Stablecoins: Types and how they work

In recent months, we have seen a “stablecoins fever” across the market, with metrics exploding, and even launches of blockchains focused on stablecoins. To explore the use cases, that are more and more real, we need to understand the basic concept behind stablecoins and how they work.

Stablecoins are a type of cryptoasset made for its value be “stable”, usually correlated with commodities or FIAT currencies, causing you to achieve the “stability” of traditional markets without leaving the crypto world. In order to remain stable and correlated, stablecoin’s issuers use different mechanisms. Among the most used we can mention:

Fiat-Backed Stablecoins

The most traditional and used in the market; is where you probably already had contact at some point. Generally used for B2B, cross-border, or even by people from countries with weak currencies to protect themselves from their local currency. The two most used stablecoins on the market (USDT and USDC) are fiat-backed.

In this mechanism, for each token in circulation, there is the same value in FIAT (or derivatives) stored in bank reserves. That is, for every $1 that has been added to the blockchain, a real “dollar” has been added to some vault. To ensure security, the major issuers of these stablecoins undergo major and rigorous audits to prove their liquidity and secure their funds.

Commodity-Backed Stablecoins

Much like the previous mechanism; however, here the stablecoin is related to the price of commodities such as Gold, Silver and Oil. Now you may be thinking: “but commodities are not stable”, and yes, you are right, but the point here is that stablecoins remain stable at the price of their correlated asset in the world outside the blockchain, and not necessarily stable at their price itself.

This type of stablecoin is very useful for those who want to easily expose themselves to other traditional markets and investments with the ease of blockchain, such as holding gold tokens instead of worrying about actually buying and storing gold. As for its mechanism, it is very similar to FIAT, however, as you might have guessed, reserves are made on the commodity itself and audited in the same way.

Crypto-Collateralized Stablecoins

Here the mechanism changes a little. We exit reserves in the “real-world” and start seeing “reserves” in cryptoassets. In this case, these tokens need to be “over-collaterized“ to protect stability, since the cryptoassets that form the reserve are much more volatile and may fall in price.

The best-known example using this mechanism is DAI, which is issued by MakerDAO, one of the largest projects in the crypto universe. A common method used is the use of smart contracts and apps, where users can deposit a “collateral” in cryptoassets and receive DAI (1 DAI = 1$). Due to the need to be over-collaterized to maintain stability even when crypto reserves fall in price, users need to deposit more than the amount they will issue in DAI.

These projects on the one hand bring a greater decentralization and also an intrinsic transparency, because the reserves are on-chain and accessible for anyone to monitor and verify the liquidity and proof of funds. However, because they are based too much on very volatile assets, this makes it difficult to be more institutionally adopted and is also vulnerable to new problems such as a possible mass liquidation in some crash for example.

Algorithmic Stablecoins

Here we have perhaps the most complex and controversial mechanism of all. Rather than having reserves in the “real-world” or collateral in contracts, algorithmic stablecoin projects rely on literally algorithms that aim to maintain that stability. These algorithms can act in a variety of ways, such as by minting tokens when the price goes up, and burning tokens when the price goes down, or even hedging and creating Delta Neutral positions for a basket of collateralized assets.

While this mechanism may seem more “modern” and even transparent throughout the process be on-chain, it is also the riskiest and where users are most suspicious. This is mainly due to the UST case, the Luna dollar, where the algorithm relied heavily on LUNA to maintain its peg. When the LUNA cryptocurrency fell more than 80% overnight, the UST went down as much as 60%, making it one of the biggest crashes in crypto history.

The Future

In addition to all these algorithms and mechanisms seeking to maintain the stability of these assets, these projects also rely on external economic incentives such as arbitrage, where traders can capitalize on slight fluctuations, which also quickly balances supply and demand. In addition to these mechanisms and incentives, strict and clear regulations and audits are increasing confidence in these assets, and old problems are increasingly becoming a thing of the past.

Stablecoins are becoming an important pillar in the financial structure of the entire global market. With the evolution of the crypto market, greater institutional and regulatory clarity, along with the popularity and understanding of the general population, these assets are set to become an even larger market share and perhaps establish themselves as the “big use case” for crypto in people’s daily lives.