What Are Stablecoins and How Do They Work?

How Do Stablecoins Work?

As with any emerging asset class, cryptocurrencies are susceptible to market forces. Accordingly, many crypto projects actively explore ways to reduce risk and bolster participation in the broader crypto ecosystem.

Current solutions go well beyond the buy, sell, and stop orders of conventional markets. Instead, price stability is being built directly into the assets themselves. The result is an entirely new subset of the cryptocurrency market known as stablecoins. These tokens are meant to function as their name suggests — with stability. 

The concept of the stablecoin was created to lessen volatility, and its popularity is growing among crypto and more traditional market investors. The growing popularity of stablecoins can be attributed to several factors, particularly, their ability to combat inflation and facilitate fast, efficient transactions. This is especially true within international exchanges. 

What Are the Benefits of Stablecoins?

Stablecoins have a handful of key advantages, and keeping these in mind can help you make more informed decisions.

Transaction Speed

When you consider the amount of time it takes for traditional banking transactions to settle, compared to the lightning speed of stablecoins, it’s easy to see the appeal of transaction speed. 

Stablecoin transactions can be completed in a matter of seconds, rather than several days as can occur with traditional banking transactions. 

User Access Globally

Fortunately, stablecoins offer a solution for sending and receiving money across borders. Because of their decentralized nature, stablecoins aren’t confined to any one country. 

Additionally, stablecoins appeal to people across many social classes in less developed countries. Due to their digital nature, stablecoins are accessible to nearly everyone from a few taps on a mobile device — they have global appeal. 

Platform Friendly and Flexible

Stablecoins can be used on a wide variety of platforms and exchanged quickly. Simply connect your wallet to an exchange and purchase stablecoins. There’s a lot of flexibility with stablecoins, and they can be bought in some ways, including by making a bank transfer or using a credit card, for example. 

Security

How safe and secure are stablecoins? Believe it or not, stablecoins offer higher security than other types of payments, and they offer the benefit of more privacy than other types of payment, as well. And for peace of mind, stablecoins are typically backed by a fiat currency.

Low Transaction Fees

Everyone wants low transaction fees, and this is a common complaint with traditional banks. Have you ever sent money overseas? The cost can be very high, which makes stablecoins an affordable option for money transfers to other countries. 

So, how are stablecoins cheaper? Stablecoins take out “the middle man.” Using blockchain technology, stablecoin uses a direct transaction approach, resulting in low transaction fees. 

What Are the Risks of Stablecoins?

All of this said, it’s also important to stay mindful of some potential drawbacks. Here’s what to know. 

Be Mindful of Reserve Management

Stablecoins are only as stable as the management of the reserve. 

Although stablecoins are less risky than many other cryptocurrencies, look out for a lack of transparency and be wary of any history of fraudulent behavior on behalf of the issuer, as this can affect the stability — which is the main attribute of stablecoins.

Centralization Concerns

Due to the nature of stablecoins, control is centralized, which has its pros and cons, but the risk is in making sure the issuer is trustworthy and has enough reserves on an ongoing basis. 

De-Pegging

One or more events, including price fluctuations, could cause stablecoins to drop below a target value, otherwise known as de-pegging. De-pegging can cause a domino effect and impact values at a more systematic level, or it can be isolated to de-pegging an individual investment. 

Any investment has both benefits and risks involved. The key is to do your research and understand your objectives and how you will use the investment. 

What To Know About Stablecoins and Use Cases

To understand why you would use stablecoins, let’s talk a little bit about why other cryptocurrencies, like Bitcoin, became so popular. 

If we look at the history of cryptocurrency, starting with Bitcoin, part of the rising popularity stemmed from a lack of trust in central banks and the desire and need for efficiency. 

These factors, among others, have put Bitcoin on the investment map, appealing to both new and seasoned investors. The downside of Bitcoin investments is this digital asset's inherent nature, making it volatile and unpredictable. This is the main reason stablecoins emerged. 

Their stable value associated with Bitcoin has made them a viable alternative to other cryptocurrencies. However, Bitcoin's uncertainty and volatility have made the digital asset less attractive for some transactions. 

So, what are stablecoins used for? 

Stablecoin Use Cases

Two main use cases generally stand out for stablecoins and contribute to their growing popularity. The first is buying and selling crypto assets — because stablecoins are pegged to another currency or commodity, this makes stablecoins a great alternative to cryptocurrency. 

A second use case for stablecoins is also one of the main benefits mentioned earlier. It’s the ability to execute cross-border payments efficiently, with the reassurance of less volatility than cryptocurrency. Additionally, due to the nature of stablecoins and other cryptocurrency, this type of payment can be sent at any time. 

These are the most popular uses, but given the stability of this digital asset, stablecoins could become more widely utilized in other, less obvious use cases. 

In 2020–21, the stablecoin market exploded, with its market cap expanding almost threefold. But what precisely is driving this appeal? Let’s start by reviewing the basics of stablecoin taxonomy.

Stablecoin Taxonomy

Stablecoins are digital currencies minted on the blockchain network that are typically identifiable by one of four underlying collateral structures: fiat-backed, crypto-backed, commodity-backed, or algorithmic. While underlying collateral structures can vary, stablecoins aim for the same goal: stability. 

