What Are Stablecoins and How Do They Work?

Why are stablecoins so critical in today’s financial ecosystem? 

Unlike typical cryptocurrencies, stablecoins are designed to maintain a consistent value, making them an important tool for traders, investors, and businesses. 

This article explains how stablecoins work, covering the diverse types and stability mechanisms that keep their value grounded.

Key Takeaways 

• Stablecoins are cryptocurrencies designed to maintain a stable value.
• They are pegged to external references like fiat currencies, commodities, or use algorithms.
• Popular types include fiat-collateralized, crypto-collateralized, commodity-backed, and algorithmic.
• They are used for cross-border payments, DeFi activities, as a store of value, and in payment systems.
• Stablecoins can coexist with central bank digital currencies (CBDCs) and offer unique advantages.

What Are Stablecoins?

Stablecoins are a type of cryptocurrency designed to maintain a stable value by pegging their market value to an external reference, such as a fiat currency like the US dollar, a commodity like gold, or another financial instrument. 

Unlike traditional cryptocurrencies like Bitcoin, which can be highly volatile, stablecoins aim to provide a more stable and predictable value, making them suitable for everyday transactions and financial services. 

Examples of popular stablecoins include Tether (USDT), USD Coin (USDC), and Dai (DAI).

The primary goal of stablecoins is to offer an alternative to the high volatility of popular cryptocurrencies, providing a reliable medium of exchange and store of value. 

They are used in various blockchain-based financial services, such as decentralized finance (DeFi) platforms, cross-border payments, and as a hedge against market volatility. 

Stablecoins can facilitate smoother transactions and reduce the risks associated with price fluctuations in the cryptocurrency market by maintaining a stable value.

As of 2024, stablecoins account for over $150 billion in market capitalization. 

Types of Stablecoins

Stablecoins come in various forms, each using different methods to maintain price stability in the cryptocurrency market.

Fiat-Collateralized Stablecoins

Fiat-collateralized stablecoins are backed by traditional currencies like the US dollar, euro, or other government-issued money. 

These stablecoins maintain their value by holding reserves of fiat currency in bank accounts or other safe financial institutions. 

For every token issued, there is an equivalent amount of fiat currency held in reserve to back it. This backing ensures that users can redeem their stablecoins for an equivalent amount of fiat currency at any time.

An example of a fiat-collateralized stablecoin is Tether (USDT), one of the most widely used stablecoins, which claims to be backed 1:1 by the US dollar. USD Coin (USDC) is another popular option, fully backed by US dollar reserves held by regulated financial institutions. 

These stablecoins are considered stable because their value is tied directly to a well-established currency. 

However, they rely heavily on trust in the institutions holding the reserves, and regular audits are important to verify that the necessary collateral exists.

Crypto-Collateralized Stablecoins

Crypto-collateralized stablecoins are backed by cryptocurrencies instead of fiat. Since cryptocurrencies are volatile, these stablecoins are often over-collateralized to protect their value from market fluctuations. 

For example, if a stablecoin is backed by Ethereum (ETH), the user might need to lock up more than 1 dollar’s worth of ETH to issue 1 stablecoin. This creates a buffer against price volatility.

Dai (DAI) is a well-known example of a crypto-collateralized stablecoin. It is backed by a variety of cryptocurrencies, including ETH, and operates on the MakerDAO protocol. 

The system uses smart contracts to maintain the value of Dai close to 1 US dollar. If the value of the collateral falls too low, the system automatically liquidates the collateral to maintain the stability of Dai. 

While this model offers more decentralization and doesn’t rely on trust in centralized institutions, it can be complex and may struggle in times of extreme market volatility.

Algorithmic Stablecoins

Algorithmic stablecoins use algorithms and smart contracts to control their supply and maintain price stability. 

Instead of being backed by fiat or cryptocurrency, they rely on mathematical formulas to manage supply and demand. 

When the price of the stablecoin rises above its target (usually 1 dollar), the system creates more tokens to increase supply and bring the price down. 

When the price falls below the target, the system reduces supply by buying back or burning tokens to drive the price up.

One example of an algorithmic stablecoin is Ampleforth (AMPL). It adjusts its supply daily based on market conditions to target a stable price. 

