What's the Deal with Stablecoins?

Stablecoins have been a trending topic lately and many believe they'll continue to remain a critical component of the larger crypto economy in the future. As developers and innovators explore the space, it's important to understand what a stablecoin is, how it works, and why would anyone use one.

A stablecoin is a digital asset that is pegged to a stable value—usually fiat currency. The biggest benefit of stablecoins is that they are not subject to the same volatility as other cryptocurrencies, which makes them less risky to hold. Just like fiat currency in traditional finance, stablecoins enable arbitrage and hedging opportunities for traders in the crypto market.

In bouts of wild volatility, traders look to stablecoins as a safe haven to park their assets. Stablecoins are still cryptocurrencies, many of which are on the Ethereum blockchain, so they seek to offer (but don't always) the same advantages of decentralization, immutability, and security.

During crypto bear markets, traders will often move their crypto holdings (like BTC or ETH) into stablecoins to weather the storm. Moving crypto into stablecoins when anticipating a market crash is a way to protect your assets from a decline in crypto value. Traders will then buy back into crypto at lower prices to increase their crypto holdings.

While all forms of stablecoins seek to offer the same thing—stability—their stable value is maintained through varying mechanisms. The three main classifications of stablecoins are those that are fiat-collateralized, crypto-collateralized, and uncollateralized.

A fiat-collateralized stablecoin is a stablecoin that is pegged to a stable value of fiat currency. To maintain the stable value, these stablecoins require a certain amount of collateral to be held in reserve. The collateral is usually held in a centralized escrow account or an equivalent trust arrangement. Ideally, fiat currency reserves are held in a 1:1 ratio with the supply of stablecoin ($1 of a stablecoin is backed by $1 USD in the issuing provider), but this is not always the case.

There are stablecoins like the Gemini Dollar (GUSD) with proven 1:1 reserves through independent audits and reserves held in FDIC-insured accounts. Proof of reserves ensures that the stablecoin supply is backed by actual funds and helps to instill trust in the stablecoin.

However, Regulation surrounding stablecoins is nebulous at best, and many stablecoin issuers have murky legal structures and information on the exact amount of fiat held in reserves. Many fiat-collateralized stablecoins employ a fractional-reserve style system where they only hold a fraction of the total stablecoins in actual fiat currency. This can introduce counterparty risk into the stablecoin, as there is no guarantee that the stablecoin issuer will be able to meet redemption requests for stablecoins.

The most popular stablecoin, Tether (USDT), is a fiat-collateralized stablecoin that is reportedly pegged to the US dollar. Tether does not release consistent reports to back up reserve claims through an independent audit. In light of this, many have speculated that Tether is not backed 1:1 by USD and that its stable value is propped up by USDT printing and market manipulation.

As regulation catches up to crypto innovation, we expect to see more stablecoins emerge that have greater transparency around their reserve holdings and legal structures.

A crypto-collateralized stablecoin is a stablecoin that is backed by another cryptocurrency as collateral. The value of the stablecoin is usually pegged to a stable value like the US dollar, but it can also be pegged to other assets like gold.

Instead of backing the coin with fiat reserves, these coins pool, stake, and over-collateralize to buffer price fluctuations. For example, let's say a stablecoin—NOAHUSD (NUSD) is pegged to the US dollar and its value is currently $1 USD. For the stablecoin to maintain its stable value, there needs to be $1.50 worth of cryptocurrency deposited as collateral for every stablecoin in circulation. So if you wanted to receive $100 in NUSD, you'd deposit $150 worth of crypto into the NUSD smart contract.

The main advantage of crypto-collateralized stablecoins is that they can be quickly created and don't require permission from a centralized authority, like a government, to issue them. The disadvantages are that these stablecoins require a large amount of collateral to maintain their stable value and they're subject to high volatility and liquidations during market downturns.

If the price of the crypto inputted goes down, the stablecoin can be liquidated to cover the value of the collateral. For example, if the price of ETH goes down significantly and there is less ETH to back NOAHUSD, the protocol will liquidate NUSD and ETH to cover the debt. This can lead to a negative feedback loop where low market prices for the collateral drive more liquidations, which drives down the price of the collateral, which triggers more liquidations...and so on.

Uncollateralized stablecoins are stablecoins that are not backed by any sort of asset. They rely on a smart contract algorithm to maintain their stable value. The most infamous example as of late was the TerraLUNA (UST) stablecoin. TerraLUNA mints stablecoins when demand is high and burns stablecoins when demand is low. This helps to keep the price stable.

But the crypto ecosystem is the ultimate equalizer. In early May, reports of capital flight from the Terra protocol stablecoin (UST) surfaced. 85 million UST were exchanged for 84.5 million USDC (another stablecoin) in a single hour. The stablecoin arbitrageurs were out in full force and cashed in on the 8% premium that UST was trading at.

The algorithm minting and burning stablecoins couldn't keep up with the selling pressure and the stablecoin crashed. As the days went on, the price of UST continued to drop as more and more people exchanged their stablecoins for other assets. By the end of May, the Terra stablecoin had lost over 97% of its value and was trading at $0.01—the blockchain was officially halted.

Algorithmic stablecoins have come and gone, but none have been able to stick around for very long. They all seem to succumb to the same problem—when there's a run on the stablecoin, the algorithm can't mint or burn stablecoins fast enough to keep up with the demand, and the stablecoin crashes.