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How Do Stablecoins Work: The Mechanics Behind Crypto Stability

For crypto users, stablecoins present a means to preserve their portfolio’s value during unpredictable market conditions and to serve as a form of digital cash, a stable medium of exchange. But what keeps these assets stable?

Deep dive
July 21, 2023
Lead Content Manager
Stablecoin mechanics

While cryptocurrencies have revolutionized the digital landscape with their decentralized nature and captured the public’s eye with their potential for substantial returns, their extreme price fluctuations have remained a UX challenge. Wild swings in portfolio value can be emotionally exhausting for users and present a problem in merchant flows: how do you price a sale in a currency that does not hold a steady value?

Stablecoins are cryptocurrencies that are designed to maintain a stable value to solve this volatility problem.

Since the 2014 release of BitUSD, the first stablecoin, the popularity of stablecoins has skyrocketed, reflecting the growing demand for stable assets in the crypto market. And today, 2 of the top 6 biggest cryptocurrencies by marketcap are stablecoins.

To fully leverage the benefits of stablecoins in your app (or to design your own), it's helpful to understand the mechanisms that keep these assets stable. Let’s take a closer look at the various types of stablecoins, the mechanisms that maintain their stability, and their potential use cases.

What Are Stablecoins?

Stablecoins, as the name implies, are digital assets that aim to maintain a stable value and mitigate the inherent volatility that plagues traditional cryptocurrencies such as Bitcoin and Ethereum. Most stablecoins achieve this stability by pegging their value on a 1:1 basis to real-world assets like fiat currency, such as the U.S. dollar, or commodities, such as gold or oil. A simple way to think about stablecoins is that 1 stablecoin = $1 (or 1 Euro, 1 Yen, etc).

A simple way to think about stablecoins is that 1 stablecoin = $1.

Experts in the crypto industry recognize the critical role stablecoins play as a medium of exchange in the broader ecosystem. According to Paul Brody, a renowned crypto analyst and global blockchain leader at Ernst & Young, "In an ecosystem like cryptocurrencies, where volatility is typically high, this is an important property. If you want to take advantage of blockchain technology without exposing yourself to the volatility in crypto prices, this is the way to do it."

Recent reports indicate a significant increase in the use of stablecoins. According to CoinGecko’s 2023 Stablecoins Statistics Report, the total market cap of stablecoins reached $138.4 billion by the end of January 2023. This surge propelled stablecoins to represent 12.9% of the entire cryptocurrency market. This growth signifies a rising usage trend, with roughly 1 million users relying on stablecoins for daily transactions.

Stablecoin Use Cases

The design of stablecoins actively maintains a relatively stable value, which increases their attractiveness for various use cases and applications:

  • E-commerce: Buyers and sellers can utilize stablecoins in transactions to insulate themselves from the volatility typical of other crypto assets. This ensures a consistent value for goods and services and that both buyer and seller are getting fair value for the transaction.
  • Remittances: Individuals can use stablecoins as a faster, more cost-effective alternative to traditional banking systems for cross-border transactions and payments. Stablecoins enable quick, global transfers with minimal fees.
  • International business: Many businesses operate internationally and have to navigate multiple currencies, which introduces operational overhead. Stablecoins can offer a path to streamline operations around a single digital currency, making businesses more efficient.
Wherever someone would use cash, that’s a use case for stablecoins.

Effectively, stablecoins are a digital form of cash that is more efficient and more decentralized than fiat currencies today. Wherever someone would use cash, that’s a use case for stablecoins.

Types of Stablecoins

Stablecoins come in various forms, each with its own mechanics and characteristics. Let's explore the different types of stablecoins that have emerged and their advantages and potential risks.

A graphic showing the different traits of stablecoins

Crypto-Backed Stablecoins

Crypto-backed stablecoins get their stability through collateralization with other cryptocurrencies. For this type of backing, the underlying cryptocurrencies' value sustains the stablecoin's value.

To mint a stablecoin, users deposit cryptocurrency as collateral in a smart contract, and the amount a user deposits influences how much of the stablecoin they can mint. Later, users can burn the stablecoins and pay the loan back (along with any interest) to retrieve their original cryptocurrency assets.

In general, crypto-backed stablecoins are capital-inefficient—to combat the underlying collateral’s volatility, the collateral must be a higher value than the minted stablecoin (e.g. users deposit $20 of crypto to mint $10 of stablecoins). They are also decentralized—users interact with a smart contract to mint the stablecoin, and the contract will automatically liquidate users if their collateralization ratio falls below a certain threshold. We’ll get back to these mechanics in a bit.

