Stablecoins are popular because they act as a buffer against unpredictable price movements in the volatile crypto market. But what is a stablecoin, and are they really trustworthy? This guide covers the various types of stablecoins on the market and the broader role of asset-backed cryptos in blockchain-based ecosystems.
KEY TAKEAWAYS
➤ Stablecoins are cryptocurrencies designed to maintain a stable value, often pegged to real-world assets.
➤ They come in four types: fiat-backed, commodity-backed, crypto-backed, and algorithmic, each offering different levels of stability.
➤ Stablecoins provide price stability, faster transactions, and are useful for trading, payments, and DeFi.
➤ Risks include centralization, lack of transparency, regulatory concerns, and vulnerability in algorithmic or crypto-backed models.
What is a stablecoin?
As the name suggests, a stablecoin is a cryptocurrency designed to maintain a set value. These financial instruments are popular with investors who want to engage with digital assets while avoiding wild price fluctuations.
Stablecoins can maintain a near-constant value because they are typically pegged to another asset, such as gold, fiat currency, or another cryptocurrency. Or, the supply might be regulated by an algorithm.
The bottom line is that the value of a stablecoin is always equal to the asset it is pegged to.
How do stablecoins work?
The crypto market’s inherent volatility has led many to see it as a highly speculative asset class — understandably so.
Stable cryptocurrencies aim to act as a counterweight to that volatility by providing a level of stability in the market. They hold a tangible and stable value by (often) pegging to real-world assets.
Stablecoins are backed up by “reserves,” where the assets backing the stablecoin are securely stored and act as collateral.
One of the main uses for stablecoins is as a reliable means of exchange. These coins are tradable like other cryptocurrencies and are commonly used to facilitate payments. This is great for both institutions and retail users since they can be sure that the price will not alter during or after the transaction.
Stablecoins have become integral to the crypto ecosystem because of their ability to bridge TradFi and digital assets.
Merchants, for example, prefer to minimize the risk of losing money if the value of crypto falls after a transaction. Institutions also view stablecoins as a reliable solution for international payments as they make cross-border transactions cheaper, faster, and more efficient overall.
Types of stablecoin
Not all stablecoins work the same way. Some are backed by another asset, while others are algorithmic. Here’s a quick overview of each type:
Fiat-backed
As the name implies, these assets are backed by fiat currencies and are supported by reserves equal to the coin’s market cap. In other words, one unit of the stablecoin can be exchanged for one unit of currency at a 1:1 ratio.
Furthermore, independent entities regularly audit and maintain these reserves to ensure their legitimacy. While this type of stablecoin is the simplest, it is also usually the most centralized.
For example, as a fiat-backed stablecoin, Tether (USDT) ties its value to the U.S. dollar at a 1:1 ratio.
Commodity-backed
Commodity-backed stablecoins draw their value from tangible assets like precious metals such as gold and silver or some other commodity. For instance, Paxos Gold (PAXG) is pegged to real gold reserves held by Paxos.
The token mirrors the price of one ounce of gold, allowing customers to own fractions of physical gold bars.
Similarly, some commodity-backed stablecoins tie their value to other commodities like crude oil or natural gas.
Crypto-backed
This type of stablecoin is backed by another cryptocurrency. They are usually issued to introduce the underlying crypto on other blockchains. Crypto-backed stablecoins are often over-collateralized, with reserves exceeding the value of issued stablecoins to account for market volatility.
For example, MakerDAO’s DAI is pegged to the USD but backed by ETH and other cryptocurrencies worth 150% of DAI in circulation.
Algorithmic
An algorithmic stablecoin may or may not have collateral reserves. Usually, they rely on a computer program with a preset formula to stabilize their value.
The algorithm adjusts the coin’s demand and supply through smart contracts, which ultimately control its price. In terms of decentralization, these stablecoins surpass others since they don’t depend on central reserves.
One well-known algorithmic stablecoin is the TerraUSD (UST), which lost its peg in 2022.
Types of stablecoin compared
| Feature | Fiat-backed stablecoins | Commodity-backed stablecoins | Crypto-backed stablecoins | Algorithmic stablecoins |
|---|---|---|---|---|
| Backing | Backed by fiat currencies (e.g., USD, EUR) | Backed by commodities (e.g., gold, oil) | Backed by other cryptocurrencies | No reserves; relies on algorithms |
| Price stability | High, tied to fiat | Moderate, depends on commodity value | Moderate, tied to volatile cryptocurrencies | Varies, depends on algorithm performance |
| Volatility | Low, due to stable fiat backing | Low to moderate, depending on commodity | Moderate, due to crypto fluctuations | Low to moderate, depending on the commodity |
| Decentralization | Usually centralized | Can be centralized or decentralized | Often decentralized | Typically decentralized |
| Use case | Payments, remittances, trading | Store of value, investment | Collateral in DeFi, lending | Payments, decentralized finance |
| Examples | USDT, USDC | Paxos Gold (PAXG), Digix Gold | DAI, sUSD | TerraUSD (UST – before depegging) |
What are the most popular stablecoins?
