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What Are Stablecoins and How Do They Work? [USDC, USDT, UST, DAI]

Jason BalesJason Bales
What Are Stablecoins and How Do They Work? [USDC, USDT, UST, DAI]

Stablecoins are essential for the development of a complete cryptocurrency economy. They provide stability during downward trends in the market, safety for low-risk investors, and a bridge between the worlds of decentralized and traditional finance. But what are stablecoins?

When thinking about cryptocurrencies, most people envision highly volatile assets like Bitcoin (BTC) and Ethereum (ETH). One day, BTC is $69,000. The next day, it’s $31,000. People can’t reliably pay for real-world items and services, like a car or rent, with speculative assets. But they could with stablecoins, as the price stays… well… stable.

This article provides answers to the most important questions about stablecoins. Learn what they are, how they work, the different types, how to use them, where to buy them, and more.

Table of Contents

What Is a Stablecoin?

Stablecoins are price-stable digital assets that reside as cryptocurrency tokens on various blockchain platforms, like Ethereum (ETH), Binance Smart Chain (BSC), Terra (LUNA), and others. Blockchains are digital ledgers that typically store data in a decentralized manner, rather than handing over control of that data to a central authority.

In simpler terms, stablecoins are pegged to, or match the price of, U.S. dollars (USD), other global fiat currencies, other cryptocurrencies, other commodities, or some other external reference point. 

Theoretically, just as $10 USD is the same at Walmart in January, the local barber shop in March, or the Internal Revenue Service (IRS) in April, $10 of USDT, or Tether (the most popular stablecoin as of the time of this writing), is the same as $10 of USDT across all blockchains and cryptocurrency platforms and protocols. That same $10 of USDT is equivalent to $10 USD and can be exchanged for fiat currency at most centralized exchanges.

This peg creates a volatility-free cryptocurrency that mimics the price of standard fiat currencies. For the global adoption of crypto in general, stablecoins are crucial. But how do they work? What different types are there and why does it matter? Are they safe? Let’s discuss. 

How Do Stablecoins Work?

Stablecoins can achieve stability through centralized backing, decentralized backing, and in certain instances, algorithmically with no backing at all. How exactly stablecoins work is complicated because USDT does not equal USDC, and USDC does not equal UST, and so on. They’re all different with unique pegging mechanisms.

Asking how stablecoins work is similar to asking how video games work. The typical response to such a question is likely confusion followed by, “which one?”

But there are certain generalized standards that make a stablecoin a stablecoin and a video game a video game. Just as most video games are run on a main processor called a CPU and utilize a special graphic processor called a GPU, stablecoins are “run” on a blockchain and utilize special coding language, for example smart contracts, or programs stored on a blockchain that execute specified code when certain conditions are met. And just as most video games have rules that must be followed and objectives that must be completed, stablecoins have peg stability mechanisms (rules that must be followed) to maintain peg stabilization and volatility-free valuations (objectives that must be completed).

When a stablecoin’s peg stability mechanism fails and the price of the asset goes “off peg” (remember that $10 USDT that was worth $10 USD, imagine if it was only worth $7 USD instead), it simultaneously fails to complete its objective. If it remains off peg for too long, it is no longer a valid volatility-free, price-stable cryptocurrency. It lost the game, and plenty of so-called stablecoins have lost the game already (more on this in Are Stablecoins Safe? Can Stablecoins Crash?).

In order to truly understand how stablecoins work, let’s look at the different types of stablecoins and how they’re generally backed or maintain their pegs.

Types of Stablecoins: Algorithmic vs Non-Algorithmic

There are two main types of stablecoins: algorithmic and non-algorithmic. 

Non-algorithmic stablecoins are easier to understand through the lens of traditional finance, so let’s start there before comparing and contrasting to algorithmic stablecoins.

Non-Algorithmic Stablecoins

Non-algorithmic stablecoins are backed, whether centrally or de-centrally, by other assets and utilize reserves to maintain the stablecoins’ pegs. 

There are three main types of non-algorithmic stablecoins: fiat-backed, cryptocurrency-backed, and commodity-backed.

Fiat-Backed Stablecoins (USDT, USDC, TUSD)

Fiat-backed stablecoins maintain their pegs by collateralizing the issued cryptocurrency tokens 1:1 with fiat currency held by a centralized entity. All this means is that for every $1 USD used to purchase $1 worth of USDT, USDC, or another fiat-backed stablecoin, $1 worth of USDT, USDC, or another fiat-backed stablecoin will be directly redeemable for $1 USD. It’s a complicated IOU (I owe you) note.

The original $1 USD used to purchase the fiat-backed stablecoin is held in a centralized reverse and re-issued back to the purchaser when and if desired. Frequent audits can provide users transparency into the total value of the reverse and all issued tokens are viewable on the blockchain.

It is easier to understand with a specific example, so here is Tether’s (USDT) explanation of how the process works, taken directly from their website’s tutorial video:

There are five steps in the life cycle of USDT:

Step 1: A KYC-verified Tether user (could be an exchange, an individual trader, a business merchant, or a trading firm) deposits fiat currency into Tether’s bank account.

