A stablecoin is a type of cryptocurrency designed to maintain a stable value relative to a specific reserve asset, such as a fiat currency, commodity, or some other basket of assets. For example, UST and USDC are pegged to the US dollar and are engineered to always be exchangeable at a 1:1 ratio. Unlike variable cryptocurrencies, like Bitcoin or Ethereum, stablecoins aim to provide price stability, making them practical for everyday transactions, trading, as a unit of account, and as a store of value within the decentralized finance (DeFi) ecosystem.
The changeable nature of cryptocurrency creates challenges for its practical use. A payment made in Bitcoin today might be worth 20% more or less tomorrow. Stablecoins solve this problem by combining the benefits of blockchain technology (fast, borderless, trust-minimized, programmable transactions) with the price stability of traditional assets or currencies.
Stablecoins serve as a bridge between traditional finance (TradFi) and decentralized finance (DeFi). They enable users to move value without leaving the blockchain system, or exposing their tokens to crypto price volatility.
In addition to facilitating payments, stablecoins have found a strong product-market fit as a store of value, particularly in countries with histories of high inflation or rapidly depreciating fiat currencies. Users in these nations often adopt stablecoins to preserve purchasing power, using them as a more reliable alternative to local money that may lose value quickly.
Stablecoins maintain their link to a reference asset through different mechanisms, each of which have clear tradeoffs in terms of decentralization, capital efficiency, and risk.
Fiat-collateralized stablecoins are backed 1:1 by traditional fiat currency or short term reserves, like US treasuries, that are held by a centralized entity. This means that for every one stablecoin issued, there is an equivalent amount of fiat currency held to back it.
Examples of these stablecoins include USDT (Tether) and USDC (USD coin) - both pegged to the US dollar. When you hold one USDC, the issuer (Circle) holds one US dollar or equivalent treasury note in reserve.
Advantages: Simple mechanisms, intuitive value proposition, high liquidity.
Disadvantages: Requires high trust in the fiat currency holder, centralized control, regulatory compliance requirements, and the need for regular audits.
Crypto-collateralized stablecoins are overcollateralized relative to other cryptocurrencies held in smart contracts. Since crypto assets are more volatile, this type of stablecoin often requires more collateral than the stablecoins actual value - sometimes reaching 150-200% of the available stablecoin circulation.
The most prominent example of this mechanism is DAI, created by MakerDAO. With DAI, users lock up a cryptocurrency, like ETH, into a smart contract to mint DAI. If the collateral value drops below a specific threshold, the smart contract automatically sells some of the deposited token to maintain DAI’s value.
Advantages: Decentralized, permissionless, transparent on-chain collateral, and no need to trust a central authority.
Disadvantages: Capital is inefficient due to overcollateralization, vulnerable to crypto market crashes, and has complex liquidation mechanisms.
Algorithmic stablecoins aim to maintain their peg through supply and demand mechanisms controlled by algorithms and smart contracts. These often don’t have any traditional collateral backing. The protocol automatically adjusts the token supply to maintain stability, creating new tokens when the price is too high, and burning tokens when the price decreases.
This category of stablecoins is highly volatile with a history of notable failures, including TerraUSD, which collapsed in May 2022. This demonstrated the risks associated with undercollateralized algorithmic stablecoin mechanisms.
Advantages: Capital efficient, with no need for reserves, and is theoretically fully decentralized.
Disadvantages: Vulnerable to death spirals, unproven at scale, and has a high risk of depegging during periods of market stress.
Commodity-collateralized stablecoins are backed by physical assets like gold, oil, or real estate. Two examples are Pax Gold (PAXG) and Tether Gold (XAUT) which are backed by physical gold reserves.
The value of these stablecoins is typically tied to the market price of the associated commodity. For example, if a $1 token is minted when gold is priced at $3,000 per ounce, the amount of gold held in reserve per token is adjusted as the market price changes, ensuring the token continues to reflect the value of the underlying asset. This mechanism allows the stablecoin to maintain a stable value relative to the commodity, even as its market price fluctuates.
Advantages: Exposure to commodity prices, and potentially inflation-resistant.
Disadvantages: Requires trust that custodians actually hold the physical assets, they are less common, and have lower liquidity.
Most stablecoins are issued as ERC-20 tokens on the Ethereum blockchain, which allows them to integrate seamlessly with wallets, exchanges, and DeFi protocols.