1. Tether
Launched in 2014, Tether (USDT) is the largest stablecoin by market capitalization.
Because of its popularity, USDT is available on almost all major crypto exchanges. Its primary use case is moving funds between exchanges rapidly. Traders can take advantage of arbitrage when the crypto prices differ on two exchanges.
Tether claims to have a 1:1 ratio to the U.S. dollar, which means for every USDT, there is one dollar in reserves. While USDT remains the most popular stablecoin, it remains a contentious entity for some.
The U.S. Commodity Futures Trading Commission (CFTC) imposed a hefty penalty of $42.5 million on Tether in October 2021. The regulatory body alleged that the USDT issuer was deceptive about its reserves between 2016 and 2019.
Whether or not Tether continues to be truthful about its reserves is a subject of controversy. The company continues to refute “misconceptions” about Tether and USDT during subsequent regulator scrutiny.
2. USD Coin
Cryptocurrency firms Circle and Coinbase launched the USD Coin in 2018. Like USDT, this coin is pegged to a 1:1 ratio to the U.S. dollar. It’s an open-source protocol that other companies and individuals can use to create their own products.
USD Coin became very popular since it provided an alternative to USDT as it provided proof of its backing by assets derived from the U.S. dollar.
DAI
Maker Foundation originally created DAI as a non-volatile lending asset for businesses, but its governance was later given to MakerDAO.
MakerDAO’s objective is to ensure DAI stability through over-collateralization. So, for every DAI that exists, collateral in excess of the value is locked in a Maker Vault as a precaution against the impact of market volatility.
DAI is the most widely used stablecoin for integrating DApps, supporting over 400 DApps and wallets.
Binance USD
The stablecoin BUSD is a collaborative project between Paxos and Binance. Paxos backs it with U.S. dollars held in its bank accounts.
It is one of the few stablecoins that Wall Street regulators have approved. However, BUSD also came under serious scrutiny over liquidity and other concerns. For instance, Coinbase delisted BUSD on Mar. 13, 2023, citing regulatory concerns, among other issues.
Furthermore, increasing SEC scrutiny has caused some trouble with the project, and now Paxos faces a lawsuit over an alleged violation of investor protection laws.
Stablecoins vs. Bitcoin
| Feature | Stablecoins | Bitcoin |
|---|---|---|
| Price stability | Pegged to assets like fiat or commodities, stable | Highly volatile, price fluctuates based on demand |
| Use case | Primarily used for payments and trading | Store of value, used for investment and trading |
| Transaction speed | Generally faster | Slower due to network congestion |
| Backing | Backed by real-world assets or algorithms | Not backed by any asset |
| Volatility | Minimal price swings | High volatility, frequent price fluctuations |
| Decentralization | Some are decentralized (algorithmic), others are not | Fully decentralized |
| Adoption | Growing in payment systems and DeFi | Widely accepted in investment and global markets |
Are stablecoins safe?
When comparing cryptocurrencies in the market, stablecoins are often considered the safest since they lack other currencies’ volatile nature.
This works in theory, but the concept collapses if companies employ shady practices and are unable to show proof of reserves.
A stablecoin’s sustainability depends on how it’s backed. Reserves that back the coin are subject to credit, market, and liquidity risks. In other words, just because the reserves existed once doesn’t guarantee they are always secure.
While stablecoins have been touted as an answer to crypto’s volatility and may be considered more regulator-friendly than other coins, the reputation of this asset class took a nose dive following the implosion of Luna (Terra): UST, the algorithmic stablecoin of the Terra ecosystem, depegged in May 2022.
Ideally, issuers should be regulated. If they’re not, this can lead to legal problems for the stablecoin project.
In fact, the lack of regulation surrounding stablecoins has made it more feasible for issuers to make false claims regarding their reserves.
To be on the safe side, it’s best to stick with stable cryptocurrencies that are more well-known and have a high market cap.
What is a stablecoin’s role in the future of crypto?
Stablecoins have greatly impacted our financial lives. This type of crypto can offer cheaper, faster transactions and greater security — in some cases. And while governments are scrambling to accelerate crypto asset regulation, stablecoins may just be a palatable solution to upgrading payment systems and facilitating cross-border remittance.
Frequently asked questions
What is the purpose of a stablecoin?
What is the benefit of a stablecoin?
How many stablecoins are there?
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