Stablecoins: What Are They and How Do They Work? A Basic Guide

The advent of blockchain technology is changing—and will continue to change—the way society thinks, interacts, relates to one another, and exchanges value. This exchange relies, to a greater or lesser extent, on digital assets (tokens and cryptocurrencies), which are essential for this complex decentralized system to function properly.

Since their inception, cryptocurrencies and tokens—despite their countless advantages—have been characterized by high volatility, which has negatively impacted the development of decentralized financial products.

Developing an investment strategy based solely on volatile assets, or transferring value between individuals or companies using cryptocurrency as a payment method, posed a major drawback that often led to abandonment or rejection.

Given this unstable and inefficient situation, the emergence of a cryptoasset with a stable price—that is, a digital asset designed to prevent sharp price fluctuations and help maintain greater market stability—was inevitable.

As you can imagine, these are called stablecoins.

What are stablecoins?

A stablecoin is essentially a token used as a digital currency on the blockchain, with a value pegged 1:1 to fiat currencies such as the dollar, the euro, or others.

Stablecoins offer numerous advantages, as they are essentially cryptoassets recorded on the blockchain and therefore retain properties such as immutability, traceability, privacy, and the ability to be traded and stored quickly and easily. In addition, they provide a framework of stability for all participants without the need to move to the off-chain world to protect against high volatility.

The popularity of stablecoins has grown exponentially in recent years, driven by widespread adoption and the emergence of new coins that peg their value to the dollar. But as we might expect, some have become more popular than others, mainly due to the mechanisms used to keep their price stable and whether those mechanisms are centralized or decentralized.

How do they work?

Stablecoins are cryptocurrencies designed to maintain a stable value relative to a fiat currency, such as the U.S. dollar. To achieve this, they use various methods, such as:

• Reserves: Reserve-backed stablecoins hold an equivalent amount of fiat currency in reserve for each unit of stablecoin issued. For example, if a stablecoin is backed by U.S. dollars, then the issuing company must hold a sufficient amount of U.S. dollars in reserve to cover all units of the stablecoin in circulation.
• Algorithms: Algorithmic stablecoins use algorithms to automatically adjust the supply of coins in circulation in order to maintain a stable value. For example, if the price of the stablecoin rises above its target value, new coins are issued to lower the price, and if the price falls below its target value, coins are burned to raise the price.
• Collateralization: Collateralized stablecoins use a cryptocurrency as collateral to back their value. For example, a Bitcoin-collateralized stablecoin might hold a certain amount of Bitcoin as collateral for each unit of the stablecoin in circulation.

They are a useful tool for those who want to use cryptocurrencies without the volatility associated with traditional digital currencies.

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How do stablecoins maintain their value?

The way stablecoins maintain their value is directly related to how they are generated or created. Let's take a closer look at this.

Stablecoins backed by fiat currency

There are different ways to create stablecoins, although the most common method involves using fiat currencies as collateral.

A company centrally generates new stablecoins while depositing the same amount of dollars or euros with a financial institution (it issues one stablecoin for every unit of fiat currency it deposits).

This means that each stablecoin is backed by a government-issued currency, and the market understands this; therefore, its price is directly linked to that of the underlying currency, and any deviations are corrected through arbitrage.

If we want to place our trust in this type of stablecoin, we should ensure that the fiat currency reserves backing them are audited; otherwise, the stablecoins might be only partially backed, with all the potential risks that this would entail.

Some of the most popular fiat-backed stablecoins are USDT, USDC, BUSD, and GUSD.

These stablecoins can be purchased on a secondary market via a DEX or a centralized exchange. You can also buy them directly on the platform that issues them, although in this case you’ll need to go through an identity verification process (KYC/AML).

Advantages

• Stable: Since they are backed by fiat currency—usually the euro or the dollar—they are fairly stable. Furthermore, if the collateralization process is done correctly, we have greater assurance regarding legal protection.
• Simplicity: The creation process is simple and quite intuitive, and it avoids the potential risks associated with smart contracts, unlike other types of stablecoins, as we will see below.

Disadvantages

• Centralized: The currency is issued by a private entity in a centralized manner, and we must place our trust in it, just as we do with government-issued currency.
• Regulatory limitations: Organizations that issue stablecoins are subject to national regulations, which could change at any time and directly affect their holders. Stablecoins may be frozen or confiscated, as has happened on occasion.
• Collateralization issues: The collateralization process is not recorded on the blockchain; therefore, we have no verifiable proof that the tokens are fully backed.

Stablecoins backed by other tokens

These stablecoins are created through token-backed loans; in other words, if, for example, I have ETH, I can take out a loan secured by ETH in the form of a stablecoin.

Their operation is more complex than that of fiat-backed stablecoins, as in this case smart contracts are used to manage issuance and collateral, ensuring that new stablecoins do not become partially undercollateralized.

The way to avoid this situation is:

1. By using multiple tokens as collateral instead of just one, so that if the price of one of them drops sharply, it will still be backed by the others.
2. Another key factor is that the issuances are overcollateralized, so that in the event of high market volatility, the protocol has time to react by selling the collateral before its value falls below the value of the stablecoins issued against that collateral.