Other stablecoins exist on alternative blockchains, such as Binance Smart Chain (BEP-20), Solana (SPL), and Algorand (ASA), depending on the ecosystem they target. These will use other chain-based token types.
Choosing a token standard affects compatibility, transaction fees, and the range of applications where the stablecoin can be used.
While ERC-20 dominates, stablecoins are increasingly multi-chain, issued in different token formats depending on the blockchain ecosystem and user base.
The mechanism for maintaining price stability varies by type of stablecoin:
Fiat-backed stablecoins rely on redemption mechanisms for stability. If the price rises above $1, arbitrageurs can buy fiat currency and mint new stablecoins. If it falls below $1, they can redeem stablecoins for fiat, thereby reducing supply.
Crypto-backed stablecoins use overcollateralization and liquidation mechanisms. Smart contracts automatically liquidate undercollateralized positions to maintain the peg.
Algorithmic stablecoins use protocol-controlled supply adjustments. This approach, however, has proven fragile in practice.
There are several key use cases for stablecoins within the crypto ecosystem, including:
Trading and liquidity:
Traders can use stablecoins to move between positions without converting to fiat currency. This provides stable trading pairs on both decentralized and centralized exchanges.
DeFi protocols:
Stablecoins serve as the foundation for lending, borrowing, and yield farming protocols where price stability is essential. They are often deposited into liquidity pools, where their stable nature helps ensure predictable returns and reduces the risk of value adjustment losses for participants.
Cross-border payments:
Stablecoins enable fast, low-cost international transfers without traditional banking intermediaries.
Hedging volatility:
Users can store funds in stablecoins during market uncertainty, without leaving the blockchain ecosystem. This is also helpful for those based in regions where traditional currency is volatile.
Smart contract settlements:
Programmable money facilities automated payments, payroll, and settlements in predictable denominations.
Self-custody:
Stablecoins allow individuals to hold and manage value directly, outside of traditional financial systems, giving users more control over their funds without relying on banks or other intermediaries.
Store of value:
Stablecoins are also practically used as a store of value. Users in countries with depreciating fiat currencies adopt them to preserve their purchasing power, as a more reliable alternative to local currencies that could lose their value.
The market is dominated by a few major players.
USDT (Tether)
The largest stablecoin by market cap. It’s 100% fiat-backed, but has faced controversy over transparency, particularly regarding whether it consistently held sufficient reserves to fully back all tokens in circulation. Despite these concerns, USDT remains widely used across exchanges and DeFi platforms as a way to move and store value.
USDC (USD Coin)
Issued by Circle, this stablecoin is known for its transparency and focus on regulatory compliance. It’s widely used in the DeFi space for payments, trading, and liquidity. The issuer provides regular attestations - independent reports confirming that the total USDC supply is fully backed by dollar reserves.
DAI
This is the leading decentralized stablecoin. It is crypto-collateralized through over-collateralized loans in MakerDAO Vaults (previously called Collateralized Debt Positions or CDPs), where users lock approved tokens to mint DAI. This system maintains its US dollar peg without relying on a central issuer.
BUSD (Binance USD)
BUSD is a fiat-backed stablecoin issued by Binance and Paxos, but is now being phased out with the removal of support for the token.
Its issuer, Paxos, was ordered by U.S. regulators to stop minting new tokens, amidst more stringent stablecoin regulations. Binance is transitioning users to a new stablecoin, FDUSD, to simplify compliance and reduce reliance on an external issuer.
USDD, FRAX, and others
These use various algorithmic and hybrid approaches, and have smaller market caps.
While stablecoins do offer stability relative to other cryptocurrencies, they also carry distinct risks that are worth noting. These include:
Centralization risk:
Fiat-backed stablecoins can be frozen by issuers and are subject to regulatory pressure. An increasing number of nations are applying restrictions or regulations on stablecoins and their providers, to better match traditional finance markets.
Collateral risk:
The reserves backing a stablecoin may not be fully audited or may include risky assets.
Depeg events:
Stablecoins can temporarily or permanently lose their peg during times of market stress, as seen with UST's collapse, especially with non asset-backed collateralized offerings.
Regulatory uncertainty:
Governments are actively developing stablecoin regulations that could impact issuers and users. These could include restrictions on minting or holding stablecoins and increased centralization.
Smart contract risk:
Decentralized stablecoins rely on immutable, permissionless code that could contain vulnerabilities.
Counterparty risk:
Trusting centralized issuers requires confidence in their reserves and operations. Ultimately, this negates the very ethos of blockchain and cryptocurrency.
