You might already know that stablecoins are basically dollars in digital form. Except that’s not exactly true because stablecoins can also be algorithmically tied to any type of fiat (government) currency – including the euro, Australian dollars and others – as well as other forms of physical assets, like gold.
No matter the type, stablecoins exist to make cryptocurrency more predictable. While predictable cryptocurrency may sound like an oxymoron, stablecoins – like their name suggests – were designed to counter crypto’s hallmark volatility and provide a convenient way for crypto traders to preserve their fiat value without having to cash out of the market and to allow users to pay for everyday goods and services in crypto without all the budgeting drama.
Let’s take a look at how stablecoins work.
How do stablecoins work?
Stablecoins generally work the same across the board: They are cryptocurrencies minted on a blockchain that users can buy, sell and trade on an exchange just like any other crypto coin. People can store stablecoins in their hot wallets and/or cold storage devices like they would bitcoin or any altcoin.
In order to have integrity, most stablecoins are linked to a reserve of external assets of some kind, whether it be a stash of fiat currency, commodities like gold or debt instruments like commercial paper. In most cases, the company or entity that develops the stablecoin owns reserves equal to the amount of stablecoins it has in circulation. This is such that any stablecoin holder should be able to redeem one stablecoin token for one dollar at any time.
The four types of stablecoins
There are four different types of stablecoins, each with its own way of fixing the value of the tokens to a stable figure.
The most popular stablecoins in the market are ones backed by fiat currency. USD coin (USDC), for instance, is fiat-backed and pegged to the U.S. dollar (USD) at a 1:1 ratio. Other stablecoins are linked to the euro, the British pound, the Japanese yen and the Chinese RMB.
Without getting too meta, crypto-backed stablecoins are cryptocurrencies pegged to the value of another more established cryptocurrency. For instance, MakerDAO is one of the most popular crypto-backed stablecoins. It uses a smart contract – a type of self-executing, code-based contract – alongside the Ethereum blockchain to pool enough ether (ETH) to use as collateral for its stablecoin. Then, once the amount of collateral reaches a certain level in the smart contract, users can mint DAI – the MakerDAO stablecoin.
As the name describes, commodity-backed stablecoins are pegged to the value of commodities like precious metals, industrial metals, oil or real estate. Commodity investors love the option of commodity-backed stablecoins because it allows them to invest in gold without the hassle of sourcing and storing it. Tether gold (XAUT) is an example of a commodity-backed stablecoin. The currency is backed by a reserve of gold kept inside a vault in Switzerland. One ounce of gold is equal to one XAUT.
Not backed by any “real-world” commodities, this category of stablecoins uses algorithms to modulate the supply based on its market demand. In short, these algorithms automatically burn (permanently remove coins from circulation) or mint new coins based on the fluctuating demand for the stablecoin at any given time.
You can think of an algorithmic stablecoin as a bucket of water left outside with a water level marked on the inside. To keep the water inside the bucket at exactly the same level, you set up a mechanism that adds or removes water depending on how far the water level has deviated from the mark. This is controlled by a computer algorithm such that if it rains and the bucket begins to fill up, the algorithm instructs the mechanism to release water out of the bottom of the bucket until it reaches the water level mark. Conversely, if it’s a hot day and water evaporates out of the bucket, the computer algorithm would instruct the mechanism to add more water to the bucket until the correct level is regained.
There’s been a lot of trial and error in the quest to successfully introduce algorithmic stablecoins to the crypto ecosystem, and the failure of Terra's UST stablecoin shows just how badly things can go if the algorithm isn't able to keep up with dramatic swings.
Why use stablecoins?
Designed for our increasingly global economy, stablecoins theoretically solve a few key problems that inhibit the exchange of money.
- Stablecoin users don’t need multiple international bank accounts to send crypto to their friends in other countries; they just need one crypto wallet.
- Stablecoins make true peer-to-peer digital transfers possible without the need for third-party intermediaries to facilitate transactions.
