What Makes Stablecoins Stable?

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With thousands of cryptocurrencies currently on the market it’s sometimes difficult to deduce what distinguishes one from another.

That said, there’s one type of cryptocurrency that stands out from the rest for several clearly definable reasons – stablecoins.

These outliers have exploded in popularity to become some of the most used cryptocurrencies in the crypto ecosystem.

One of the main reasons for this is that they’re seen as safer than other cryptos because they’re not subject to the extreme volatility that can impact many digital currencies.

What is a stablecoin?

Stablecoins are a type of cryptocurrency designed to minimise price fluctuations and maintain a stable value.

They do this using a variety of mechanisms, such as being pegged to real-world assets like fiat currencies (ie US Dollar), commodities or even other cryptocurrencies (more on this below).

The pegging mechanism is designed to ensure stablecoins retain their value. This is useful for a variety of reasons, including:

• It makes stablecoins viable as a store of value.
• It means they can be used as a reliable medium of exchange.
• It creates an environment where they’re a unit of account.

Popular stablecoins include Tether (USDT), USD Coins (USDC), Binance USD (BUSD) and Dai (DAI).

What makes stablecoins stable?

Different mechanisms are used to maintain a stablecoin’s stability, but all are designed to ensure the coin’s value stays within a predetermined range.

Stablecoin mechanisms include:

Fiat-collateralised: These stablecoins use reserves of traditional fiat currencies as backing. This might include US Dollars or Euros which are held in a custodial account by the coin issuing company. For every stablecoin circulating there’s an equivalent amount of currency held in reserve. This is known as a one-to-one peg. Tether was the world’s first fiat-collateralised stablecoin when it was launched in 2014.

Crypto-collateralised: These stablecoins use other cryptocurrencies as backing. The coins used are typically those with higher liquidity, such as Ethereum (ETH). Smart contacts are used to maintain the crypto-collateralised stablecoin’s desired value by managing the ratio of collateral to the number of coins in circulation. Dai uses Ethereum to achieve its stability.

Algorithmic: These stablecoins do not rely on any collateral, whether fiat, crypto or a commodity. As a result, they’re often referred to as non-collateralised stablecoins. Instead, they use smart contracts and algorithms to expand or contract the supply depending on market demand. Some algorithmic stablecoins mint or burn tokens depending on the coin’s price deviation. These are known as rebase algorithmic stablecoins. For example, if the coin price is greater than $1 new coins are minted but if the price is less than $1 coins are burned.

Hybrid models: Some stablecoins combine elements from the mechanisms above to achieve their stability. For example, a stablecoin might be partly backed by fiat reserves while simultaneously using an algorithmic mechanism to control the remaining supply. The purpose of hybrid models is to achieve even greater stability.

Why are stablecoins popular?

Since Tether was launched, stablecoins have become extremely popular in the cryptosphere and are now widely used.

The reasons for this widespread adoption include:

Reduced volatility: The key principle of a stablecoin is maintaining a stable value. This makes them attractive for everyday transactions and a useful hedge against market volatility and fluctuations.

Easy transactions: Stablecoins enable low-cost, fast transactions across borders. They’re universally traded and are a globally accepted form of money.

High yield earning potential: Stablecoins are prominent in the DeFi (decentralised finance) ecosystem meaning holders can earn significant yield from activities such as yield farming and liquidity provision.

Stablecoins are often seen as a more acceptable form of cryptocurrency due to the nature of their pegged value and ability to mimic traditional fiat currencies.

They’re not without controversy though, highlighted by the $45 billion collapse of the TerraUSD (UST) algorithmic stablecoin in 2022.

Are stablecoins cryptocurrencies?

The short answer is yes, stablecoins are cryptocurrencies. However, there’s some debate over whether they’re a true cryptocurrency.

Stablecoins have certainly emerged as a distinctive category of cryptocurrency due to their unique proposition to investors and users.

While true cryptocurrencies are typically built on decentralised blockchains, some, although not all, stablecoins rely on centralised entities to manage reserves and for governance.

Many stablecoins also differ from other cryptocurrencies in how the supply is managed.

Traditional cryptocurrencies generally use a fixed supply model while stablecoins often have an elastic supply which adjusts based on market demand or algorithmic mechanisms.

While stablecoins certainly share some characteristics with traditional cryptocurrencies they differ in certain fundamental ways meaning the debate over whether they’re a true crypto or not is likely to continue.

Final word

Stablecoins are a valuable tool for numerous financial activities because of the stability of their value.

They’re universally accepted and offer seamless digital transactions and the facilitation of decentralized finance.

The traits of stablecoins and other cryptocurrencies cater to different needs and preferences, but both serve an important role in the cryptocurrency ecosystem.

Stablecoins are seen by many as safer than traditional cryptocurrencies, but there are still concerns about the transparency of the mechanisms used to maintain their stability and the potential impact of regulation on their future use.