DAI, operating on the Ethereum blockchain, is an example of this stablecoin model.

Fiat-Backed Stablecoins

Fiat-backed stablecoins maintain their value through fiat reserves held by trusted custodians, usually the stablecoin provider. For example, if a user deposits $10 to mint $10 worth of USDT, the stablecoin provider keeps that deposited $10 in reserve. This method allows users to redeem their USDT for cash anytime.

As you can imagine, these stablecoins are centralized and operated by companies that custody that cash. That introduces risk: you have to trust that the company is in fact holding those dollars in reserve, and because those reserves are off-chain, you can’t verify it. For example, Tether's lack of transparency has long caused scrutiny due to ambiguities surrounding its reserves.

However, these stablecoins are also capital-efficient. Among the various stablecoin designs, fiat-backed stablecoins have found the most success, with USDT and USDC ranking among the top 6 cryptocurrencies by market cap.

Commodity-Backed Stablecoins

Commodity-backed stablecoins tie themselves to physical assets such as gold, oil, and other commodities. Each stablecoin actively pegs itself to a specific quantity of the underlying commodity (such as 1 troy fine ounce of gold), bridging the gap between the digital and physical. This setup allows users to gain digital exposure to physical commodities.

Importantly, the price of a commodity-backed stablecoin rises and falls with the underlying commodity it is tied to—these coins are not designed to maintain a 1:1 peg with a fiat currency.

These stablecoins are centralized, and challenges arise in verifying the existence of the underlying assets. Like fiat-backed stablecoins, you are trusting a third-party. The storage and transfer of those physical commodities also make these stablecoins capital-inefficient.

Given these stablecoins are not stable in price, much of the discussion in this article does not apply here, and we won’t spend too much time talking about these coins. They have a different use case than the other stablecoins described here (digital exposure to commodities). Pax Gold (PAXG) and Tether Gold (XAUT) are examples of gold-backed stablecoins.

Algorithmic Stablecoins

Algorithmic stablecoins use unique mechanisms to create a stablecoin that do not rely on collateral at all. Instead, these currencies rely on algorithmic supply adjustments, elastic supply models, algorithmic rebasing, second currencies acting as a bond token, and more, in order to maintain the peg.

Hypothetically, these stablecoins are both decentralized and capital-efficient, the ideal stablecoin. However, because of this innovative approach (and there are many approaches—no two algorithmic stablecoins are alike), these stablecoins present their own challenges. Their reliance on market dynamics can make timely responses to crises impossible (if everyone tries to cash out at once, there is no collateral to support them), which puts these stablecoins at risk of destablization due to swings in market sentiment or economic shocks.

Many projects, like Basis, UST, and Frax, have attempted to build an algorithmic stablecoin, but all 3 failed in the process.

A chart showing stablecoin characteristics

Mechanics of Stablecoin Stability

Cryptocurrencies, designed for decentralization and freedom from centralized control, inherently exhibit price volatility (it’s a byproduct of an asset with a fixed supply and variable demand). How, then, do stablecoins achieve stability in this dynamic landscape?

Collateralization in Stablecoins

Stablecoins use various methods to maintain stability. Far and away the most important concept to understand is collateralization, which you see in fiat-backed, crypto-backed and commodity-backed stablecoins.

For these coins, users lock up an asset as collateral and mint stablecoins, and that underlying collateral is what supports the price of the stablecoin. For most projects, that collateral is held in reserve, so that if a user burns a stablecoin to redeem (claim) the collateral asset, the project has that collateral on demand. In general, collateralization takes two forms:

  • Over-collateralization: the value of all deposited collateral is higher than the value of all minted stablecoins. From a UX perspective, this could mean a user would have to deposit $20 of BTC collateral in order to mint $10 of stablecoin. 
  • Under-collateralization: the value of all deposited collateral is less than the value of all minted stablecoins. As a user, you would still pay $1 per stablecoin (or more), but importantly all of the money isn’t kept in reserve (hence under-collateralized). For example, the stablecoin protocol (or company) could loan out deposited collateral to earn interest on it.

Many projects are over-collateralized. It’s safer and ensures that there is always enough collateral to redeem the stablecoin for the underlying asset. This is particularly important in the context of crypto-backed stablecoins where the volatility of the underlying asset could mean that the value of the crypto collateral could fall, making the stablecoin under-collateralized, which poses a risk—what happens if all stablecoin holders ask to redeem their coins at once? The money isn’t there, and the stablecoin collapses.