In theory, stablecoins cut down on the fees, transfer time and potential privacy infringement we’ve grown accustomed to under the paradigm of central banking.
Say you were a Chinese business owner who wanted to pay an invoice to a client in Japan who also had subcontractors in Europe.
“You’d need to have a Chinese bank account, a Japanese bank account and a European bank account,” explains William Quigley, co-founder of the WAX blockchain and one of the founders of USDT issuer Tether. “If somebody wants to send you euros or yen or RMB, the intermediaries who can hold those accounts swap out those currencies for the currency you are able to hold and send it to your bank. And along the way, they've skimmed a lot of money off the top for that.”
We can't all have 50 different bank accounts in 50 different countries, says Quigley. But with stablecoins there’s no need.
Privacy lovers, in particular, appreciate this facet of stablecoins since they can avoid the process known as KYC, or know your customer – aka submitting photo ID and Social Security information to open a financial account. While KYC has become, for most of us, a normal part of dealing with money, crypto proponents argue KYC is prohibitive when applied to central banking institutions in other countries.
“This is why it's extraordinary to me that an individual in New York, California or Texas can hold in their Ledger [wallet] 10 different tokenized currencies that stay in their native form,” said Quigley. “You don't need a Chinese bank account. You can keep a token representing that Chinese currency and use it as though it is Chinese currency without ever converting.”
This direct, peer-to-peer model of stablecoins helps save money that otherwise goes to pay processing fees and administrative costs for third-party intermediaries.
“There's a trillion dollars each year siphoned out of the global economy – from businesses and consumers – to these ‘money changers,’” Quigley says. “That disappears if the currency can be maintained in its original form because it's been tokenized and held on a blockchain accessible to the user instantly, rather than in a bank.”
How do you pick the right stablecoin?
There’s a wide variety of stablecoins now available within the broader ecosystem of 16,000+ cryptocurrencies, so choosing which ones to buy, trade or simply use for everyday transactions remains a challenge even for experts.
As with all things crypto, there’s a perpetual balance to keep in mind between centralization and decentralization, stability and freedom, regulation and permissionless-ness.
Fiat-backed stablecoins, for instance, are popular because they are as stable as the U.S. dollar (USD) or other widely accepted currencies. However, linking crypto to a federal currency makes fiat-backed cryptos a target for governmental regulation and overall more centralized – a certain trade-off when compared with algorithmic stablecoins, the most decentralized option.
There’s also the issue of what exactly is backing each currency. For instance, not all the USD-backed stablecoins (USDT and BUSD – to name a few) are backed by an exact 1:1 ratio of dollars to crypto. What’s inside the reserves varies depending on the entity behind the coin.
Tether (USDT), for instance, used to be set up where the dollar amount in reserves was identical to the amount of minted USDT. But that has changed, says Quigley, adding: “What Tether [the issuing company] has done now is they have a certain quantity of the outstanding tether [USDT] held in fiat and then a certain quantity held in liquid marketable securities.”
So instead of dollar bills, there might be liquid reserves in the form of bonds, CDs, treasury bonds and cash equivalents.
“They periodically disclose the mix,” Quigley says of Tether.
Another difference is on which platforms and exchanges you can find each stablecoin. USDC, for example, can be bought and sold on Coinbase, a popular crypto exchange. USDT, on the other hand, cannot.
When considering which stablecoins to add to your portfolio, consider the following questions:
- Where can I buy and exchange the stablecoin?
- On what platform is the stablecoin minted?
- How often are the reserves audited and how transparent is the reporting?
- What’s the market cap and circulating supply?
According to some analysts, 2022 could be a big year for stablecoins as the U.S. Federal Reserve seeks to tighten monetary policy, which, in turn, should strengthen the greenback and drive up demand for any digital assets pegged to it. Whether this comes to fruition or not, though, is difficult to say, especially given the string of U.S government agencies looking to ramp up regulations regarding stablecoins over the coming months.
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