TerraUSD (UST) was another notable example, but it lost its peg and collapsed, showing that algorithmic stablecoins can be vulnerable to failure if the market conditions are unfavorable. 

The major advantage of algorithmic stablecoins is that they don’t require collateral, but their success depends on maintaining market confidence in the stability mechanism.

Commodity-Backed Stablecoins

Commodity-backed stablecoins are backed by physical assets like gold, oil, or other commodities. These stablecoins derive their value from the underlying commodity, and the issuer holds a reserve of the commodity to back the tokens. 

This makes them an attractive option for people looking to invest in stable assets like gold while enjoying the benefits of digital currency.

Paxos Gold (PAXG) and Tether Gold (XAUT) are examples of commodity-backed stablecoins. Both are backed by gold reserves, with each token representing a specific amount of physical gold. 

These stablecoins provide an easy way for users to trade and store gold digitally. 

However, like fiat-collateralized stablecoins, they rely on trust in the issuer to hold the correct amount of the commodity in reserve and to allow redemption. 

While they offer a stable store of value based on the commodity market, they also face risks related to the fluctuations in the price of the underlying asset.

The daily trading volume of stablecoins has surpassed $1 trillion

Read Also: The Safety of Storing Money in Stablecoins | UPay

Mechanisms of Stability

Stablecoins rely on various stability mechanisms to ensure their prices stay aligned with their underlying assets.

Collateralization

Collateralization is the process of backing a stablecoin with a reserve of assets to ensure its value remains stable. 

This reserve can be made up of fiat currencies, cryptocurrencies, or commodities, depending on the type of stablecoin. 

Collateralization helps create trust because users know that their stablecoins are backed by a tangible asset, which can be redeemed if necessary.

In fiat-collateralized stablecoins like USDC or Tether (USDT), each issued token is backed by an equivalent amount of fiat currency held in reserve. This means that for every 1 USDC or USDT token in circulation, there is 1 dollar sitting in a bank account. 

For crypto-collateralized stablecoins like Dai (DAI), the backing comes from cryptocurrencies like Ethereum, with users locking up more value in crypto than the stablecoins they receive. 

This is called over-collateralization and is used to protect the stablecoin from cryptocurrency price fluctuations. 

The stability of collateralized stablecoins depends on the management of the reserves and the trust in the institutions or protocols holding the collateral.

Pegging to a Stable Asset

Pegging is the process of linking a stablecoin’s value to a specific asset, usually a fiat currency like the US dollar, but it could also be a commodity like gold or another stable asset.

The stablecoin issuer or system uses various mechanisms to maintain the stablecoin’s price in line with the pegged asset.

For fiat-backed stablecoins, the peg is maintained by holding reserves equal to the stablecoins in circulation. If demand for the stablecoin increases and causes the price to rise above the peg, the issuer can release more coins to bring the price back down. 

If the price falls below the peg, the issuer can buy back coins from the market. For algorithmic stablecoins, like TerraUSD (UST), smart contracts were used to mint and burn coins to maintain the peg. 

However, the failure of TerraUSD showed that pegging can be risky if the system loses market confidence. 

Pegging works best when there is a clear reserve of assets backing the stablecoin, or when the system has a proven mechanism for adjusting supply and demand.

Minting and Burning Mechanism

The minting and burning mechanism is a key tool for controlling the supply of stablecoins to keep their price stable. 

Minting creates new stablecoins when demand rises, increasing supply to prevent the price from climbing above the intended value. 

Burning destroys stablecoins when demand falls, reducing supply to prevent the price from dropping below the peg.

In fiat-collateralized stablecoins, minting occurs when users deposit fiat currency with the issuer, who then mints an equivalent amount of stablecoins. 

Burning happens when users redeem their stablecoins for fiat currency, and the issuer removes those stablecoins from circulation. 

Algorithmic stablecoins use smart contracts to automatically mint and burn tokens. 

For example, in systems like Ampleforth (AMPL), when the price of the stablecoin rises above 1 dollar, the protocol mints new tokens to bring the price down, and when it falls below, it burns tokens to raise the price. 

