What is a Stablecoin
Stablecoins are an effort to create a stable digital asset. A standard definition of a stablecoin is a cryptocurrency whose value is pegged to another asset, such as the US dollar or gold. Ideally, this makes the stablecoin’s price stable over time, or at least stable relative to the underlying pegged asset. Due to the nature of a stablecoin, it actually is a token and not a coin - a bit of a misnomer if you ask us.
Cryptocurrencies such as Bitcoin and Ethereum are volatile and unpredictable, and as such it can be difficult to predict future prices or their value for real transactions. Stablecoins have many of the benefits of crypto (24/7 access, use with crypto brokerages, digital rather than physical, built upon smart contracts framework etc.), but without the volatility.
To aptly track and peg to an asset in the real world, a common way to create a stablecoin is to back it with the asset that it is pegged to – most commonly, the US dollar. There are a few ways people have attempted to do this, but the most popular is to create a ‘reserve’ with a banking or custody institution that securely stores the asset. This money or asset stored in the reserve acts as a collateral for the stablecoin, so if someone wishes to cash out their stablecoins, there is an equal amount of its pegged asset in the reserve waiting for them. If they want the stablecoin, they must put dollars in the reserve for new coins to be ‘minted.’ Popular examples of this, referred to as fiat-collateralized stablecoins, include USDC, USDT, and PAX.
From Left to Right: PAX Stablecoin, USDC, USDT
A similar approach can be done with commodities such as gold. One stablecoin is worth one unit of the pegged commodity such as an ounce of gold. These are called commodity backed-stablecoins and include PAX gold (PAXG), Tether gold (xAUt), and Gold Coin (GLC).
Another approach is to have a stablecoin that is collateralized by other cryptocurrencies, but still pegs itself to an asset in the real world, also called crypto-collateralized. The most famous example is Dai, created by Maker. A user will offer up another cryptocurrency as collateral to be stored in their “Vault,” which used to be called the Collateralized Debt Position, and once secured, new ‘Dai’ stablecoins are minted.
Due to crypto’s volatile nature, Dai requires an over-collateralized position in order for new Dai to be minted. As the price of the underlying collateral changes, the user may need to add more funds or return some Dai, otherwise they risk their collateral being liquidated. The Dai they have borrowed has its own mechanisms to remain at 1 USD through a system of smart contracts on the Ethereum chain. While a bit more complicated due to the collateral’s changing price, Dai is a popular project because it allows the use of other cryptocurrencies, it is decentralized, and community run.
Another type worth mentioning is the algorithmic stablecoin. These utilize two tokens and on-chain algorithms to maintain a healthy supply and demand relationship to keep the value of the stablecoin at 1 USD. The best example of this was LUNA and UST, where UST was kept at $1 USD by maintaining a supply and demand relationship with its pegged token LUNA. If UST was trading over $1USD, users were incentivized to trade it in for LUNA with arbitrage opportunities until UST balanced out. In May of 2022, UST de-pegged, leading to one of the most significant crashes of crypto to date. There are a number of projects still attempting to create a successful algorithmic stablecoin, but many are skeptical as the prominent ones over the last few years have failed, including a token called IRON that Mark Cuban was famously invested in.
