While the most popular stablecoins are pegged to a traditional fiat currency (like the US Dollar, the Euro, or the Japanese Yen), they can also represent other commodities, such as gold or silver.
Stablecoins provide transparency and ease of transfer benefits that other cryptocurrencies enjoy while protecting investors from the volatility of these assets.
There are a few different ways that stablecoins maintain their peg to the designed asset. Some are backed by assets held in reserves while some rely on smart contracts to expand and contract the supply of the cryptocurrency based on the demand for that token.
History of stablecoins
The idea for electronic cash is not a new one. Long before Bitcoin, there were several projects that attempted to create digital money through cryptography.
The first one, B-money, was proposed by computer scientist Wei Dai in 1998 and was intended to work as an anonymous and distributed digital cash. This was followed by Bit Gold, an attempt to create a decentralized online currency created in 1998 by Nick Szabo. While both projects never saw the light of day, eCash was the first major attempt at creating an anonymous online payment using cryptography and was used by one bank in the US for three years but was dismantled in 1998 due to poor adoption.
Bitcoin, created in 2009 by the pseudonymous Satoshi Nakamoto, was the first cryptocurrency to achieve full decentralization as a peer-to-peer cryptocurrency. However, as soon as Bitcoin started trading on the open market, its price became highly volatile and detracted certain users from using it as a form of cash.
The need to remove volatility is an important reason why stablecoins came into existence. The very first one created was called BitUSD and issued on the BitShare blockchain by blockchain industry pioneers Charles Hoskinson and Dan Larimer in 2014.
The most widely used stablecoin, however, is USDT, a cash-collateralized stablecoin issued by Tether Limited, a merger company consisting of the Realcoin startup and the Bitfinex cryptocurrency exchange. Created in 2014, USDT was the first stablecoin to be backed by real assets held in Tether Limited’s reserves.
Many stablecoins have since been created using different methods to maintain their peg.
The Tether stablecoin is knowns as a cash-collateralized cryptocurrency, meaning that each token is backed 1:1 by an underlying asset like a central bank-issued currency (e.g.: US Dollar or Euro) or other commodities (e.g.: gold).
In the early days, Tether Limited, the company in charge of backing USDT, faced controversy for due to its failure to provide audited financial statements proving that it had adequate reserves backing its tokens. However, the company has released quarterly reports detailing their reserves since March 2021.
The UST stablecoin issued by Terra was known as an algorithmic stablecoin and was a two-asset system: the stablecoin itself, UST, and a more volatile asset, LUNA, that served as an arbitrage mechanism to absorb the market volatility.
In May 2022, UST began to experience a deviation from its peg. LUNA’s price also began to decline along with the broader crypto market. Due to this, demand for UST shrunk rapidly, putting a downward pressure on LUNA, incentivizing users to redeem more of the stablecoin. This type of dynamic is also called a “death spiral”. In August 2022, UST collapsed and was relaunched as TerraClassicUSD (USTC).
How do stablecoins work?
Cash-collateralized stablecoins are backed 1:1 by an underlying currency (like USD or EUR) or cash equivalents (like US government bonds) by the issuer of the stablecoin for every minted token.
The central operator thus tracks the stablecoin’s circulation and allows anyone to mint and redeem tokens in their reserves.
Examples of cash-collateralized stablecoins: USDT, USDC
Like cash-collateralized stablecoins, the value of the commodity-based stablecoin is tied to a physical (e.g.; gold or silver) or digital (e.g., Bitcoin) commodity in a 1:1 ratio held by an issuer. Generally, these also use the same IOU model as cash-collateralized stablecoins.
Examples of commodity-collateralized stablecoins: PAXG, wBTC
Crypto-collateralized stablecoins are backed by cryptocurrency held in smart contracts. Often, each stablecoin minted is overcollateralized, meaning that each stablecoin token requires its holder to lock cryptocurrencies worth more than the amount they mint to ensure the stability of its $1 peg, even with fluctuations in the crypto market.
In order to redeem the underlying cryptocurrency deposited, users often have to return the stablecoins to the protocol, along with a small fee.
Examples of crypto-collateralized stablecoins: DAI
Rebasing algorithmic stablecoins
Rebasing algorithmic stablecoins use a protocol based on smart contracts to expand and contract the total supply of tokens according to the demand of the token. Using the rebase process, a correction is made to stabilize the price of the stablecoin to maintain its fixed peg, for example $1.
Example of rebasing algorithmic stablecoins: AMPL
Seigniorage algorithmic stablecoins
Seigniorage stablecoins often involve at least two assets: the stable asset and one or more volatile assets intended to serve as an arbitrage mechanism which fluctuate based on volatility in the demand for the stable asset. The purpose of the arbitrage mechanism is to increase or decrease the supply of the stablecoin to ensure it maintains its peg.
Example of seigniorage algorithmic stablecoins: UST, Basis Cash
Why are stablecoins useful?
Stablecoins have proven useful in many different contexts.
First, they offer all the benefits of other cryptocurrencies, such as transparency, ease of transfer, instant finality and being borderless, while protecting users from their sometimes-high volatility. This helps when trying to purchase goods and services locally, or on a bigger scale as an alternative to the traditional SWIFT or Western Union for global payments and remittances.
Stablecoins are also useful for traders who wish to get in and out of trades 24/7 and to transfer their wealth between various exchanges to find different cryptocurrencies or arbitrage opportunities.
Stablecoins also prove useful to exchanges like Bitstamp in order to offer more fiat-crypto trading pairs that can be settled instantly.
How to buy stablecoins
You can buy a few stablecoins on Bitstamp, like USDT and DAI. Sign up for a Bitstamp account and start trading stablecoins today!
Disclosure: Bitstamp is licensed to engage in virtual currency business activity by the New York State Department of Financial Services.