The ultimate 101 guide to stablecoins

Learn about different types of stablecoins and their evolution from being a simple hedge against market volatility to the backbone of DeFi.

Equilibrium concept, stock image.

The stablecoin, as the name implies, is a digital currency designed to be as immune to market volatility as possible. Such a goal is reached by pegging the token to a certain “stable” asset, usually the U.S. dollar, but other major fiat currencies, such as euro, yen, peso, or yuan, are also in use. The simple idea behind stablecoins is that they are supposed to maintain a certain price target, serving as a store of value and a payment option for goods and services. The reality, however, is far more nuanced and complex. 

The history of stablecoins dates back to July 2014, when BitUSD, the world’s first stablecoin, was introduced by Dan Larimer (EOS) and Charles Hoskinson (Cardano). BitUSD was backed by BitShares native token, BTS, and its $1 peg was maintained by overcollateralization, which for that time was a novel and counter-intuitive idea. But over time, new stablecoin designs emerged that required just 1:1 backing or no backing at all. How did it become possible? Let’s go over the evolution of stablecoins and take a closer look at some of the most outstanding examples of such assets. 

Crypto collateralized stablecoins

As you could guess from the name, crypto collateralized stablecoins are backed by other crypto assets. There’s no reliance on a central issuer – instead, the collateral is locked in a smart contract and remains inaccessible until the user returns their stablecoins to withdraw the original amount they put in. However, due to the volatile nature of crypto, the required collateralization ratio is more than 1:1. That means that if you want to buy $1,000 worth of stablecoins, you will need to deposit $1,500 or $2,000 worth of collateral, which equals to 50% and 100% overcollateralization ratio, respectively. Thanks to it, even if the price of the locked assets goes down, the stablecoin will maintain its $1 peg. 

However, there’s still a degree of probability that the price of the collateral drops below the set threshold. In that case, crypto assets locked in a smart contract get liquidated, and more stablecoins are bought to reduce the supply and sustain the peg. 

The most prominent stablecoin in this category is DAI, issued by MakerDAO. However, the protocol’s community is now considering the possibility of dropping the dollar peg to reduce the exposure to USDC, which currently collateralizes 50% of DAI. Such a drastic move is a reaction to the USDC issuer’s decision to freeze funds in wallets linked to Tornado Cash, a crypto mixing service sanctioned by the U.S. Treasury in August. 

Read also: Maker Price Prediction 2023. Should I buy MKR?

Another example of a crypto-collateralized stablecoin is RAI, the Ethereum-backed fork of Maker’s DAI that relies on an automatic interest rate algorithm incentivizing users to keep RAI at its target price range. Then there are also MIM, a native stablecoin of the Abracadabra DeFi lending platform backed by yield-bearing crypto assets, and LUSD, a fully redeemable USD-pegged stablecoin issued by the Liquity Protocol. 

Fiat-collateralized stablecoins

Unlike their crypto-backed siblings, fiat-collateralized stablecoins are issued by centralized entities that hold fiat reserves equal to their stablecoin supply. In this case, the value is stored in cash, bonds, funds, commercial paper loans, and other low-risk TradFi instruments that are administered by independent custodians. Being truly backed by real-world assets, fiat-collateralized stablecoins are perceived as more reliable, hence their popularity among investors – the three biggest stablecoins, Tether’s USDT, Circle’s USDC, and Binance’s BUSD, are all fiat-backed. However, there is a catch: the issuers need to have their accounts externally audited. Thus, the issue of transparency arises.

Tether, the biggest stablecoin issuer, has long been called a “ticking time bomb of crypto” due to its reluctance to disclose the details of its holdings. When crypto news service CoinDesk requested the release of the “asset reserve composition,” Tether initiated a months-long legal battle, filing a court petition to keep the information confidential, arguing that the disclosure would hurt the company’s business. Eventually, Tether was legally forced to publish the breakdown of its reserves, but a bitter aftertaste remained a long time after.

Moreover, with the recent crackdown on Tornado Cash, the censorship resistance of centralized stablecoins became a hot topic as well. Since fiat-backed stablecoin issuers have to comply with regulators of their respective jurisdictions, one can’t be sure that one day their holdings won’t be frozen as a result of sanctions compliance. 

Commodity-backed stablecoins

Commodity-backed stablecoins are pegged to the value of physical assets like real estate, oil, or precious metals. They can also be based on index funds tracking the basket of commodities. As in the case of fiat-backed stablecoins, the collateral is stored in a vault of a trusted third party, but redemptions aren’t always honored, since it’s impossible to receive a fraction of property or a barrel of oil. And you should also keep in mind that the price of a commodity can fluctuate, which means that purchased stablecoins can lose in value. 

The most popular commodity for stablecoin backing is gold, with Tether Gold (XAUT) and Paxos Gold (PAXG) being the two biggest gold-backed stablecoins, redeemable for physical gold under the condition that users hold at least one bar-worth of tokens. Other notable examples of commodity-backed stablecoins are PTR, Venezuela’s cryptocurrency backed with oil, SRC, which is pegged to the value of a portfolio of Swiss real estate, and TCX, which is backed by a combination of seven precious metals. 

Algorithmic stablecoins 

Algorithmic stablecoins, unlike other types, aren’t collateralized at all – instead, their dollar peg is maintained through algorithmic wizardry. The price stability is achieved by adjusting the supply and demand of the pair of stablecoin and its underlying token. When the price of a stablecoin goes below $1, arbitrageurs can burn it in exchange for $1 worth of its sister coin, reducing the circulating supply and restoring the peg. Similarly, if the price jumps above $1, new stablecoins are minted to lower the demand. Basically, the underlying token serves as a buffer, absorbing excess volatility. 

Elegant and flawless on paper, such a mechanism turned out to be inherently fragile to any Black Swan event, such as strong FUD (Fear, Uncertainty, Doubt) among investors, or a drastic drop in cryptocurrency prices. The spectacular collapse of Terra’s UST stablecoin in May 2022 proved that the algorithmic model is risky and difficult to keep stable in the long run, having cost many investors their life savings. 

Bottom line

Ironically, stablecoins’ price is rarely 100 percent stable – almost every stablecoin from those mentioned above has experienced a brief depeg at least once throughout its history. Stablecoins, unfortunately, aren’t the crypto equivalent of a money market fund, despite being advertised as such. That means you should approach them with a degree of caution, and keep in mind that investing in stablecoins is almost as risky as investing in other cryptocurrencies. 

However, the significance of stablecoins is not to be underestimated – they are serving as a gateway that connects traditional financial markets with a burgeoning DeFi ecosystem, opening new doors to the mainstream adoption of cryptocurrencies. On top of that, stablecoins are often the last resort for unbanked or underbanked individuals to gain access to financial services such as loans, deposits, and transfers.