Stablecoins have become a distinct class of crypto, where they are pegged against certain traditional currencies (mostly the US dollar). Pegged means when one asset’s price (like a stablecoin) is directly linked to another’s (in this case, a government-backed currency). This way, the coin’s price remains “stable”, hence the name stablecoin. 

They bridge the gap between the speed of crypto transactions and the stability of fiat, taking volatility out of the equation. Today, there are several stablecoins in the market, each offering the ability to move wealth, pay for services, and even trade cryptocurrencies. 

But how do these stablecoins become stable? A US dollar will always be worth $1, but why will any US-pegged stablecoin be equal to $1? What drives the engine of price firmness is more than what meets the eye.

The “why” before the “how”

The bigger question than what makes a stablecoin stable is why the need for it? Bitcoin and subsequent coins have changed the world. Terms like financial inclusion and breaking down barriers are frequently used. However, volatility is something that is a part and parcel of crypto. When the digital tokens’ prices start to swing (and swing they do), it becomes a hurdle for people to hold and transact these.

Double-digit percentage movements are not as uncommon in crypto, and that makes these a bit impractical for everyday commerce or payments. What if you were paid in crypto? A payment worth $1,000 in the morning could be worth $900 or $1,100 by evening. That’s the price volatility.

Using stablecoins makes sense in this and other cases. But why is a stablecoin, well, stable? What mechanisms are at work that ensure the price is fixed to a fiat? There are a few ways this is achieved.

Fiat collateralized stablecoins

The most straightforward type of stablecoin is the fiat-backed model. Operating on a 1:1 ratio, every single token or coin issued is backed by the same amount of fiat, usually held in a regulated bank or a custodial service.

The issuers may also be subject to regulations, like the EU’s MiCA and the US’s GENIUS Act, that require stablecoin issuers to not only maintain strict liquidable reserves but also undergo regulatory oversight to ensure user rights are protected.

The operation is straightforward. Users interested in the stablecoin send fiat to the issuing company, which then locks it up in its reserves and sends the same amount of stablecoin to the user’s wallet. When the token holder wants to cash out, they can redeem for the fiat by sending the stablecoins back to the issuer, who transfers them the fiat. This is how Tether (USDT) operates.

Benefits of fiat collateralized stablecoins

• Prices aim to remain stable as the coins can only be redeemed for the fixed fiat value. However, this is not a guarantee, as severe market swings can cause de-pegging.
• Easy concept to grasp for novices and traditional investors

Drawback of fiat collateralized stablecoins

• They are a centralized model, with a single authority issuing and redeeming the tokens. They hold the power to censor transactions by essentially freezing assets.
• Require reputable third-party audits of reserves to build and maintain trust.

Crypto collateralized stablecoins

Fiat collateralization, while making it easy to circulate and use, breaks the decentralization part with its sole issuer concept. Stablecoins backed by other crypto are a workaround, keeping the entire process on the blockchain.

These stablecoins are issued through a smart contract, allowing anyone to mint these tokens by depositing the right crypto. Subsequently, users can redeem the underlying crypto by depositing the stablecoins back into the smart contract.

Stablecoins backed by crypto are usually overcollateralized. This acts as a buffer to counter volatility in the underlying assets’ price, making sure there is enough value against the issued stablecoins in a downward market.  USDS by Sky, for example, is a crypto collateralized stablecoin that typically runs a 1.5:1 ratio.

Benefits of crypto collateralized stablecoins

• No central authority, with smart contracts running the issuing and redemption.
• No censorship, and no one can freeze the issued assets.

Drawbacks of crypto collateralized stablecoins

• Overcollateralization is required to counter the underlying asset’s volatility, leading to a larger lock-up than the required stablecoins.
• May trigger a liquidation (selling off deposited assets to protect the peg) if the overcollateralization ratio falls to a predefined level.
• The smart contract can itself be a weak point, subject to a hack or manipulation, such as a flash loan attack.

Non-collateralized, algorithm-based stablecoins

An ambitious methodology, algorithmic stablecoins require no collateralization. Instead of publicly accepted assets backing and creating value for these tokens, stablecoins rely on algorithms and smart contracts to balance the supply in real time.

The value is maintained using the classic supply and demand method. If the stablecoin price starts to go higher than a certain limit, the algorithm and smart contract mint more to create a small oversupply and drive the price down to acceptable levels.

If the price falls below a threshold, the token holders are incentivized to redeem the (now) cheaper coins, as the smart contract will always pay back in the higher official pegged value. This drives up the demand to acquire and shrinks the supply by burning, pushing the price upwards.