The first cryptocurrency-backed stablecoin to emerge was DAI, and it is currently one of the best-known. Through its decentralized protocol (Maker DAO), DAI allows users to create stablecoins by taking out a loan, using ETH or other cryptocurrencies as collateral.

The protocol ensures stability by locking in the collateral; if the collateral’s value falls below a predefined threshold (collateralization ratio), the position will be automatically liquidated. We will devote an entire article to discussing this revolutionary protocol.

As you might imagine, this type of stablecoin aligns with the philosophy and principles of blockchain technology by maintaining decentralized issuance, storage, and governance, without relying on any bank or centrally managed collateral.

Advantages

• Decentralized: We should not rely on a centralized company to guarantee that stablecoins are backed, but rather on public smart contracts that anyone can review and audit. Furthermore, the rules governing issuance are set by a community that votes on and supports the protocol, ensuring its proper functioning.
• Eliminates regulatory risks: Because it is fully decentralized, it is not directly exposed to regulatory risks.
• Enables leverage: thanks to these protocols, any user can leverage their cryptocurrencies and borrow stablecoins.
• Greater privacy: There is no need to go through an identification process; simply by having a wallet, we can create new stablecoins.

Disadvantages

• Risks associated with smart contracts: if contracts are not programmed perfectly, they may be subject to bugs or cyberattacks. It is also possible that they fail to account for an irrational or unforeseen situation in which the protocol could collapse.
• Greater volatility: Because they are backed by tokens and cryptocurrencies, they tend to be more volatile than other types of stablecoins.
• Liquidations: If we purchase these tokens directly from the protocol, we run the risk of having our deposited collateral liquidated during periods of high volatility.

Algorithmic stablecoins

Unlike the previous ones, algorithmic stablecoins are not backed by any currency or token; instead, their price is determined algorithmically through smart contracts that adjust the supply of coins based on demand.

If the price of the stablecoin falls below the fiat currency it represents, the system will automatically reduce the total supply of tokens (without us having to do anything). Similarly, if the price rises, the system will issue more stablecoins to adjust the price and maintain parity.

Advantages

• Decentralized: It is a fully decentralized system based on smart contracts.
• Unsecured: They do not rely on collateral and are therefore not exposed to potential fluctuations in the price of such collateral.

Disadvantages

• Poor user experience: Less experienced users may have a negative experience when they see their stablecoins increase or decrease in their wallet (even though their value remains the same).
• System prone to failures: The smart contracts responsible for adjusting the supply of stablecoins are complex to create, monitor, and audit, and may contain flaws that compromise the price-stabilization mechanism.

Key use cases for stablecoins

Store of value and protection against market volatility

Since it has a 1:1 peg to the dollar or euro, this effectively means we have tokenized fiat currency, which can be very useful for mitigating the risks associated with market volatility.

For example, a user can use stablecoins during bear markets to protect their capital and withdraw it without having to convert it to fiat currency, which is much more practical and efficient.

They also help boost the liquidity of cryptoassets, since almost all tokens and cryptocurrencies are typically traded for a stablecoin, as this is safer and easier for investors.

Finally, if we live in countries severely affected by inflation—such as Argentina—it might be useful to use stablecoins as a way to protect the value of our assets, with greater privacy than if we were to do so directly in dollars.

Payment methods and digital money

Although this may seem like a trivial use case—since, as we’ve mentioned, they represent fiat currency—it isn’t very widespread at the moment, though it’s true that we’re already seeing some projects that allow payments at retail stores using stablecoins. In the near future, we could see greater adoption driven by the advantages of having a fiat currency represented by a token.

Among these advantages are much faster international payments, as well as micropayments, and greater accessibility and adoption by countries with unbanked populations.

DeFi Protocols

This is perhaps the most widespread use case and one of the main reasons behind the creation of this type of token. Stablecoins lay the foundation for decentralized finance and enable the development of financial products that would be difficult to implement without them.

Thanks to stablecoins, decentralized finance protocols are more stable and secure, and they offer investment options that are more attractive than those of traditional banks.

We can use stablecoins to generate returns on our savings by providing liquidity to a DeFi protocol, or by lending our money in the form of stablecoins to other users in a fully decentralized manner in exchange for interest, or by engaging in yield farming alongside another token or cryptocurrency.

Conclusion

We can say that stablecoins are here to stay and that they are solving major problems that were holding back the growth of the crypto world.

They enhance the user experience and, as a result, increase adoption; they help protect against high volatility; they make it possible to design a more affordable and straightforward investment strategy; and, of course, they generate passive income through the use of DeFi protocols, such as Compound, a borrowing and lending protocol.

But despite all these advantages, we must not overlook the underlying risks, such as the high volatility of the cryptocurrency market, increasingly strict regulations, potential security flaws in smart contracts, and the significant responsibility involved in storing them (losing the private key associated with the wallet would result in the loss of all funds).