What is a Stablecoin?

Stablecoins are a type of cryptocurrencies designed to maintain a stable value by being pegged to a reserve asset like fiat currencies (e.g., Dollar, Euro) or commodities like precious metals. Stablecoins have become popular because they offer the stability of traditional currencies while providing the speed and low cost of cryptocurrency, especially for cross-border payments. Traders use them to protect against crypto market price volatility, and they are essential in decentralized finance (DeFi) for lending and earning interest. This stability also makes them suitable for everyday transactions, bridging the gap between digital and traditional finance (TradFi).

How Stablecoins Work

Stablecoins use various mechanisms to maintain a stable value, typically pegged to an asset like a fiat currency (e.g., the U.S. Dollar). They are usually backed by a reserve of assets that serves as collateral, ensuring their value remains stable. For example, an issuer might hold $1 million in reserve to support one million stablecoin units, allowing holders to redeem their stablecoins for an equivalent amount of the reserve asset. This linkage keeps the stablecoin’s value tied to real-world assets, like fiat currency. Depending on the type of stablecoin, stability can be maintained through reserves, collateralization, or algorithmic supply adjustments. Some stablecoins, such as Angle’s USDA and EURA, are decentralized and backed by cryptocurrencies rather than fiat, aligning with the decentralized philosophy of blockchain.

Types of Stablecoins

Stablecoins can be categorized into four main types, each with distinct characteristics. Fiat-backed stablecoins are pegged to traditional currencies like the U.S. Dollar or Euro and are maintained through reserves managed by custodians, with examples including Tether (USDT) and USDC. Commodity-backed stablecoins are tied to the value of physical assets like gold or silver, providing access to commodity investments but relying on centralized reserve management. Crypto-backed stablecoins are secured by various cryptocurrencies and are often over-collateralized, promoting decentralization and transparency; notable examples include DAI (now USDS) and USDA from Angle Protocol. Lastly, algorithmic stablecoins use software algorithms to adjust supply based on demand to maintain price stability without holding reserves, although they carry significant risks, as evidenced by the collapse of TerraUSD (UST) in 2022 when its associated Luna token lost substantial value. Each stablecoins type offers different levels of price stability and risk.

Fiat-backed stablecoins

Fiat-collateralized stablecoins are backed by traditional currencies like the U.S. Dollar or Euro, providing stability through reserves held by custodians and subject to audits for transparency. Examples include Tether (USDT) and USDC, both maintaining a 1:1 value with the Dollar, with Tether being the third-largest cryptocurrency by market capitalization as of October 2024. However, they rely on centralized entities to manage reserves, which contrasts with the decentralized nature of cryptocurrency. Additionally, while these stablecoins generate revenue from reserves, users don't share in the profits, and concerns about transparency in audits and reserve backing persist.

Commodity-backed stablecoins

Commodity-backed stablecoins are tied to the value of resources like gold, silver, or oil, with reserves often held by third-party custodians or invested in related financial instruments like ETFs. They offer the advantage of easy access to commodity investments through tokens. However, like fiat-backed stablecoins, they depend on centralized entities to manage reserves, which conflicts with cryptocurrency’s decentralized nature, and concerns about transparency and audits may arise.

Crypto-backed stablecoins

Crypto-backed stablecoins are backed by a basket of cryptocurrencies, with assets proportioned to their volatility to maintain price stability. They are often over-collateralized for added security and transparency, allowing users to verify reserves without relying on centralized entities. Decentralized and accessible to all, these stablecoins align with the principles of cryptocurrency, and many share revenue from reserves with users, offering passive income. Examples include DAI (now USDS) from Sky and USDA from Angle. However, they generally have lower liquidity compared to fiat-backed stablecoins, and significant drops in the value of underlying cryptocurrencies can pose challenges.

Algorithmic stablecoins

Algorithmic stablecoins use software algorithms and smart contracts to adjust their supply based on demand, aiming to maintain a stable price without holding real reserves. Their key advantage is their decentralized nature. However, they can be risky due to the complexity of their mechanisms, which may fail to maintain the price peg. A prominent example is TerraUSD (UST), which lost its peg to the U.S. Dollar on May 11, 2022, after the Luna token's value collapsed, causing UST to drop by over 60%.

Example of Popular Stablecoins in the Market

Tether (USDT)

Launched in 2014 by Tether Limited, Tether (USDT) is one of the most widely used stablecoins available. It is designed to maintain a 1:1 peg with the U.S. Dollar price, with each USDT supposedly backed by a Dollar held in reserve. Intended for fast value transfers while minimizing the price volatility associated with other cryptocurrencies, USDT has gained popularity among traders and investors. However, questions regarding the transparency of its reserves have sparked controversy. Nonetheless, Tether continues to be the largest stablecoin by market capitalization.

