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What is a stablecoin?

By definition, a stablecoin is a digital currency that attempts to stay pegged to the price of an asset that retains a relatively consistent value over time. Like other cryptocurrencies, a stablecoin exists on a blockchain network. Unlike crypto assets like BTC or ETH, stablecoins employ various mechanisms and monetary policies to achieve price stability.

The most common use of stablecoins is on crypto exchanges like OKX. Stablecoins emerged in response to the extreme volatility of BTC and other digital currencies. Price stability is important for crypto investors and traders buying and selling digital assets that often have highly correlated price action. Yet, supporting trading pairs that use central bank-issued fiat currencies is challenging from both a logistical and regulatory standpoint. Stablecoins provide a convenient alternative, enabling traders to exit from markets during periods of high price volatility. 

In this article, we give an introduction to stablecoins. We firstly cover stablecoins’ growth, the different types of stablecoins, their price-stability mechanisms and their advantages over traditional payment systems. Lastly, we explain how stablecoins are used and how they work. 

The rise of stablecoins

The very first stablecoin was called BitUSD, and it was launched in 2014 on the BitShares blockchain. BitUSD was followed that same year by Tether — or USDT. Today, USDT is the stablecoin people are most familiar with, and it is the most adopted. It experienced massive growth during the 2017 bull run, during which BTC rose from its previous all-time high of around $1,200 to just short of $20,000. 

In more recent years, the continued adoption of digital currencies has mirrored the adoption of stablecoins. CoinGecko lists 80 different stablecoins, as of the time of this writing, and reports a total market capitalization of more than $190 billion. Most of these stablecoins attempt to reflect the price of the United States dollar and may be referred to as USD coins. However, blockchain-based versions of other fiat currencies also exist, and some stablecoins are pegged to precious metals or a basket of currencies, too. 

The combined stablecoin supply of the 15 top USD-denominated stablecoins is now more than $182 billion. Source: The Block

Top 10 stablecoins by market cap

The following stablecoins list contains the top 10 projects by market capitalization as of March 2022. 

  • USDT — $81.7 billion
  • USDC — $52.4 billion
  • BUSD — $17.6 billion
  • UST — $16.35 billion
  • DAI — $9.2 billion
  • MIM — $2.8 billion
  • FRAX — $2.7 billion
  • TUSD — $1.3 billion
  • USDP — $964 million
  • USDN — $857 million

Stablecoin advantages

Stablecoins have several advantages over both traditional fiat currencies and crypto assets like BTC. Firstly, they benefit from the relative price stability of central bank-issued fiat and also from being natively digital. Below are some additional advantages of stablecoins: 

  • Fast — Unlike traditional payment methods, blockchain-based currencies are agnostic to national borders and arrive at their destination must faster than payments on legacy financial networks. 
  • Cheap — Sending international payments can be expensive. It’s often much cheaper to use a stablecoin, particularly if the stablecoin is on a high-capacity network like Algorand rather than the more expensive Ethereum blockchain.
  • Less friction — Implementing stablecoins on exchange platforms like OKX is much easier and involves fewer regulations than fiat currencies — for now, at least.
  • Price stability — Price stability is vital for crypto investors, traders and DeFi users. If you exit a position anticipating a future BTC price decline, you want to ensure the asset you’re holding instead isn’t going to dump alongside BTC. Similarly, using volatile crypto assets as collateral for loans from decentralized financial services is not ideal.
  • More utility — It is impossible to use actual dollars, euros or yuan with DeFi protocols. 

How are stablecoins used?

Stablecoins are used in many ways, fueling the asset class’s adoption. They include: 

  • Medium of exchange — Many merchants accept stablecoins in exchange for products and services, just as they do fiat currencies. Similarly, on-chain goods, such as NFTs, can be bought and sold using USDT, USDC and other stablecoins. 
  • As a base currency at crypto exchanges — Crypto traders use stable assets to exit volatile positions during extreme market movements. 
  • Within DeFi — Price stability is helpful in decentralized finance. Examples include providing liquidity or trading on a decentralized exchange, as well as taking an on-chain loan. 
  • Store of value — Holding stablecoins denominated in strong fiat currencies like USD may preserve purchasing power for those living in nations with weaker currencies. 

How do stablecoins work and what keeps them stable?

Different types of stablecoins employ various mechanisms to keep them stable. Distinguishing them is the degree of trust involved, and some are generally more effective at achieving price stability than others. 

Centralized stablecoins

Asset-backed and fiat-backed stablecoins

An asset-backed stablecoin is a digital currency that derives its value from collateral held by a centralized entity. This centralized entity then issues stablecoins in accordance with the amount of the assets held: For every 1 USD-denominated, asset- or fiat-backed stablecoin in existence, there should be collateral held in a bank worth at least $1. 

A fiat-backed stablecoin is a type of asset-backed stablecoin; however, the latter isn’t necessarily backed by central bank-issued fiat currency. Instead, an asset-backed stablecoin may use more than one asset to back its supply — such as a precious metal like gold, as in the case of PAXG or Tether Gold. Alternatively, asset-backed stablecoins might hold commercial paper or debt in their reserves. Although Tether once claimed USDT to be backed entirely by U.S. dollars held in bank accounts, subsequent revelations indicate that Tether actually uses a basket of various assets worth the equivalent of USDT’s circulating supply.  

For the issuer of a fiat-backed stablecoin to create currency units, it must take in additional assets to maintain a one-to-one peg with the price of the asset it’s trying to mirror. If the collateral backing the stablecoin shrinks, the issuer destroys stablecoin units. 

