Stablecoins
Bridging Traditional and Digital Finance
Introduction
Cryptocurrencies promised a new form of money, but extreme volatility created practical problems. How can you price goods when the currency might change ten percent before dinner? How can businesses accept crypto when values swing wildly?
Stablecoins emerged to solve these problems, maintaining stable values while preserving cryptocurrency benefits: programmability, fast settlement, and 24/7 operation without traditional banking infrastructure.
Stablecoins have become critical cryptocurrency infrastructure. They enable trading between volatile assets, power DeFi applications, and provide dollar-denominated savings access for people in countries with volatile currencies.
This lesson examines stablecoins: how they work, different stability mechanisms, and the regulatory and risk considerations.
What Are Stablecoins?
Stablecoins are cryptocurrencies designed to maintain stable value relative to a reference asset—most commonly the US dollar.
The Value Proposition:
Rather than fluctuating like Bitcoin, a dollar-pegged stablecoin aims to always be worth approximately one dollar. This enables:
- Reliable pricing for commerce
- Stable base for DeFi applications
- Dollar access for global users
- Trading pair without volatility
Cryptocurrency Benefits Retained:
Stablecoins preserve key crypto properties:
- Global Transfers: Send value anywhere in minutes
- Programmability: Use in smart contracts
- Self-Custody: Control your own assets
- 24/7 Availability: No banking hours
Market Scale:
Stablecoins have grown enormously:
- Collective market cap exceeds $100 billion
- Daily trading volumes often exceed Bitcoin
- Critical infrastructure for crypto markets
Fiat-Backed Stablecoins
The simplest mechanism: for every stablecoin in circulation, the issuer holds equivalent fiat currency in reserve.
How It Works:
- User sends $1 to issuer
- Issuer mints 1 stablecoin
- User receives stablecoin
- $1 held in reserve
Users can redeem stablecoins for dollars, creating arbitrage that maintains the peg:
- If trading below $1, arbitragers buy and redeem
- If trading above $1, arbitragers mint and sell
Tether (USDT):
The largest stablecoin by market cap:
- Launched 2014, pioneered the concept
- Over $80 billion in circulation
- Controversies about reserve composition
- Faced questions about audit transparency
- Remains dominant despite concerns
USD Coin (USDC):
Positioned as more transparent alternative:
- Issued by Circle (co-founded with Coinbase)
- Regular attestations of reserves
- Reserves in cash and short-term Treasuries
- Strong regulatory engagement
Trust Requirements:
Fiat-backed stablecoins require trusting:
- The issuer's reserve claims
- The custodian holding reserves
- The jurisdiction's legal protections
- The ability to redeem when needed
Crypto-Backed Stablecoins
Some stablecoins use cryptocurrency as collateral rather than fiat reserves.
MakerDAO and DAI:
DAI is the leading crypto-backed stablecoin:
- Users deposit approved collateral (ETH, other tokens)
- They can borrow DAI against this collateral
- Overcollateralization required (deposit $150 to borrow $100)
- If collateral value falls, automatic liquidation
- Governance by MKR token holders
Why Overcollateralization?:
Crypto is volatile, so 1:1 backing wouldn't work:
- $100 ETH collateral backing $100 DAI
- ETH drops 20%: collateral now $80, DAI underbacked
- Solution: require $150+ collateral for $100 DAI
- Liquidation occurs before undercollateralization
Advantages:
- Decentralized—no central issuer
- Transparent—collateral visible on-chain
- Censorship resistant
- DAI has maintained peg through multiple market cycles
Limitations:
- Capital inefficient (need $150 to get $100)
- Complex for average users
- Smart contract risk
- Dependent on collateral asset values
Algorithmic Stablecoins
Some stablecoins attempt stability without collateral, using algorithms to adjust supply.
The Concept:
- When price above peg: increase supply
- When price below peg: decrease supply
- Automated through smart contracts
Terra/UST Collapse:
Terra's UST was the largest algorithmic stablecoin until May 2022:
- UST maintained peg through relationship with LUNA token
- 1 UST could always be exchanged for $1 worth of LUNA
- High yields (Anchor Protocol ~20%) attracted billions
- When confidence dropped, a "death spiral" began
- UST holders rushed to exit, minting LUNA
- LUNA price crashed, destroying the mechanism
- Tens of billions in value destroyed in days
Lessons Learned:
The Terra collapse demonstrated:
- Pure algorithmic mechanisms are fragile
- Confidence can evaporate instantly
- "Death spirals" are real risks
- Unsustainable yields signal risk
Hybrid Approaches:
Newer designs often combine elements:
- Frax: Partially collateralized, partially algorithmic
- Adjusts collateral ratio based on market conditions
- More capital efficient than fully collateralized
- More resilient than pure algorithmic
Use Cases and Applications
Trading:
The most common stablecoin use:
- Move between crypto positions without converting to fiat
- 24/7 trading availability
- Faster execution than bank transfers
- Pairs with nearly every cryptocurrency
DeFi:
Stablecoins are foundational to DeFi:
- Lending collateral and borrowed assets
- Liquidity pool pairs
- Yield farming strategies
- Prediction markets
Remittances:
International money transfers:
- Faster than traditional systems
- Often cheaper
- Available to anyone with internet
- Growing adoption in remittance corridors
Dollar Access:
For people in countries with currency instability:
- Access dollar-denominated value
- Protection against local currency depreciation
- Often the primary crypto use case in some regions
Business Payments:
Emerging use cases:
- Payroll for remote workers
- Supplier payments
- Cross-border B2B transfers
Regulatory and Risk Considerations
Regulatory Attention:
Stablecoins have attracted significant regulatory focus:
- Concerns about financial stability
- Consumer protection questions
- AML/KYC compliance
- Banking law applicability
Proposed Frameworks:
Various jurisdictions developing rules:
- Reserve requirements
- Audit and disclosure standards
- Redemption rights
- Capital requirements
Risk Factors:
Users should understand risks:
- Reserve Risk: Are reserves actually held?
- Bank Run Risk: Can redemptions be honored?
- Smart Contract Risk: For crypto-backed stablecoins
- Regulatory Risk: Rules may change
- Counterparty Risk: Issuers can be shut down
The De-peg Risk:
Stablecoins can temporarily lose their peg:
- USDC briefly dropped to $0.87 during bank stress
- DAI has deviated during extreme market events
- Arbitrage usually restores peg, but not instantly
Competitive Landscape
Current Leaders:
- Tether (USDT): Largest by market cap
- USD Coin (USDC): Second, more transparent
- DAI: Leading decentralized option
- Binance USD (BUSD): Exchange-associated
Future Directions:
- CBDCs may compete with or complement stablecoins
- More regional stablecoins (Euro, etc.)
- Better regulatory clarity may consolidate market
- Decentralized options may grow
Key Takeaways
- Stablecoins maintain stable values while preserving cryptocurrency benefits
- Fiat-backed stablecoins like Tether and USDC hold reserves matching tokens in circulation
- Crypto-backed stablecoins like DAI use overcollateralized cryptocurrency deposits
- Key uses include trading, DeFi applications, international remittances, and business payments
- Regulatory frameworks are developing rapidly as stablecoins have become systemically important
Summary
Stablecoins solve cryptocurrency volatility by maintaining stable values, typically pegged to the US dollar. Different mechanisms exist, from fiat backing to crypto collateral to algorithmic approaches, each with distinct risk profiles. The Terra collapse demonstrated dangers of insufficiently backed designs. As stablecoins have grown and become critical infrastructure, regulatory attention has intensified.