The success of this mechanism depends on how well it responds to market conditions and whether users trust the system to maintain balance.

Arbitrage Mechanism

Arbitrage is a strategy that helps maintain the price stability of a stablecoin by taking advantage of price differences in different markets. 

It is particularly useful when the stablecoin’s price deviates slightly from its peg. 

Arbitrage traders buy the stablecoin when its price is below the peg and sell it when the price is above, profiting from the price difference while helping to bring the price back to its intended value.

For example, if Dai (DAI), which is meant to stay close to 1 US dollar, drops to $0.98, arbitrage traders will buy Dai at the lower price, expecting to sell it later when the price returns to $1. 

This increase in demand pushes the price back up. Conversely, if Dai rises to $1.02, traders will sell Dai to bring the price down. 

The arbitrage mechanism works because it encourages traders to exploit price differences, which naturally leads to price corrections and helps keep the stablecoin stable. 

This mechanism is especially effective in liquid markets where traders can act quickly. However, in less liquid or volatile markets, arbitrage opportunities may not always be enough to maintain stability.

Read Also: Can You Lose Money With Stablecoins? Here’s What You Need to Know

Use Cases of Stablecoins

Stablecoins have a wide range of practical applications, making them an important tool in both traditional finance and decentralized ecosystems.

1. Cross-Border Payments

Stablecoins enable faster and cheaper cross-border payments compared to traditional banking systems. 

Individuals and businesses can send and receive money across borders without the need for intermediaries, reducing transaction fees and processing times by using stablecoins.

For example, platforms like Ripple use XRP, a type of stablecoin, to facilitate cross-border transactions. 

Also, Siam Commercial Bank (SCB) in Thailand has launched a stablecoin-based cross-border payment solution, which includes remittance services. This new initiative successfully emerged from the regulatory sandbox of the Bank of Thailand in October 2024.

2. Decentralized Finance (DeFi)

Stablecoins play an important role in the DeFi ecosystem by providing a stable value for trading, lending, and borrowing. 

Users can participate in DeFi activities more easily because they lessen the volatility of other cryptocurrencies.

For instance, platforms like Aave and Compound use stablecoins like DAI and USDC for lending and borrowing. 

Decentralized stablecoins, such as DAI, are governed by a community and stabilized by algorithms, providing a decentralized alternative to centralized stablecoins.

3. Store of Value

Stablecoins offer a reliable store of value during times of market volatility. 

Unlike other cryptocurrencies, stablecoins maintain a stable price, making them an attractive option for investors looking to preserve their wealth. 

For example, during periods of high volatility in the cryptocurrency market, investors may convert their assets into stablecoins like USDT or USDC to protect their value. 

Stablecoins are backed by assets such as fiat currencies or commodities, ensuring their stability.

The number of stablecoins has grown from 10 in 2018 to over 100 in 2024.

4. Payment Systems

Stablecoins can be used as a medium of exchange in various payment systems. 

They provide a stable and reliable alternative to traditional fiat currencies, especially in regions with unstable local currencies. 

For example, platforms like BitPay and Circle allow users to make payments using stablecoins like USDC and BUSD. 

Stripe, a fintech giant, has shown interest in stablecoins by acquiring a stablecoin platform, highlighting their growing importance in the payments sector.

5. Central Bank Digital Currencies (CBDCs) vs. Stablecoins

While both CBDCs and stablecoins aim to provide a digital form of money, they differ in their issuance and control. 

CBDCs are issued and regulated by central banks, whereas stablecoins are typically issued by private companies. 

CBDCs are designed to replace or complement traditional fiat currencies, while stablecoins are designed to maintain a stable value relative to a specific asset or currency. 

The coexistence and potential competition between CBDCs and stablecoins are topics of ongoing debate and research.

The market cap of the top five stablecoins represents over 80% of the total stablecoin market. 

Risks and Challenges of Stablecoins

While stablecoins offer benefits like price stability, they also come with unique risks and challenges that must be carefully managed.

1. Regulatory Risks

Stablecoins face significant regulatory risks as governments and financial authorities work to establish clear guidelines and oversight. The lack of standardized regulations can lead to legal uncertainties and potential compliance issues. 

