Stablecoins Ultimate Guide: Definition, How They Work, and Types

Stablecoins have become a cornerstone of the cryptocurrency market, offering the benefits of digital assets while minimizing the price volatility often associated with traditional cryptocurrencies. Designed to hold a stable value, these digital assets are pegged to stable assets such as fiat currencies, commodities, providing a bridge between traditional finance (TradFi) and decentralized finance (DeFi). This article explores what stablecoins are, how they work, and the different types of stablecoins available, from fiat-backed, crypto-backed, commodity-backed, and algorithmic stablecoins. Understanding stablecoins is essential for anyone interested in the growing landscape of digital currencies and blockchain-based finance.

Stablecoins are a type of cryptocurrency designed to maintain a stable value by pegging their worth to another asset, such as a fiat currency (like the Dollar or Euro) or commodities like gold. By linking their value to more stable assets, stablecoins aim to reduce the price volatility commonly associated with cryptocurrencies.

Stablecoins are essential for reducing the price volatility that often affects the cryptocurrency market. While cryptocurrencies like Bitcoin (BTC) and Ethereum (ETH) offer benefits such as decentralized transactions, their unpredictable price swings can complicate everyday use. Stablecoins address this issue by maintaining a steady value pegged to stable assets like fiat currencies or commodities. This predictability allows users to transact confidently, ensuring that their purchasing power remains stable and facilitating broader adoption in everyday transactions.

For crypto traders, capitalizing on market gains is essential, especially when conditions are favorable. Converting your traditional cryptocurrencies into stablecoins can be an effective strategy for locking in profits from your crypto services, ensuring you secure funds before a potential market decline. This approach is particularly beneficial for traders who frequently switch between various volatile cryptocurrencies throughout the day or week. In summary, stablecoins enable you to protect against market volatility without the hassle of off-ramping your assets.

Stablecoins are crucial for global payments because they offer a fast, low-cost, and secure way to transfer funds across borders. Unlike traditional methods, which often involve high fees and long processing times, stablecoins allow instant transactions with minimal costs. This makes them especially useful for people sending money to family abroad, ensuring the value sent is the value received, without the price volatility associated with other cryptocurrencies.

A stablecoin is typically backed by a reserve of assets, which acts as collateral to maintain its value. For example, the entity issuing the stablecoin may hold $1 million in a traditional bank to back one million stablecoin units. This ensures that whenever a holder wants to redeem their stablecoins, an equivalent amount of the backing asset is withdrawn from the reserve. This system keeps the stablecoin’s value pegged to real-world assets, like fiat currency. There are also more complex stablecoins backed by other cryptocurrencies, such as Angle’s USDA and EURA.

Stablecoins are classified into four main types based on how they're backed. Fiat-collateralized stablecoins are tied to traditional currencies like the US Dollar, offering stability through reserves. Commodity-backed stablecoins are pegged to the market value of resources like gold, silver, or oil. Crypto-backed stablecoins use cryptocurrencies as collateral, often requiring over-collateralization. Algorithmic stablecoins rely on algorithms to manage supply and stabilize their value without backing from any asset. Each type has different pros and cons regarding stability and risk.

Fiat-backed stablecoins are digital assets designed to maintain a stable value by being tied directly to a government-issued currency, such as the U.S. Dollar or Euro. Each unit of a fiat-backed stablecoin is typically backed by an equivalent amount of fiat currency held in reserve by a trusted institution, like a bank. This backing structure aims to keep the stablecoin’s value close to the fiat currency, usually at a 1:1 ratio.

Benefits of fiat-collateralized stablecoins

Fiat-backed stablecoins provide stability by being directly backed by traditional currencies like the U.S. Dollar or the Euro. The reserves are held by custodians and regularly audited for transparency. Popular examples include Tether (USDT) and USDC from Circle, both maintaining a 1:1 value with the Dollar. As of October 2024, Tether (USDT) is the third-largest cryptocurrency by market capitalization.

Disadvantages of fiat-collateralized stablecoins

Fiat-backed stablecoins have several notable drawbacks. They rely on centralized entities to manage reserves, which contradicts the decentralized ethos of cryptocurrency. While these stablecoins generate revenue from their reserves, they do not share any of this profit with users, limiting benefits for holders. Additionally, the opacity of reserves and unclear audits can raise concerns, leaving users unsure about the actual backing of these stablecoins.

Crypto-backed stablecoins are a type of stablecoin that maintain their value through collateral in other cryptocurrencies rather than fiat currencies.

