What Are Stablecoins? Definition, How They Work, Types

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Cryptocurrency exchange

December 4, 2023

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MakerDAO is run by a decentralized autonomous organization (DAO) and issues DAI stablecoins to borrowers, ensuring its reserve assets are always overcollateralized. Overcollateralization means the reserve holds more assets than DAI’s total supply value. Maker only holds cryptocurrencies such as Ethereum and USDC in the reserves. It’s true that Bitcoin revolutionized the financial industry and provided society with a new perspective on decentralized payments and peer-to-peer transactions.

Money, payments and spending

Unfortunately, though the model worked for some time, UST ultimately failed to hold its peg. The exact circumstances of the Terra USD crash are still unknown, but in mid-May, it suddenly entered into a “death spiral” as UST lost its peg and its value crashed. The algorithm what is a stablecoin desperately minted billions of LUNA in an effort to maintain the peg, but it was unable to keep up. Within a couple of days, the value of UST fell to just a few cents, while LUNA crashed to zero. In this way, every single dUSD token is directly backed by excess collateral.

The Disadvantages of Stablecoins

And there’s always a chance that you could lose the private keys that give you access to your cryptocurrency, either through a hack or user error. Government agencies have discussed ways to regulate stablecoins, and have taken action against organizations that may have misrepresented their reserve holdings. And stablecoin issuers may share some details about what and where they’re holding their reserves. While cryptocurrencies and the crypto ecosystem may present interesting and rewarding opportunities, many investors are cautious to invest in them due to their extremely volatile nature. Bitcoin (BTC), Ether (ETH), and other altcoins have historically been volatile. While this provides many opportunities for speculation, it does have drawbacks.

• As such, stablecoins can be considered ‘relatively’ stable, rather than absolutely stable—particularly when compared to volatile assets like Bitcoin.
• Second, because cryptocurrencies are usually more volatile than other assets, these organizations typically hold more in their reserves than the amount in circulation.
• Their proposed framework would prohibit anyone from issuing a stablecoin unless they were a registered non-depository trust or a depository institution with authorization to issue them.
• She also emphasizes the state’s commitment to transparency to maintain public trust.
• They are an early indicator of the benefits and efficiencies that mass adoption of digital assets can bring.

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In this tutorial, you will come across all the essential questions related to Stablecoins. Stablecoins are not without their pain points and have certain drawbacks to be aware of. Built In strives to maintain accuracy in all its editorial coverage, but it is not intended to be a substitute for financial or legal advice. Sign up for free online courses covering the most important core topics in the crypto universe and earn your on-chain certificate – demonstrating your new knowledge of major Web3 topics. Counterparty risk is the probability that the other party in the asset may not fulfill part of the deal and default on the contractual obligation.

How do stablecoins work, and how many types are there?

At a consumer level, some early adopters were also making use of cryptocurrencies to send remittances without a formal service, particularly in markets where local fiat currencies saw significant volatility. A somewhat more successful algorithmic stablecoin is Frax (FRAX), which boasts a market cap of around $1.4 billion and has, until now, managed to maintain its peg. FRAX is based on an open-source protocol that lives on the Ethereum blockchain, and it uses a combination of collateral and algorithms. When it launched, it was originally fully backed by a combination of USDC and USDT as collateral, but over time this supply has diminished, to be replaced by an algorithm. The most prominent fiat-collateralized stablecoin is Tether (USDT) though it’s a bit more controversial. At the time of writing, USDT is the third biggest cryptocurrency by market capitalization, behind just Bitcoin and Ethereum.

• By holding a commodity-collateralized stablecoin, the owner is, in effect, holding a share of a tangible asset in the physical world, providing a tonic to the often-repeated argument that crypto has no intrinsic value.
• The third kind of stablecoin that’s been growing in popularity lately is backed by real-world assets such as precious metals and oil.
• For example, a dollar-based stablecoin will aim to stay pegged to $1, while a gold stablecoin aims to stay pegged to the market price of gold.
• In May 2022, the meltdown of TerraUSD showed that not every stablecoin can guarantee price stability.
• The intent behind them is to create a crypto asset with much lower price volatility, which makes them better for use in transactions.

Fiat-backed stablecoin: TrueUSD (TUSD)

• If the price falls below $1, the algorithm “burns,” or removes, coins from circulation to increase its price.
• This hesitation in the market indicates that many traders believe the price drop may not be over yet.
• Besides his extensive derivative trading expertise, Adam is an expert in economics and behavioral finance.
• NerdWallet, Inc. is an independent publisher and comparison service, not an investment advisor.
• Given the role they play, stablecoins have emerged as a critical pillar of the crypto economy.
• This is because they can then effortlessly purchase and trade the cryptos they want on this platform, or stake the stablecoin for fixed interest or yield.