain in March 2021, intended to have a stable value and be backed by other coins such as STEEL. Users could buy IRON with BUSD and STEEL. At first, IRON worked well, but there were also times when its value dropped. It then moved to Polygon and used TITAN instead of STEEL.

Yields on IRON pairs went up after the move to Polygon. This led to big profits for yield farmers. The popularity drove up demand for IRON, but also for TITAN, which was required to mint IRON.

Mark Cuban’s involvement reduced trust, and investors felt IRON wasn’t safe. IRON’s value collapsed when problems were discovered. Investors decided to sell TITAN and IRON, setting off a chain reaction. TITAN crashed, creating a problem for IRON’s value.

This event called TITAN’s value into question. TITAN and IRON collapsed sharply, causing losses. The IRON collapse is an example of the risks in the crypto industry and of the importance of doing careful research before you invest.

FRAX

Although algorithmic stablecoins have had a troubled history, FRAX has managed to strike a balance between value and security. It is a type of stablecoin issued by Frax Finance. FRAX uses an algorithm to keep its value stable and combines backing from other coins (mainly USDC) with an internal token (FXS) used for governance.

The algorithm decides how much backing from other coins and how much from the internal token is needed, adjusting it according to demand and the markets. So if demand for FRAX rises, the protocol lowers the share of backing from other coins, making it more efficient. Conversely, if demand falls, the protocol increases the backing from other coins to keep it stable.

This feature makes FRAX flexible and efficient compared with other similar systems, such as Maker. While Maker’s collateral backing stays fixed, FRAX adjusts dynamically based on market needs. This helps avoid imbalances and maintain its value, making FRAX a more reliable alternative.

Conclusion on algorithmic stablecoins

Algorithmic stablecoins are cryptocurrencies that try to keep their value stable through algorithms. Although the idea sounds good, it has failed many times. Even if the algorithm is reliable, stablecoins can weaken if large investors decide to exit. Without a guarantee that the algorithmic coin can be redeemed for stable assets, the market on its own cannot prevent a collapse.
One example of a successful algorithmic stablecoin is FRAX, which adjusts how it works to stay stable, reacting to changes in the market. However, success is not guaranteed: even Terra’s UST, which was initially stable, failed when its value grew. Weaknesses in FRAX’s algorithm could come to light if its market cap grows, causing problems like those Terra’s UST had in the past.

The future of stablecoins

In this article we looked at the concept, creation and operation of stablecoins. We explained the three main types that exist, presented the advantages and challenges of each type of stablecoin, and their relationship to the crypto space.

The first type described is a stablecoin backed by Bitcoin, using delta-neutral derivatives. This means the issuer holds BTC/USD futures contracts, backed by Bitcoin, to create a synthetic USD stablecoin. This approach has advantages, but there are also counterparty and valuation risks.

The idea of central bank digital currencies (CBDCs) is also mentioned, in which central banks would issue fiat money on blockchains, controlling supply and demand. This approach avoids the collateral problem and guarantees the coins’ value, but the meaning and idea of decentralization are lost.

The rise of algorithmic stablecoins is also presented, with examples such as TerraUST and Frax Finance. Their advantages and problems are highlighted, as well as their impact on the crypto space.

Finally, it is pointed out that centralized stablecoins dominate the market, and the open issues and challenges that each type of stablecoin faces are discussed.

Overall, the article analyzes the different ways stablecoins are created and work, offering an in-depth look at every aspect of them and highlighting the challenges and possible developments in this field.