These stablecoins are managed through smart contracts on blockchain platforms, where users lock up their crypto assets as collateral to mint stablecoins. If the value of the collateral falls below a certain threshold, it can be liquidated to maintain the stablecoin's peg to a stable asset, typically the U.S. Dollar.

Benefits of crypto-backed stablecoins

Crypto-backed stablecoins offer several advantages. They are backed by a diverse basket of cryptocurrencies, with the proportion of each asset adjusted according to its volatility to maintain a stable price. These stablecoins are often over-collateralized to provide extra security and reduce the risk of value fluctuations. One of the main benefits of crypto-backed stablecoins is that they are decentralized and accessible to everyone, aligning with the core principles of cryptocurrency. Many of these stablecoins share the revenue generated from their backing with users, enabling holders to earn passive income. Additionally, their reserves are typically transparent and verifiable, which means users don’t have to rely on centralized entities. Examples include DAI (now USDS) from Sky and USDA from Angle, which illustrate these benefits.

Disadvantages of crypto-backed stablecoins

While crypto-backed stablecoins have their benefits, they also come with notable disadvantages. They generally have less liquidity than fiat-backed stablecoins, which dominate the market. Finally, if these stablecoins are typically over-collateralized to mitigate potential price volatility, a significant drop in the price of the underlying cryptocurrency can create challenges.

Commodity-backed stablecoins are stablecoins that derive their value from reserves of physical assets, such as precious metals (like gold and silver), oil, or other commodities. Each unit of a commodity-backed stablecoin represents a specific quantity or value of the underlying commodity, and the issuing entity typically holds this commodity in reserve. This backing helps the stablecoin maintain a more stable value, similar to the price of the underlying commodity.

Benefits of commodity-backed stablecoins

Commodity-backed stablecoins can be considered a sub-category of fiat-collateralized stablecoins. These cryptocurrencies are pegged to the market value of resources. Typically, they hold the physical commodities through third-party custodians or invest in financial instruments related to these assets, such as ETFs. The main advantage of these stablecoins is that they allow easy access to investing in a commodity, just like any other token.

Disadvantages of commodity-backed stablecoins

Just like fiat-backed stablecoins, commodity-backed stablecoins also have their drawbacks. They rely on centralized entities to manage reserves, which contradicts the decentralized ethos of cryptocurrencies. Additionally, a lack of transparency and unclear audits can raise concerns about the actual backing of these stablecoins.

Algorithmic stablecoins are a type of stablecoin that use software algorithms to automatically adjust the coin's supply in response to changes in demand, aiming to maintain a stable price without holding real reserves.

For example, when demand for the stablecoin rises and its price goes above the intended peg (usually $1), the algorithm will increase the supply by minting more coins, thereby bringing the price down. Conversely, if the price falls below the peg, the algorithm will reduce supply, often by buying back or burning coins, to help push the price up.

Benefits of algorithmic stablecoins

Algorithmic stablecoins offer advantages, including decentralization and independence from collateral, which reduces reliance on banks or centralized entities and aligns with blockchain’s decentralized ethos. They are able to adjust supply to meet demand without requiring additional reserves. Their lack of traditional asset backing can also reduce regulatory risks, providing resilience to certain restrictions.

Disadvantages of algorithmic stablecoins

Algorithmic stablecoins come with several disadvantages that can pose significant risks. One major issue is their reliance on complex mechanisms, which can lead to failures in maintaining the price peg. A notable example is the TerraUSD (UST), whose value plummeted by over 60% on May 11, 2022, as the associated Luna token lost more than 80% of its value overnight, resulting in a complete loss of its peg to the U.S. Dollar.

Tether (USDT), launched in 2014 by Tether Limited, is one of the most popular stablecoins on the market. Its concept is based on a 1:1 peg to the US Dollar, with each USDT issued supposedly backed by $1 Dollar held in reserve. Created to enable quick value transfers and avoid the price volatility of other cryptocurrencies, USDT has attracted traders and investors. However, controversies have arisen over the transparency of its reserves. Despite this, Tether remains the largest stablecoin by market capitalization.

USD Coin (USDC), launched in September 2018 by Circle in collaboration with Coinbase, is a stablecoin pegged 1:1 to the US Dollar. Unlike some other stablecoins, USDC is fully regulated and regularly audited, providing greater transparency about its reserves. Circle stores its fiat reserves in centralized financial institutions, which introduces a degree of counterparty risk. Despite this, USDC has gained popularity as a more transparent alternative to Tether, backed by strong financial partnerships, including investments from companies like Goldman Sachs and Baidu.