Benefits of algorithmic stablecoins

• Completely decentralized and transparent, algorithmic stablecoins are censorship-resistant.
• Requiring no collateralization, these stablecoins can help free up capital otherwise locked up.

Drawbacks of algorithmic stablecoins

• Considered high-risk assets due to their noncollateralized nature. Require carefully created algorithms and strong market confidence.
• A runaway can cause irreversible damage, such as the 2022 Luna’s UST debacle. Falling LUNA token prices and UST depegging pushed holders to sell the stablecoin faster than the algorithm could stabilize it.

Commodity-pegged stablecoins

What if a stablecoin represented not a fiat, but something entirely different, like a precious metal? At first glance, these may not sound stable. After all, commodities like gold and silver keep fluctuating in price. These coins are stable because they remain pegged to the commodity, even if the commodity price itself fluctuates. 

For example, just like a normal stablecoin is pegged to a fiat, where one token is equivalent to one unit of currency, the commodity pegged stablecoins are always equal to their counterpart. PAX Gold, one of the most used commodity-pegged stablecoin, costs (and is redeemable) against 1 troy ounce of gold. If gold moves up or down in the market, the gold-backed stablecoin reflects that.

In short, it is stable against the value of the asset, not a currency.

Benefits of commodity-pegged stablecoins

• Gives holders exposure to the underlying commodity without the need to physically take possession of the asset.
• Can be bought and sold on crypto exchanges, effectively making a good digital alternative to hedge against inflation.

Drawbacks of commodity-pegged stablecoins

• Similar to fiat pegged stablecoins, commodity ones rely on a central issuer and third-party audits for market confidence.
• Can carry significant overhead costs factored into the token price, as the issuer needs to spend on storage space, insurance, and security of the commodity.

Why do stablecoins depeg?

Stablecoin issuers use different means to keep the price pegged to the underlying asset. But that is not set in stone, and not only can stablecoins depeg, but they have also depegged in the past.

Mass selling can break the peg

If the market experiences a sudden influx of stablecoin, especially in decentralized exchanges, there may not be enough buyers to absorb the inflow. This causes more supply of the stablecoins than the demand, causing price slippage and depegging.

A bank run can cause a panic

With a 1:1 backing, stablecoins regulatory compliant issuers keep their reserves in dedicated banks and vaults. If the holding institutions themselves face liquidity issues, this can mean the issuer may be unable to honor redemption due to cash shortage, which can cause a panic, circling back to the mass selloff situation and even insolvency.

The maths can fail in an algorithmic stablecoin

Algorithm-based stablecoins play a precarious act of balance to maintain the peg. This is done through holding other crypto, normally overcollateralized. In extreme market fluctuations, the underlying cryptocurrencies can crash to a point that even the overcollateralization isn’t enough to maintain the stablecoin’s peg.

Knowing which stablecoin type is the best

There is no certain way to describe any of these types as “best”, as each has its own pros and cons. However, there are some things you must look at. Check for stablecoin attestation report (backing assets and/or smart contracts), liquidity, and governance models, and match against your requirements.

It would also be better to see local regulations as one (or more) type of stablecoin may not be allowed or available in your jurisdiction

Stablecoin Models FAQs

Are stablecoins risk-free?

No. While stablecoins are designed to be stable and maintain their value, they are not risk-free. Issues like bugs in their smart contract, custodial services facing liquidity issues, and extreme market forces can cause them to depeg or not be redeemable.

Are stablecoins regulated?

Regulation varies by jurisdiction. While laws such as the US GENIUS Act and the EU MiCA do put regulations on stablecoins operating in their jurisdictions, this may not be the case with all stablecoin issuers. You should always check with the issuer’s website to see if it complies with your local laws.

How do I know if my stablecoin issuer has the dollars it claims to back it up?

Reputable stablecoin issuers hire independent auditors who verify the reserve balances. These verifications are available as “attestation reports”, which let users know how much money is in reserve vs how many stablecoins are issued. Depending on the jurisdiction, this report may also be a regulatory requirement.

How do fiat-pegged stablecoins lose their peg?

Fiat-backed stablecoins, although having a 1:1 reserve, can lose their peg. This can be either when a mass selling occurs, leading to more supply in the market than the demand, which can bring the price down, or when the issuer is unable to honor redemption against the pegged price (which can be due to a bank run, a liquidity crunch, etc.).