This is why reserve management is important and why stablecoins often have a liquidation ratio: if the collateral value falls below a certain threshold (e.g. 1.5:1), then the user forfeits their deposited collateral to the protocol (crypto-backed stablecoins) or to the stablecoin issuer (fiat-backed stablecoins) to defend the peg and recover the debt, ensuring that there is enough collateral to cover outstanding stablecoins.

Market Arbitrage

A graphic showing how market arbitrage stabilizes prices

The other important concept to understand here is arbitrage. Let’s say a stablecoin slips from its peg of $1 and is now trading at $0.98. Traders are incentivized to buy these stablecoins (at a discount) and redeem them for $1 of collateral, contracting the circulating supply of stablecoins. Similarly, if stablecoins are trading above the peg (at $1.02), then users are incentivized to mint more stablecoins and sell at a $0.02 profit (increasing the circulating supply) until that price discrepancy closes back to $1.

Rational market behavior helps defend the peg.

In this way, rational market behavior helps defend the peg, and arbitrage will close any deviations from the peg by encouraging supply growth in times of high demand and supply contraction when that demand decreases.

Algorithmic Stablecoins and Stability

The mechanics behind algorithmic stablecoins are different than the collateral mechanic discussed above (though it’s worth noting that some algorithmic stablecoins are under-collateralized and use algorithms to cover the difference).

Algorithmic stablecoins can use a variety of systems to maintain their peg. Those systems can include a second “bond” token. For example, UST had a companion token LUNA, and the supply of LUNA would expand and contract to stabilize UST and ensure that $1 of LUNA could always be exchange for $1 of UST. Basis explored a similar concept of using multiple tokens and had Basis (the stablecoin), which can be minted when demand grows, as well as a bond token to contract the Basis supply when demand drops (incentivizing users to burn Basis by giving them an IOU for future Basis at a discount). Both systems failed for different reasons, but if you squint, you can see how a second token could help stabilize a cryptocurrency at a hypothetical level. That code hasn't been cracked yet though.

Other designs take other approaches. For example, the Ampleforth protocol uses rebasing to adjust the token supply of AMPL, where the number of tokens in a user’s wallet will automatically go up or down on a daily basis based on the daily average price of the token. In other words, rather than owning a set number of tokens, users own a set % of the AMPL network, whose total supply rises and falls alongside demand.

However, algorithmic stablecoins are very much in the research phase, and none have had large-scale success like collateral-backed tokens have. Further research and experimentation is needed to refine algorithmic stablecoins and improve their robustness.

Stablecoin Regulatory Landscape

Stablecoins face regulatory scrutiny as governments and financial authorities navigate the challenges and opportunities of digital assets: how should you regulate natively-digital money? It’s a big question, and to date, there isn’t a clear answer.

How should natively-digital money be regulated?

But the repercussions of stablecoins are already affecting millions of people around the world. On the positive, around 1 million wallets are transacting with stablecoins every day (there is clear product-market fit). On the negative, the lack of clear regulation and understanding of stablecoin design are rugging retail investors—in 2022, the algorithmic stablecoin UST crashed, costing retail users billions of dollars—and affecting entrepreneurs—in 2018, Basis shut down their operations due to ‘regulatory constraints.’

The regulatory landscape surrounding stablecoins is evolving in real time, and there isn’t a clear legal framework today. However, there is increasing attention on regulators on what to do with these assets.  Global organizations like the Financial Action Task Force (FATF) and more recently the Financial Stability Board (FSB) are developing proposals to address risks associated with stablecoin activities, including financial stability, money laundering, terrorism financing, and consumer protection.

Stablecoins are also unsurprisingly facing scrutiny from individual nations. If done right, regulatory oversight can boost trust in stablecoins, provide operational frameworks, and mitigate risks for users. However, navigating complex, evolving regulatory requirements can challenge stablecoin projects, especially those seeking decentralization and global reach.

Like the Crypto Industry, Stablecoins Will Continue to Evolve

Stablecoins serve as a trustworthy medium of exchange, store of value, and link between the crypto and traditional financial systems. By understanding the various types of stablecoins, their underlying mechanisms, and the challenges they face, you can make informed decisions and actively contribute to advancing this technology.

As the crypto industry continues evolving, stablecoins will likely witness further innovations. The creation of a capital-efficient, decentralized, stable stablecoin remains something of a philosopher’s stone, and no one has yet been able to crack the code. If you’re inspired to start building, check out our guide to developing smart contracts:

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