DAI, launched in 2017 by MakerDAO, is a decentralized stablecoin pegged to the US Dollar. Unlike traditional fiat-backed stablecoins, DAI is backed by cryptocurrencies such as Ether (ETH) and USDC, creating a unique system where its value is stabilized through self-executing smart contracts on the Ethereum blockchain. New DAI tokens are created when loans are taken out on the MakerDAO platform, and the supply is adjusted to maintain the $1 peg. While DAI's decentralization offers independence from centralized control, its reliance on volatile crypto assets introduces risks, such as potential depegging during market downturns.

DAI is currently being migrated to USDS, and MakerDAO has been rebranded as Sky.

USDA, the stablecoin by Angle Protocol, represents the future of stablecoins with its innovative over-collateralized model. Pegged 1:1 to the US Dollar, USDA is backed by a diversified reserve of assets, including tokenized Treasury Bills, government bonds, Ethereum, Bitcoin, and other liquid stablecoins. What truly sets USDA apart is its ability to generate safe yields for holders, sourced from both traditional finance (TradFi) and decentralized finance (DeFi). This allows users to enjoy optimal returns without needing to switch between systems. As liquid as USDC, USDA can be exchanged easily with no fees or slippage, positioning it as a key player in on-chain forex markets.

EURA, the Euro stablecoin by Angle Protocol, is currently the most traded Euro stablecoin on the market. Designed to withstand adverse market conditions, EURA is backed by secured debt and Euro-denominated stable assets, with anti-depeg mechanisms built on advanced research. Available on over 13 blockchains, EURA also offers a Euro yield to its users, sourced from the returns generated by its backing assets. As liquid as EURC, it can be exchanged 1:1 with EURC from Circle, without any fees or slippage, making it a reliable and efficient choice for Euro-based on-chain transactions. With Angle, transparency is not just a feature but a foundation, allowing users to track the collateral reserves behind EURA in real-time.

Stablecoins play a crucial role in the cryptocurrency ecosystem due to their stability. While cryptocurrencies like Bitcoin and Ether offer benefits such as trustless transactions without intermediaries, their unpredictable price fluctuations make them challenging for everyday use. Stablecoins address this issue by pegging their value to more stable assets, typically fiat currencies. This design helps maintain their value over time, encouraging wider adoption for regular transactions and providing a reliable means of exchange in the crypto market.

Stablecoins have several disadvantages and risks that users should consider. A major concern is centralization, especially with fiat-backed stablecoins, which rely on traditional banking systems for reserves. If a bank fails, the value of these stablecoins may be compromised, undermining their intended stability. Crypto-collateralized stablecoins also face risks; while they are typically over-collateralized, significant drops in cryptocurrency prices can threaten their value. Additionally, regulatory uncertainty is growing, as governments around the world call for tighter regulations, which could impact the stability and adoption of stablecoins.

The main difference between Central Bank Digital Currencies (CBDCs) and stablecoins lies in their backing and regulatory status. CBDCs are issued and regulated by central banks, representing a digital form of a country's fiat currency, which ensures their stability and trustworthiness. In contrast, stablecoins are typically issued by private entities and are pegged to stable assets like fiat currencies or commodities. While both aim to provide a stable digital currency option, CBDCs are government-backed and centralized, whereas stablecoins can be decentralized and may rely on various mechanisms for maintaining their value.

Stablecoins are increasingly coming under regulatory scrutiny due to their rapid growth and potential impact on the broader financial system. As the stablecoin market has expanded to hundreds of billions of Dollars, regulators worldwide are paying closer attention to these digital assets to ensure compliance with financial laws and regulations. In October 2021, the International Organization of Securities Commissions (IOSCO) suggested that stablecoins be regulated as financial market infrastructure, especially those deemed systemically important. In Europe, under the Markets in Crypto-Assets (MiCa) regulation, centralized stablecoins require a license to operate, while decentralized stablecoins are currently exempt.

No, Bitcoin is not a stablecoin. Unlike stablecoins, which are designed to provide a stable value and reduce the high price volatility typically associated with cryptocurrencies, Bitcoin (BTC) experiences significant price fluctuations. Stablecoins aim to offer a more reliable alternative for everyday transactions by maintaining a consistent value, often pegged to a fiat currency like the US Dollar. In contrast, Bitcoin's volatility can make it less suitable for common transactions, as its price can change dramatically in a short period.