How Do Stablecoins Work?

And why, occasionally, they don’t

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Stablecoins are cryptocurrencies linked to the market price of another asset. Popular stablecoins are pegged to the U.S. dollar, the price of gold, and other cryptocurrencies, such as Bitcoin and Ethereum. In this article, you’ll learn how stablecoins work, the risks, and what they’re used for.

Key Takeaways

  • Stablecoins are cryptocurrencies pegged to the price of another asset, such as the U.S. dollar, gold, or stock in a public company.
  • Some stablecoins are backed by assets; other stablecoins are backed by algorithms or volatile cryptocurrencies.
  • Stablecoins sometimes lose parity with the asset to which they’re pegged.
  • Loss of peg is usually due to mismanagement of the reserves, or faulty or badly designed code.

How Do Stablecoins Work?

Stablecoins are cryptocurrencies linked to the price of another asset through algorithms or vast reserves. The peg is a price that a stablecoin always shoots for, relative to the asset it’s pegged to. In the case of a U.S. dollar stablecoin, that’s $1.

The assumption is that stablecoins can be readily redeemed or traded for the value of the asset they’re pegged to. While some stablecoins are backed by tangible assets—PAX Gold, for instance, is backed by gold bullion bars stored in vaults—more volatile cryptocurrencies back others.

Cryptocurrencies can see significant price fluctuations over a short period of time, which means a stablecoin pegged to a cryptocurrency facing volatility could also witness extreme swings in value.

The main advantage of stablecoins is that their prices, when working properly, maintain parity with the asset they’re pegged to.

They’re a “safe haven in the wild world of crypto,” said Manuel Rensink, director of strategy and innovation at crypto company Securrency.

The most popular stablecoins are pegged to fiat currencies (standard currencies issued by almost every nation in the world). Consider them like digital cash. In times of market volatility, you could exchange cryptocurrencies experiencing price swings for fiat-backed stablecoins that would ordinarily not move much due to their fiat peg. Because of the way crypto exchanges work, such a transaction would be quicker than cashing out that cryptocurrency, and you’d still remain invested in cryptocurrencies.

Stablecoins also allow traders to invest in an off-chain asset (an asset not on the blockchain, such as gold), within a decentralized finance (DeFi) protocol on the blockchain. They also allow traders to port assets from one blockchain to another.

Wrapped Bitcoin (WBTC), for instance, is a Bitcoin stablecoin that lets holders invest an asset that represents the price of Bitcoin on the Ethereum network. Since Bitcoin is the largest cryptocurrency by market cap, it would give you the advantage of investing in an asset that mirrors its price, without being tied to the Bitcoin blockchain. The Ethereum network has more applications, and supports more kinds of transactions, which would make it beneficial if you’re looking to spend that WBTC.

Types of Stablecoins

Based on the type of assets they’re pegged to, stablecoins can be classified into a number of categories.

Fiat-Backed Stablecoins

Fiat-backed stablecoins are cryptocurrencies that are backed with huge cash reserves, or cash equivalents. Fiat currencies are regular currencies issued by central banks, such as the U.S. dollar, the British pound, and the euro. As of May 2022, the three largest fiat-backed stablecoins by market capitalization are Tether, Binance USD Coin (BUSD), and USD Coin (USDC).

As of March 31, 2022, BUSD, a U.S. dollar stablecoin managed by crypto exchange Binance and stablecoin issuer Paxos, was mostly backed by U.S. dollars and government debt. USDC, which is issued by a Circle and Coinbase-led consortium called Centre, is backed by similar assets.

There is no consistency in how the information about reserves is presented across different coins. There is also a lack of clarity and standards about reporting the composition of those reserves.

That is one issue that has plagued Tether, the largest U.S. dollar stablecoin, whose backing is not very clear. Tether ran afoul of multiple regulators and had to pay fines for improper disclosure of reserves.

In the most recent data available, as of December 2021, Tether said it held 83.74% of its reserves in cash and cash equivalents, plus short-term deposits and commercial paper—in other words, short-term corporate debt. Of this, 36.68% was in commercial paper.

However, Tether does not disclose the breakdown of commercial paper it holds. If it is not well-diversified, debt exposure to a single company or sector could pose a significant risk.

If stablecoin companies are found to have misled customers about their reserves (as was the case with Tether, which in 2019 admitted it was only 74% backed), people may no longer believe that a single USDT, BUSD, or USDC coin is worth a dollar, and the price may crater.

