Stablecoins: what are they, and how do they work?

While many might think of NFTs and the Metaverse as the most significant trend in 2021, stablecoins have continued to increase their Market Cap. The combined Market Cap of stablecoins is now over $162 billion, and traders rely heavily on them for activities such as entering leveraged positions or simply locking in some gains without leaving crypto.

But what are stablecoins, and how do they work?

What are stablecoins?

Generally, cryptocurrencies are very volatile. This year alone, we've witnessed Bitcoin dropping from heights around $69,000 to below $40,000 within less than 24 hours. This volatility is highly beneficial for traders but less helpful for anyone looking to use crypto as money.

Money generally fulfills three functions: unit of account, store of value, and medium of exchange.

Bitcoin supporters often highlight it as a better store of value than gold. Looking at the historical performance of the digital asset in the last few years, it has outperformed gold for the third year in a row. However, the caveat of being highly volatile makes it complicated to use it as a unit of account and as a medium of exchange.

Nevertheless, blockchain-based assets have apparent benefits: they are fast, remove inefficiencies in the transfer process, are available 24/7, and are secure and digitally native. Stablecoins attempt to combine the stability of fiat money (government-issued currency) with all the benefits of cryptocurrencies.

A few use cases of stablecoins include:

  • minimizing volatility.
  • saving: dollar-pegged stablecoins tend to be a better way for users in high-inflation countries to store value.
  • earning interest: stablecoins can earn users up to 20% interest on lending protocols.
  • remittances: stablecoins can efficiently transfer money across country borders without relying on banks or other intermediaries.

How do stablecoins work?

The top 5 stablecoins according to CoinMarketCap are Tether, USD Coin, Binance USD, TerraUSD, and Dai. What stands out is that they're not all precisely worth $1. And there's more to it because how they maintain their value differs as well.

Before explaining how one can categorize stablecoins, a quick word on pegged vs. backed. You will hear both concerning stablecoins.

  • Pegged: When a stablecoin is pegged to another currency (or asset), that means that it "aspires" to maintain the same value. If the coin is pegged to the Dollar, the stablecoin will attempt to preserve the purchasing power of $1.
  • Backed: When a stablecoin is backed, that means that for every $1 worth of stablecoin, there is $1 worth of assets in the stablecoins treasury.

Of the top 5 stablecoins by Market Cap, all are backed by other assets except for UST and each one is pegged to the US-Dollar. How do they maintain that value?

Custodial (centralized) vs. decentralized

The first broad differentiation we can make for stablecoins is custodial or centralized.

Custodial stablecoins rely on a centralized custodian to maintain the peg. Tether (UST), USD Coin (USDC), and Binance USD work this way. They all keep a reserve to back stablecoins they issue. Therefore they are also called "Reserve-based." In practice, stablecoin issuance then works this way:

1. Alice deposits $100 into the bank account of the stablecoin issuer.

2. The stablecoin issuer mints $100 worth of stablecoin.

3. The issuer deposits it into Alice's wallet.

While it's an efficient way to issue stable assets on-chain, custodial stablecoins often lack transparency, auditability and are prone to censorship. For an idea of how that plays out, just perform a search for Tether FUD.

Decentralized stablecoins provide more transparency, are censorship-resistant, and are accessible. They stabilize the value of the stablecoin using smart contracts and economic theory. However, they are highly capital-inefficient.

We can further differentiate decentralized stablecoins between collateralized and algorithmic stablecoins. Among the top 5, we have one of each.

Collateralized stablecoins

Collateralized stablecoins rely on a concept from traditional finance that's well-accepted in the area of lending. When taking out a loan, borrowers often are required to put up a certain amount of money or a valuable asset as collateral. This collateral ensures that the lender can recover a part of the loan value in the worst case and reduces risk.

Collateralized stablecoins apply this concept to crypto and run on protocols without a central custodian.

How does one create a stable currency based on volatile collateral?

The answer is over-collateralization. This means that to create, for example, $1000 worth of a stablecoin; a borrower has to deposit at least $1500 worth of collateral in crypto (mostly ETH and other ERC-20 assets). By requiring more than the loan value in crypto, the protocol creates a buffer against price drops.

The most prominent stablecoin DAI by MakerDao functions based on the concept of over-collateralization. New DAI only enters the circulation when someone mints it by depositing crypto into the MakerDAO smart contract. When the price drops and the collateral to loan ratio reaches a critical level, borrowers can deposit more crypto or pay back their loan. If they don't do either, they will be liquidated: the protocol will sell their collateral to maintain the stablecoin peg.

In addition to over-collateralizing its stablecoin, MakerDao uses its native protocol token MKR to implement a stability fee (a fee for minting) that resembles how central banks influence demand through interest rates.