USD Coin (USDC)

Launched in September 2018 by Circle in partnership with Coinbase, USD Coin (USDC) is a stablecoin that maintains a 1:1 peg to the price of U.S. Dollar. Unlike some other stablecoins, USDC is fully regulated and undergoes regular audits, offering greater transparency regarding its reserves. Circle holds its fiat reserves in centralized financial institutions, which carries some counterparty risk. Nonetheless, USDC has become a popular choice as a more transparent alternative to Tether, supported by strong financial partnerships, including investments from companies like Goldman Sachs and Baidu.

Dai (DAI)

DAI, launched in 2017 by MakerDAO, is a decentralized stablecoin that is pegged to the U.S. Dollar price. Unlike traditional fiat-backed stablecoins, DAI is supported by cryptocurrencies like Ether (ETH) and USDC, utilizing a unique system where its value is stabilized through self-executing smart contracts on the Ethereum blockchain. New DAI tokens are generated when loans are taken out on the MakerDAO platform, and the supply is adjusted to maintain the $1 peg. While DAI's decentralization provides independence from centralized control, its dependence on volatile crypto assets poses risks, such as potential depegging during market downturns. DAI tokens is currently in the process of migrating to USDS, and MakerDAO has been rebranded as Sky.

Challenges and Risks of Stablecoins

Stablecoins face several challenges and risks that users need to be aware of. One major concern is centralization, particularly with fiat-backed stablecoins that depend on traditional banking systems for their reserves; a bank failure could compromise the value of these stablecoins, undermining their stability, like the USDC depeg with the Silicon Valley Bank (SVB). Algorithmic stablecoins rely on complex mechanisms to maintain their pegs, and failures in these systems can lead to significant price volatility and depegging during market stress. Additionally, the growing regulatory scrutiny poses a risk, as governments worldwide seek to impose stricter regulations on stablecoins due to their rapid expansion and potential effects on the broader financial system. Regulatory bodies are advocating for stablecoins to be treated as financial market infrastructure, especially those considered systemically important, which could influence their future stability and adoption.

The Next Generation of Stablecoins

USDA (USDA)

USDA is a decentralized and over-collateralized stablecoin developed by Angle Protocol. Its peg to the Dollar is supported by reserves that include tokenized Treasury bills, government bonds (RWAs), Ethereum, Bitcoin, and other liquid USD stablecoins. Price stability is maintained through multi-audited smart contracts. In addition to ensuring price stability, USDA provides a permissionless on-chain Dollar savings solution, enabling users to earn passive yields on their stablecoin. USDA is easily accessible and can be found across various blockchains, including Ethereum, Arbitrum, Optimism, Base, Polygon, Polygon zkEVM, BNB, Avalanche, Linea, and Celo. It can be purchased effortlessly by swapping crypto assets on decentralized exchanges like 1inch or Uniswap, and users can also borrow USDA directly from Morpho Blue.

EURA (EURA)

EURA (formerly agEUR) is a stablecoin developed by Angle Protocol that maintains a 1:1 peg to the Euro. This decentralized and over-collateralized stablecoin ensures its parity with the Euro through reserves comprising tokenized Treasury bills, government bonds (RWAs), Ethereum, Bitcoin, and other liquid Euro stablecoins. Multi-audited smart contracts are employed to maintain price stability. In addition to providing stability, EURA offers a permissionless on-chain Euro savings product, enabling users to earn passive yields on their stablecoin deposits. EURA is widely accessible across various blockchains, including Ethereum, Arbitrum, Optimism, Base, Polygon, Polygon zkEVM, BNB, Avalanche, Linea, and Celo. It can be easily purchased by swapping crypto assets on decentralized exchanges like 1inch or Uniswap, and users can also borrow EURA through the Angle app.

Use Cases and Benefits of Stablecoins

Stablecoins present various use cases and advantages that increase their attractiveness within the cryptocurrency landscape. By pegging their value to traditional currencies or assets, they maintain price stability, making them suitable for transactions and remittances where fluctuations can be problematic. This price stability facilitates easy conversion between fiat and cryptocurrencies, promoting trading on decentralized exchanges and lowering risk. Moreover, stablecoins enhance cross-border payment efficiency by decreasing transaction costs and processing times compared to conventional banking systems. They also act as a dependable store of value and provide opportunities for earning passive income through yield-generating platforms, appealing to individual investors and businesses aiming to utilize digital crypto assets without the price volatility risks of other cryptocurrencies.