Cryptocurrency-Backed Stablecoins

Cryptocurrency-backed stablecoins are stablecoins backed by other cryptocurrencies. The most popular variant by market capitalization is Wrapped Bitcoin (WBTC), a token that mirrors Bitcoin but is issued on the Ethereum blockchain. Reserves of Wrapped Bitcoin are held in vaults operated by custodians. Other crypto-backed stablecoins, such as renBTC, are held in vaults managed by smart contracts—bits of cryptocurrency code.

The risk with crypto-backed stablecoins is that someone will steal the cryptocurrency that backs the stablecoins, leaving you with a cryptocurrency that cannot be redeemed for the underlying cryptocurrency. Another risk is that an attack on the stablecoin smart contract itself may break the peg to the underlying cryptocurrency.

A hacker could exploit faults with the smart contracts to steal the cryptocurrency. This happened to Wormhole in February 2022, when 120k Wrapped Ethereum (wETH) was stolen from its smart contracts.

Asset-Backed Stablecoins

Fiat currencies aren’t the only off-chain assets represented by on-chain stablecoins. Other assets include commodities such as gold (like Tether Gold and Paxos Gold) or stock-based tokens.

Similar to fiat-backed stablecoins, these are usually backed by reserves of a more tangible asset. And like fiat-backed stablecoins, the risks are comparable—what happens if Tether hasn’t really bought the gold it says it has?

Algorithmic Stablecoins

Algorithmic stablecoins are backed by other cryptocurrencies, but that backing is not exactly in terms of reserves of that cryptocurrency. Simply put, the peg is determined by rules or software code linked to another cryptocurrency rather than holding the underlying cryptocurrency in a vault. Dai maintains its peg to the U.S dollar through collateralized loans of coins such as Ether, Bitcoin, and fiat-backed stablecoins such as USDC. Terra backed its U.S. dollar stablecoin, UST, with a second, volatile cryptocurrency called LUNA, which arbitrageurs could always swap for $1 UST.

Cryptocurrencies can be too volatile to sustain a peg to the U.S. dollar, as the de-peg of UST in May 2022 demonstrated. When LUNA fell 94% in a single day, the price of UST plunged, and not even Terra’s multi-billion-dollar reserves of Bitcoin could save it.

"Under-collateralization is incredibly dangerous,” warned Ruben Merre, co-founder of crypto-wallet company NGRAVE. “Over-collateralization is conservative, but in the long term, much more likely to stand the test of time.”

What Are Stablecoins Used For?

Stablecoins can also allow on-chain representations of off-chain assets (such as gold) as well as assets from another blockchain). The purpose is to use the value of the original asset within the crypto ecosystem. As the name suggests, their main advantage is stability. The stability of U.S. dollar stablecoins has made them the most popular pairing on a crypto exchange, and a popular coin to stake within DeFi protocols such as Yearn Finance, which allows you to lend and generate yields on your cryptocurrency.

The Bottom Line

Stablecoins are useful assets, but they’re not without their risks. Algo-stablecoins might not be able to maintain their peg in the event of a market crash, and unaudited fiat-backed stablecoins might not be backed by the reserves advertised by the companies that issue them.

“You’re relying on the team that put together the stability mechanism. A flawed algorithmic mechanism that breaks down in times of market stress can wipe out any promised yields and much more—as we have seen with Terra,” said Rensink.

Before investing, Rensick advises that you research the stablecoin before buying. “Adequate collateralization and sustainable yields are key,” he said. “An emphasis should be put on high-quality collateral that is on-chain but not protocol-native (as Luna is/was), that provides a solid backstop in times of stress."

Investors should review audits and attestation reports, work out what a coin is backed by, and read whitepapers. But above all else, Rensink advised the obvious: “Check how the coin performed in times of market stress. Was it able to keep the peg?”

Frequently Asked Questions (FAQs)

What are stablecoins?

Stablecoins are cryptocurrencies pegged to the price of another asset.

How many stablecoins are there?

There are dozens of stablecoins, but only six have market capitalizations above $1 billion, as of May 2022: Tether, USDC, Binance USD, Dai, TerraUST and TrueUSD.

What are the best stablecoins?

This is tricky to answer, and those that are stable in times of great market confidence may shatter when the going gets rough. Historically, U.S. dollar stablecoins such as USDC and Dai have proven resilient during market crashes, maintained their pegs, or temporarily deviated by just a few cents.

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