Collateralized stablecoins are highly capital-inefficient but maintain the spirit of DeFi by providing a more trustless way to borrow without third-party involvement. Regardless, MakerDAO currently captures 17.92% of the value locked in DeFi.

It might seem counterintuitive to take out a loan and deposit more than one can take out. Yet, there are use cases such as leveraging one's position or paying the bills without exiting crypto that seem to explain more than $18 bn worth of assets locked in MakerDAO.

As an aside, collateralized DeFi stablecoin are still relatively new and carry their risks. In 2020, MakerDAO experienced a Black Swan event when the price of Ether collapsed. In the end, the protocol had accrued more than $5.6 million in debt.

To quickly summarize, custodial stablecoins are very capital efficient but require trust in a third party. In contrast, collateralized stablecoins follow the spirit of DeFi in being trustless, but they remain capital-inefficient.

Algorithmic stablecoins attempt to create a stable currency that is capital-efficient yet trustless.

Algorithmic stablecoins

To be capital efficient, algorithmic stablecoins don't require any collateral but create an entire ecosystem to maintain the value of their currency. Note that depending on which stablecoin project in crypto you might consult, the definition of "algorithmic stablecoin" could differ.

For example, while many consider Ampleforth's AMPL token to be an algorithmic stablecoin, their team doesn't agree with that. Potentially not least because their token is far from stable. In their own documentation, they describe it as a "fully algorithmic unit of account" and refer to it as an alternative to stablecoins.

We think that algorithmic stablecoins are broadly stablecoins that don't rely on any on-, or off-chain collateral and achieve their stability through algorithms managing the supply.

While we're all familiar with the notion of a central bank such as the FED, the ECB, or BoJ managing our money through dictating rates, and controlling money supply, in the case of algorithmic stablecoins, protocols fulfill that role. Instead of relying on human decision-making and politics, algorithmic stablecoins run on algorithms and smart contracts. At which price point the protocol intervenes, and how is encoded in smart contracts that will automatically execute.

These rules can be changed through governance decisions for algorithmic stablecoins where the protocol is governed through a DAO (decentralized autonomous organization).

As with any protocol that relies on external information such as prices, algorithmic stablecoins require Oracles (such as Chainlink) which feed prices and real-world data into their smart contract.

Broadly speaking, algorithmic stablecoins are designed per one of the following two models:

  • Rebase model: in this model, stablecoin issuers directly change the supply of the stablecoins in circulation. If the stablecoin is trading above its peg, the protocol will automatically increase the supply to bring down the value of one coin. Inversely, when the price of the stablecoin is below the peg, the protocol contracts supply.
  • Seigniorage shares model: There are two different classes of users, the stablecoin users and so-called seigniorage shareholders (who hold a more volatile coin). An example of a pure seigniorage shares stablecoin is Carbon. New stablecoins are issued and given to seigniorage shareholders when demand increases based on how many shares they own. The more complicated part is contracting supply in such a system as the protocol has to incentivize users to "trade-in" their stablecoin for shares (in other protocols called bonds) at the prospect of turning a profit at a later stage.

Both models offer transparency and auditability since the protocol runs entirely on algorithms and is openly available on the blockchain. However, all algorithmic stablecoins face the immense challenge of creating an algorithm that decides issuance and supply contraction but remains resilient to manipulation.

There are various accounts of algorithmic stablecoins losing their peg, including Terra USD, which fell to $0.92 on May 23rd, 2021.

Maybe the most significant challenge for algorithmic stablecoins outside of setting up their algorithms right is that the initial setup will always require people to trust that the coin can maintain its peg and the algorithms are resilient to manipulation.

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Overall,stablecoins continue playing an essential role in the crypto ecosystem, from providing traders with an escape from volatility to enabling users in high-inflation countries to save money. While it seems that centralized stablecoins capture a bigger market in the short term, the emergence of TerraUSD and the longevity of DAI show that users are willing to try different models.

With custodial stablecoins that are currently most prevalent in the market, we still have to rely on an external party to keep our funds safe. While this setup might not have the same issues as owning digital bank money, a trust crisis or any revelation of stablecoin issuers' treasury not fully backing their supply could deteriorate holdings' value fast. And then, earning 10% in interest won't help.

As new ideas show, decentralization and a stablecoin governed through a DAO could offer ways to achieve relatively stable assets on-chain. We believe that for any genuinely decentralized stablecoin, a decentralized base layer will be crucial. Anyone should be able to take full custody of their stablecoin if they want to and verify transactions without relying on an external party.

That's why we're building Minima. It is a completely decentralized network where everyone runs a full constructing and validating node using their phone.