What keeps stablecoins stable?

Everyone knows that the crypto market is highly volatile and dealing with it is akin to gambling. Why are some virtual currencies called stablecoins then? Let’s find out


What keeps stablecoins stable?. Source: pixabay.com

Stablecoin is a digital asset, backed by a more traditional financial investment tool. Thus, stablecoins can be pegged to any fiat currency, foreign exchange-traded commodities, precious or industrial metals.

These unique assets have a stable price. They behave somewhat like fiat money but maintain the mobility and utility of cryptocurrencies at the same time. ‘Stable’ crypto assets are highly valued by investors. Because of their relative stability, stablecoins also have more chances to comply with regulators.

Since the beginning of 2020, the stablecoin market has seen an unprecedented boom. Its market cap has expanded by over eleven times. In total, the market grew from $5B in Q1 2020 to around $20.2B in Q3 2020. It was just a humble beginning, though. This March, the market was nearing $58B, driven by DeFi growth.

The most popular stablecoins include Tether (USDT), USD Coin (USDC), Binance USD (BUSD), True USD (TUSD), Paxos Standard (PAX), etc.

There are a few basic mechanisms used to keep stablecoins stable.

Fiat backing

Fiat-backed stablecoins are backed at a 1:1 ratio, meaning 1 stablecoin is equal to 1 unit of a certain fiat currency. Fiat-backed stablecoins keep a reserve of the chosen currency as collateral. This reserve is administered through an independent custodian and audited on a scheduled basis to ensure compliance. When someone wants to redeem fiat money with their crypto coins, the custodian pays out the amount of fiat from their reserve. The equivalent stablecoins are then destroyed or taken out of circulation. Most of the fiat-backed stablecoins use US dollar reserves.

Euro and GBP are also emerging as collateral, with new stablecoins increasingly launched. For instance, this March, the Lugh (EUR-L) – a new French euro-backed stablecoin anchored to euro reserves held in an account with Societe Generale – has been developed in a partnership between the Lugh Company and the crypto trading platform Coinhouse. In Germany, Bankhaus von der Heydt (BVDH) collaborated with Bitbond to launch a Euro stablecoin on the Stellar network. A few GBP-backed crypto projects like LBXPeg, TrueGBP, GBPX, or BGBP have started and closed during the last few years due to low demand.

Commodity backing

Any commonly valued commodity may become the solid backbone of a stablecoin. Physical assets like precious metals, oil, and real estate are used for this purpose, with gold being the most popular option. Holders of such stablecoins can either sell them for cash or redeem their tokens in exchange for the real underlying gold. At the same time, stablecoins backed by other commodities such as oil or real estate often lack the same utility. They can be redeemed for tokens in the monetary value of the pegged item rather than a physical barrel of oil or a house. Diversified baskets of precious metals are also popular as collateral. Since commodities have the potential to appreciate in value over time, people are inclined to hold and use the related stablecoins.

Crypto backing

Stablecoins can use other crypto assets as collateral too. In this case, stablecoins remain much more decentralized than fiat-backed ones while still holding intrinsic stability. Such tokens are often backed by multiple cryptocurrencies in order to distribute risk. When purchasing this kind of stablecoin, the buyer locks the cryptocurrency into a smart contract to obtain tokens of equal representative value. You can then put your stablecoin back into the same smart contract to withdraw your original collateral amount. Since the scheme is quite complex, this type of stablecoin is not as popular as more traditional variants. However, as the example of Dai shows, there’s great potential there.

Algorithm backing

These types of coins are non-collateralized. Instead, they use an algorithmically governed approach to control the stablecoin supply. This is a model known as seigniorage shares. Specialized algorithms and smart contracts reduce the number of crypto tokens in circulation when their market price falls below the price of the fiat currency they aim to correspond to. On the contrary, if the price of the token exceeds the price of the fiat currency it tracks, new tokens enter into circulation. The idea of seigniorage as backing came from a white paper from noted cryptographer Robert Sams. He proposed a system consisting of two tokens: the supply-elastic currency itself and investment “seigniorage shares” of the network. Owners of the latter assets are the sole receptors of inflationary rewards from positive supply increases and the sole bearers of the debt burden when demand for the currency falls and the network contracts. Tokens stabilized by algorithms are not redeemable 1:1 for fiat currencies or gold. Their demand is driven by market sentiment and momentum. This way, the stability of algorithmic stablecoins is still questionable, being determined solely by collective market psychology.