Let’s discuss the four primary types of stablecoins.

Traditional Collateral (Off-Chain)

The most popular stablecoins are backed 1:1 by fiat currency. Because the underlying collateral isn’t another cryptocurrency, this type of stablecoin is considered an off-chain asset. Fiat collateral remains in reserve with a central issuer or financial institution and must remain proportionate to the number of stablecoin tokens in circulation.

For example, if an issuer has $10 million in fiat currency, it can only distribute $10 million in stablecoins, each worth one dollar. 

Some of the biggest stablecoins in this category by market value include:

• Tether (USDT)

• Gemini Dollar (GUSD)

• USD Coin (USDC)

• True USD (TUSD)

• Paxos Standard (PAX)

Crypto Collateral (On-Chain)

As the name implies, crypto-collateralized stablecoins are backed by another cryptocurrency as collateral. This process occurs on-chain and employs smart contracts instead of relying on a central stablecoin issuer. 

When purchasing crypto-backed stablecoins, you lock your cryptocurrency into a smart contract to obtain tokens of equal representative value. You can then put your stablecoin back into the same smart contract to withdraw your original collateral amount. DAI is the most prominent stablecoin in this category that uses this mechanism. This is realized by utilizing a collateralized debt position (CDP) via MakerDAO to secure assets as collateral on the blockchain.

Crypto-collateralized stablecoins are also over-collateralized to buffer against price fluctuations in the required cryptocurrency collateral asset. To provide a real-world example: If you want to buy $1,000 worth of DAI stablecoins, you would need to deposit $2,000 worth of Ethereum (ETH) — this equates to a 200% collateralized ratio. 

If the market price of ETH drops but remains above a set threshold, the excess collateral buffers DAI’s price to maintain stability. However, if the ETH price drops below a set threshold, collateral is paid back into the smart contract to liquidate the CDP.

Algorithmic Stablecoins

Algorithmic stablecoins do not use fiat or cryptocurrency as collateral. Instead, their price stability results from using specialized algorithms and smart contracts that manage the supply of tokens in circulation. An algorithmic stablecoin system will reduce the number of tokens in circulation when the market price falls below the price of the fiat currency it tracks. 

Alternatively, if the token price exceeds the price of the fiat currency it tracks, new tokens enter into circulation to adjust the stablecoin value downward.

Commodity-Backed Stablecoins

Commodity-backed stablecoins are collateralized using physical assets like precious metals, oil, and real estate. The most popular commodity to be collateralized is gold; Tether Gold (XAUT) and Paxos Gold (PAXG) are two of the most liquid gold-backed stablecoins. 

However, it’s important to remember that these commodities can, and are more likely to, fluctuate in price and, therefore, have the potential to lose value.

Commodity-backed stablecoins facilitate investments in assets that may otherwise be out of reach locally. For instance, obtaining a gold bar and finding a secure storage location in many regions is complex and expensive. As a result, holding physical commodities like gold and silver isn’t always a realistic proposition. 

Commodity-backed stablecoins also afford utility to those who want to exchange tokens for cash or acquire the underlying tokenized asset. Holders of Paxos Gold (PAXG) stablecoins can sell them for cash or acquire the underlying gold. 

However, because London Good Delivery gold bars range from 370 to 430 per ounce, and each token represents one ounce, users must hold a minimum of 430 PAXG to execute token redemption. Once redeemed, token holders can take possession of their gold at vaults throughout the UK.

Similarly, holders of Tether Gold can redeem XAUT tokens in exchange for physical gold if they complete the TG Commodities Limited verification process and hold a minimum of 430 XAUT. This minimum reflects the standard 430 oz London Bullion Market Association (LBMA) gold bar. Once XAUT is redeemed, holders can take possession of their gold at a location they choose within Switzerland. 

Although the ability to redeem gold-backed stablecoins for physical gold is universal across active platforms, other commodity-backed stablecoins lack the same utility. For example, Venezuela's exploratory Petro stablecoin isn’t redeemable for a barrel of oil. While stablecoins backed by other commodities like real estate have made headlines in recent years, a lack of active projects makes it difficult to draw further comparisons.

In contrast, asset tokenization continues to generate interest in a closely related market segment. Similar to commodity-backed stablecoins, tokenized assets are valued from external, tradable assets like gold.

Medium of Exchange and Store of Value

The most immediately apparent advantage of stablecoin technology is its utility as a medium of exchange, effectively bridging the gap between fiat and cryptocurrency. By minimizing price volatility, stablecoins can achieve a utility that is wholly separate from the ownership of legacy cryptocurrencies.

As their name suggests, stablecoins are inherently stable assets. This makes them suitable stores of value and encourages their use in everyday transactions. Further, stablecoins improve the mobility of crypto assets throughout the ecosystem.

Stablecoins point toward integrating traditional financial systems with the quickly evolving decentralized finance (DeFi) industry. As a force for market stability, stablecoins present a primary vehicle for cryptocurrency adoption in loan and credit markets while inheriting much of the utility previously reserved for only fiat currency.

Stablecoins are gaining popularity due to their low costs, ease of use, access, and flexibility. This type of cryptocurrency is tied to a different kind of currency, so it’s less vulnerable to market volatility overall. Start building your portfolio today with Gemini.