For example, the collapse of TerraUSD (UST) in 2022 highlighted the need for robust regulatory frameworks to protect investors and maintain financial stability.

• Inconsistent Regulations: Different countries have varying approaches to regulating stablecoins, which can create challenges for international use and compliance.
• Compliance Requirements: Stablecoin issuers may need to adhere to strict compliance measures, such as anti-money laundering (AML) and know-your-customer (KYC) regulations, which can be resource-intensive.
• Potential Bans: Some countries might impose bans or restrictions on the use of stablecoins, limiting their adoption and utility.

2. Centralization vs. Decentralization

The debate between centralized and decentralized stablecoins revolves around control and transparency. 

Centralized stablecoins are managed by a single entity, which can provide stability and trust but also introduce a single point of failure. 

Decentralized stablecoins, on the other hand, are governed by a community and rely on algorithms, offering greater transparency and resistance to censorship but potentially less stability.

• Centralized Control: Centralized stablecoins, like USDC and Tether, rely on trust in the issuing entity to maintain the peg and manage reserves.
• Single Point of Failure: Centralized systems are vulnerable to regulatory actions, operational failures, and security breaches at the entity level.
• Decentralized Governance: Decentralized stablecoins, like DAI, are managed by decentralized autonomous organizations (DAOs), which can be more resilient but also face challenges in governance and decision-making.
• Transparency vs. Stability: Decentralized stablecoins offer greater transparency and resistance to censorship but can be less stable due to reliance on algorithms and market dynamics.

3. Market Risks

Market risks for stablecoins include price volatility and the potential for market manipulation. 

While stablecoins are designed to maintain a stable value, sudden market movements can still impact their peg to the underlying asset. 

For instance, if the value of the collateral backing a crypto-collateralized stablecoin drops significantly, it can lead to a loss of confidence and a decrease in value.

• Price Volatility: Stablecoins can still experience short-term price volatility, especially during periods of high market stress or low liquidity.
• Market Manipulation: Large market participants can potentially manipulate stablecoin prices by exploiting liquidity imbalances or coordinating trades.
• Collateral Value Fluctuations: The value of collateral backing crypto-collateralized stablecoins can fluctuate, affecting the stability of the stablecoin.

4. Liquidity Risks

Liquidity risks arise when there is insufficient market demand to buy or sell stablecoins quickly. 

This can lead to significant price fluctuations and challenges in maintaining the peg to the underlying asset. 

For example, during periods of high market stress, stablecoins may face redemption pressures, making it difficult to maintain liquidity and stability.

• Redemption Pressures: High demand for redemptions can strain liquidity reserves, making it difficult to meet all withdrawal requests.
• Market Depth: Limited market depth can lead to slippage and price instability when large trades are executed.
• Liquidity Provision: Stablecoin issuers may need to actively manage liquidity provision to ensure that there is sufficient market demand and supply.

5. Technological Risks

Technological risks include vulnerabilities in the blockchain infrastructure and smart contracts that underpin stablecoins. 

These risks can lead to security breaches, operational failures, and loss of funds. 

Ensuring robust cybersecurity measures and regular audits is essential to mitigate these risks and maintain user trust.

• Smart Contract Vulnerabilities: Bugs or exploits in smart contracts can lead to unintended behaviors, loss of funds, or system failures.
• Security Breaches: Hacks and security breaches can compromise the integrity and trustworthiness of stablecoin platforms.
• Operational Failures: Technical glitches, network congestion, or other operational issues can disrupt stablecoin transactions and cause temporary instability.
• Continuous Audits: Regular audits and security assessments are necessary to identify and address potential vulnerabilities and ensure the ongoing reliability of stablecoin systems.

Conclusion 

Stablecoins have brought a new dimension to the cryptocurrency space by offering stability and reliability. 

They provide a versatile tool for various use cases, from cross-border payments to decentralized finance by bridging the gap between traditional financial systems and the digital economy. 

As stablecoins continue to gain acceptance and develop, their role in the financial ecosystem will only grow, making them an important topic for anyone interested in the future of digital assets.

FAQs About How Stablecoins Work

This FAQ section addresses some common questions that can help you narrow down your choices: