What are stablecoins, and how do they work ?
Alexis Hebrard
October 3, 2023
Tokenomics
In the world of cryptocurrencies, volatility is often the rule rather than the exception. As a matter of fact, it's not uncommon for Bitcoin, Ethereum, and other altcoins to experience significant price fluctuations. Faced with this volatility, one category of cryptocurrencies stands out: stablecoins.
But what are stablecoins exactly? How do they work? And do they have limitations?
That's what we'll explore in this article.
"Stablecoins were created to bridge the gap between the real world, represented by fiat currency, and the blockchain world. The stablecoin is like the bank account of the crypto world. It's a practical tool commonly used as a safe haven or for easy conversion between cryptocurrencies."
Philippe de Gouville, Co-founder of ISMO
Stablecoins are a type of cryptocurrency designed to maintain a stable value, usually pegged to a traditional currency like the US dollar. This innovation offers a solution to the volatility of cryptocurrencies by providing an asset with a stable price while preserving the mobility and utility associated with cryptocurrencies.
Stablecoins have a role to play in the growth of the cryptocurrency market. One of the most promising applications is their utility as an on-ramp for traditional capital (fiat currencies) into crypto. Instead of thinking of stablecoins as a kind of ballast that keeps the crypto ship steady, think of them as a harbor—a place where people can load and unload assets.
Traditional payment systems could be directly linked to stablecoins, with a wallet, enabling daily transactions. Investors would be able to purchase tokenized assets tied to company stocks, bonds, real estate, commodities, and collectibles.
As shown in the graph below, the growing market capitalization of stablecoins clearly indicates their adoption. Currently, three stablecoins dominate 90% of the market: Tether, USD Coin, and DAI, respectively.
Hedging against fluctuations: Bitcoin and Ethereum are often referred to as new stores of value, especially Bitcoin, which is starting to be considered digital gold. However, the value of cryptocurrencies fluctuates greatly, sometimes within minutes. Stablecoins were created to solve this problem by offering a stable value regardless of market conditions. For example, traders commonly use these tokens to secure their profits and gains in a stable currency.
Facilitating Transactions: Blockchains are accessible 24/7 from anywhere, allowing payments or fund transfers at any time. There are no border constraints; sending stablecoins worldwide is a breeze. This accessibility significantly expands financial inclusion globally, using just a smartphone or computer. Moreover, making an international transfer with blockchain takes seconds and costs only a few cents, regardless of the amount.
Providing Liquidity: This use case is more complex and relates to facilitating liquidity provision in decentralized finance (DeFi) protocols. Without going into technical details, many DeFi protocols rely on what are known as liquidity pools. These pools are funded by liquidity providers (LPs) who receive compensation in return. In most cases, these pools consist of asset pairs, where one asset is exchanged for another (e.g., a Bitcoin/Ethereum pool allows you to exchange BTC for ETH and vice versa without using a centralized platform).
In these pairs, usually one of the assets is often a stablecoin, which helps stabilize the pair. Consider a simple example: it's easier to agree on the price of a car in dollars than to determine the price of a car in terms of apples. The same applies to Bitcoin as the car, Ethereum as the apple, and the dollar as Tether (USDT). It's easier to estimate the price of Bitcoin in Tether (USDT) than to determine the price of Bitcoin in Ethereum.
There are four types of stablecoins, distinguishable by their underlying structure:
These stablecoins are directly backed by a traditional fiat currency (e.g., USD, Euro). This means that for every stablecoin issued, there is a corresponding cash reserve held in a bank account, known as a 1:1 collateralization. If the reserve holds $1 million, only $1 million worth of tokens can be distributed. If there are more tokens than money in the reserve, the token's value will fall below $1 because the 1:1 rule hasn't been met. This type of stablecoin is considered centralized because the management of assets is carried out by a financial institution. To assess the security of a traditional stablecoin, it is necessary to verify the reserves of the issuer.
Below, you can see the official reserves of Tether as of June 30, 2023:
As the name suggests, stablecoins in this category are backed by another cryptocurrency, often a basket of various cryptocurrencies. This structure helps mitigate the risk of volatility. With a mix of cryptocurrencies, even if one experiences a significant price drop, other currencies can offset the decline, theoretically ensuring stable token value. However, since all cryptocurrencies are highly correlated, the diversification of the basket is not optimal. For example, DAI is the most significant stablecoin in this category. It was previously 100% backed by cryptocurrencies, but the protocol decided to add traditional assets to counter market correlation (the collateral list for DAI is available here).
Another significant factor of cryptocurrency-collateralized stablecoins is that they are often over-collateralized. This structure is necessary to manage market value fluctuations efficiently. By providing more collateral than necessary, the sudden price crash risks are mitigated. For example, a traditional stablecoin is backed 1:1 with USD, while a decentralized stablecoin is often backed 1:2 with cryptocurrencies.
In their purest form, algorithmic stablecoins are entirely non-collateralized, meaning their value is not backed by an external asset. Instead, they use algorithms—specific instructions or rules followed by a computer to produce a certain outcome. These algorithms are designed to influence market participants' behavior by manipulating supply and demand so that, theoretically, the price of each coin stabilizes around the reference value of $1.
The most common algorithm is based on the seigniorage system. But how does this model work?
The distinctive feature of the Seigniorage model is its ability to maintain stability. Stability is generally defined relative to a reference, such as $1 per token. When the token's market price exceeds this parity, the Seigniorage model intervenes. If the token's price surpasses parity, the smart contract mints new tokens and sells them on the market. This increases the token's supply, driving down the price. Conversely, if the token's price falls below parity, tokens are bought back from the market, reducing supply and driving up the price. The algorithm thus acts similarly to a central bank by regulating supply and demand. To maintain stability, users are incentivized to participate in the mechanism. They can buy or sell tokens based on market signals, and by participating, they can receive rewards in the form of additional tokens.
It's essential to note that this type of algorithm is often supported by a minimal collateral reserve (in crypto). This reserve often serves as a backup for the protocol. Although the Seigniorage model presents an innovative approach to creating stablecoins, it comes with considerations. Stability depends heavily on users' trust in the protocol and how collateral reserves are managed efficiently. It's also important to note that in the early stages, there may be periods of significant price fluctuations. The most famous example of a crash of an algorithmic stablecoin is the incident with the UST token, which experienced a 90% drop in less than three days, wiping out over 30 billion dollars . However, the causes of its fall are more complex than the theory described above and would deserve an entire article on the subject.
Commodity-collateralized stablecoins
Finally, a fourth type, although less commonly used than the three mentioned above, is worth mentioning. Commodity-collateralized stablecoins are backed by physical assets such as precious metals, oil, or real estate. The most commonly used commodity is gold, as is the case with Tether Gold (XAUT).
These stablecoins are less susceptible to inflation compared to fiat-collateralized stablecoins and are a good choice for those looking to invest in precious metals but have difficulty obtaining direct access. However, their main drawback is that they are significantly less liquid than other options, and commodity prices can fluctuate and are prone to losing value.
Stablecoins, as they exist today, face an inherent trilemma—concurrently maintaining complete decentralization, capital efficiency, and price stability. History has shown that these three objectives cannot be achieved simultaneously.
Indeed, a stablecoin that aims to maintain its peg and be entirely decentralized must be overcollateralized (e.g., DAI), which means it is capital-inefficient.
Alternatively, a capital-efficient stablecoin that does not need to be overcollateralized, cannot be entirely decentralized because it requires a centralized issuer and custodian (e.g., Tether or Circle).
Or, a fully decentralized and capital-efficient stablecoin must have an algorithmic stabilization mechanism, but history shows that this comes at the expense of price stability.
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Stablecoins have become an essential component of the crypto ecosystem, offering price stability and utility similar to fiat currencies while retaining the advantages of cryptocurrencies. They are used for payments, store of value, and facilitating exchanges. However, it's important to note that each category of stablecoins has its own advantages and risks. Users should be aware of these factors and exercise due diligence when using stablecoins. Despite the challenges related to decentralization, capital efficiency, and price stability, stablecoins continue to evolve and innovate to meet the growing market demand. Therefore, it's crucial to closely monitor these developments and stay informed about the latest advancements in this field.
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