This mechanism relies on trust between the stablecoin user and its issuer. The user must trust the issuer to maintain the peg responsibly by increasing and decreasing the circulating supply, and by actually holding the assets the issuer claims are in reserve. Audits of an issuer’s reserve assets can help establish this trust. While these stablecoins attract criticism for their centralized implementations, fiat-backed or asset-collateralized stablecoins are usually considered the best stablecoins for maintaining a consistent price over time. 

USDT rarely deviates more than 1% from its $1 peg. Source: CoinGecko

A significant drawback of centralized stablecoins is their lack of censorship resistance. Typically, crypto assets can be sent to any valid address on their respective network. With a centrally issued stablecoin like USDT or USDC, the issuer has the power to blacklist addresses. Previously, such restrictions have been reserved only for wallets containing hacked funds. However, regulatory pressure may eventually force stablecoin issuers into blocking addresses for other reasons. 

Decentralized stablecoins

Decentralized stablecoins come in two main varieties: crypto-backed and algorithmic. Their decentralized nature means they are more trust-minimized than their centralized counterparts. However, because their price-stability mechanisms are less efficient, they are more prone to deviate from their target price. 

Crypto-collateralized stablecoins

Crypto-backed stablecoins usually fall into the decentralized category and involve a smart contract custodying reserve funds in place of a centralized entity. Because an on-chain smart contract holds the collateral backing these stablecoins, the assets used must also be on-chain. 

Most on-chain asset prices are highly volatile. As such, crypto-collateralized stablecoins usually require over-collateralization — i.e., the value of assets backing must exceed the value of the entire circulating stablecoin supply. This helps prevent a sudden downward price movement in the collateral asset from causing the stablecoin it backs to break the peg.

Take the most famous example of a crypto-collateralized stablecoin, DAI. DAI is “soft-pegged” to USD and issued on the Ethereum blockchain by the MakerDAO DeFi protocol against deposits of ETH, WBTC and other crypto assets. 

ETH and WBTC are prone to large price swings in either direction. If the value of ETH falls significantly, there is a risk that the collateral value drops below the circulating supply’s supposed value, at which point the price peg would fail. As such, every DAI issued against crypto deposits currently requires more than $1 worth of collateral backing it. For example, for every 1 DAI issued against WBTC, the user must deposit $1.75 in WBTC to the relevant vault.   

Because their collateral value is volatile, crypto-backed stablecoins are generally less efficient at maintaining their price peg. That said, outside of the most extreme market moves, DAI and similar stablecoins do a reasonable job of achieving price stability. 

Less consistent than centralized alternatives, crypto-backed stablecoins still manage to achieve relatively stable prices via their over-collateralization mechanism. Source: CoinGecko

The main advantage of a crypto-backed stablecoin is that no single entity can implement restrictions on transactions as they can with centralized alternatives. For example, any address on the network on which the stablecoin is deployed can send and receive DAI. Such universal accessibility fits well with cryptocurrency’s decentralized and permissionless ethos. 

Algorithmic stablecoins

The final main category is algorithmic stablecoins, which attempt to achieve price stability by automatically adjusting the circulating supply in accordance with demand. Adjustments are made algorithmically via a smart contract deployed on the Ethereum blockchain or a similar smart contract-enabled network. 

In the simplest terms, when demand rises, an algorithmic stablecoin protocol issues new units. Conversely, when demand falls, the protocol destroys units. This usually involves some incentive mechanism to encourage participation in the stability functions. 

The main advantages of algo stablecoins are that they are decentralized and censorship-resistant, and use capital much more efficiently than over-collateralized implementations. With DAI, for example, a user must lock up 150% or more of the value of the stablecoin they receive. There is no capital lockup with an “elastic supply” stablecoin.  

Although there are many examples of algorithmic stablecoins, few have managed to achieve a consistent peg in the long term. We covered these elastic-supply stablecoins and their shortcomings in an OKX Insights’ in-depth article, finding that the incentive mechanism can collapse in extreme cases, breaking the peg entirely. 

Even if a so-called “death spiral” does not occur, purely algorithmic stablecoins are less reliable, as adjusting supply according to demand is less efficient than changing it according to the value of assets held. Therefore, if absolute price stability is crucial, these might not be the best stablecoins for you. 

Algo stablecoin Empty Set Dollar is supposed to represent $1 but now trades at less than $0.01. Source: CoinGecko

In an effort to achieve both the price stability of crypto-backed stablecoins and the capital efficiency of algorithmic stablecoins, some solutions involve a combination of the two mechanisms. FRAX is probably the most successful example and has stayed within 3% of its target price of $1. 

FRAX has traded close to its $1 peg throughout its existence. Source: CoinGecko

Stablecoins — integral to the crypto markets

Stablecoins are an essential part of the cryptocurrency ecosystem. They help to expand access to basic financial services to those previously excluded, and they provide a safe haven for crypto investors and traders — as well as those living in parts of the world suffering currency devaluation. 

Stablecoins are also somewhat controversial. Centralized implementations like Tether have faced criticism over their lack of transparency regarding reserve audits. Even when Tether disclosed what actually is backing USDT, some argued that commercial paper is an inferior substitute for actual dollars. Similarly, issues surrounding the blacklisting of accounts also attract disapproval from many corners of the crypto industry.

Although they are much more resistant to transaction censorship, crypto-collateralized and algorithmic stablecoins present their own risks to users. Beyond general smart contract risks, if a stablecoin can’t maintain its peg, it’s pretty useless! 

Thanks to the clear demand for a robust stablecoin solution from crypto investors and traders — and increasingly from beyond the digital currency industry — work to create better, more trust-minimized stablecoins is ongoing. More modern, hybrid stablecoin implementations like FRAX and UST are encouraging, as they attempt to balance the advantages of collateralized and algorithmic stablecoins while retaining maximum decentralization. 


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