Step 2: Tether issues USDT and sends the tokens to the user’s crypto wallet address. The amount of tokens that enter circulation is equal to the user’s deposited amount minus fees.

Step 3: USDT is used for transactions by users. They can be transferred, traded, or stored for further use.

Step 4: A user can redeem their USDT for fiat currency by depositing the tokens into their account at tether.to.

Step 5: Tether removes the USDT from circulation and sends the equal amount of fiat currency to the user’s bank account. Tether is the only party that can issue USDT into circulation or remove USDT from circulation.

It’s a simple and relatively safe process. There are, however, still risks involved with fiat-backed stablecoins, such as regulation concerns, a mismanaged reserve (like when Tether itself failed to disclose that its reserve was partly backed by non-fiat assets), or the collapse of the centralized entity holding the fiat currency (more on this in Pros and Cons of Different Stablecoins).

Cryptocurrency-Backed Stablecoins (DAI)

Cryptocurrency-backed stablecoins are similar to fiat-backed stablecoins but they maintain their pegs by collateralizing the issued cryptocurrency tokens 1:X with volatile, speculative cryptocurrency assets. 

The X in the cryptocurrency-backed stablecoin equation means the tokens are not backed 1:1. Instead, they’re overcollateralized because the price of cryptocurrencies are highly volatile (the reason the market needs stablecoins in the first place). As the price of the collateral moves, the more volatile the stablecoin could potentially get. 

For example, DAI is a stablecoin created by MakerDAO and backed by a reserve of Ether (ETH), Ethereum network’s transactional token. Each DAI token is pegged 1:1 with a U.S. dollar. That peg is maintained by the value of the ETH in MakerDAO’s reserve, and ETH is a volatile asset. Therefore, each DAI token must be backed by more than $1 USD worth of ETH (typically 1.5 to 2x the amount). 

The amount of ETH required to back DAI and maintain its peg is calculated via complicated smart contracts called Maker Vaults. Here’s how it works according to MakerDAO’s whitepaper:

Step 1: A user creates a Vault via the Oasis Borrow portal or a community-created interface, such as Instadapp, Zerion, or MyEtherWallet, by funding it with a specific type and amount of collateral that will be used to generate DAI. Once funded, a Vault is considered collateralized.

Step 2: The Vault owner initiates a transaction, and then confirms it in her unhosted cryptocurrency wallet in order to generate a specific amount of DAI in exchange for keeping her collateral locked in the Vault.

Step 3: To retrieve a portion or all of the collateral, a Vault owner must pay down or completely pay back the DAI she generated, plus the Stability Fee that continuously accrues on the DAI outstanding. The Stability Fee can only be paid in DAI.

Step 4: With the DAI returned and the Stability Fee paid, the Vault owner can withdraw all or some of her collateral back to her wallet. Once all DAI is completely returned and all collateral is retrieved, the Vault remains empty until the owner chooses to make another deposit.

Why go through this complicated process just to achieve the same peg as fiat-backed stablecoins? MakerDAO is completely decentralized. Cryptocurrency-backed stablecoins tend to be decentralized and avoid central authorities controlling the reserve. 

As is the case with all stablecoins, cryptocurrency-backed stablecoins have their own set of unique problems and challenges: the volatility of crypto assets, smart contract failures, etc. (again, more on this in the Pros and Cons of Different Stablecoins).

Commodity-Backed Stablecoins (XAUT, PAXG, DGX)

Commodity-backed stablecoins operate in the same way as fiat-backed stablecoins but they maintain their pegs by collateralizing the issued cryptocurrency tokens 1:X with commodities, typically precious metals like gold.

The X in the commodity-backed stablecoin equation means the tokens are not all backed by the same measurement. Commodity-backed stablecoins can be backed by gold, silver, copper, oil, or any other commodity. And the amount of that commodity per token issued can change, too.

Again, let’s look at an example: Digix (DGX). 

Digix’s token DGX is pegged 1:1 with 1 gram of gold (this is not the only way to peg to commodities, Tether Gold (XAUt) is pegged 1:1 with 1 troy fine ounce of gold). The process here similar to fiat-backed stables like Tether (USDT), where DGX is purchased from a centralized entity, the centralized entity purchases (or documents the acquisition of) the gold, the gold is held in a reserve, and the DGX token is redeemable for that gold at a future date.

There is no in-depth explanation of this process on Digix’s website, but if there was, it would look something like this:

Step 1: A KYC-verified Digix user (could be an exchange, an individual trader, a business merchant, or a trading firm) deposits fiat currency into Digix’s bank account.

Step 2: Digix purchases gold, issues DGX tokens, and sends them directly to the user’s crypto wallet address. The amount of tokens that enter circulation is equal to the user’s deposited amount (calculated in grams of gold) minus fees.

Step 3: DGX is used for transactions by users. They can be transferred, traded, or stored for further use.

Step 4: A user can redeem their DGX for the fiat currency equivalent of gold by depositing the tokens into their account at digix.global.

Step 5: Digix removes the DGX from circulation and sends the equal amount of fiat currency to the user’s bank account. Digix is the only party that can issue DGX into circulation or remove DGX from circulation.

Commodity-backed stablecoins are stable in relation to the commodity that backs them. That commodity, however, is not always stable. The fiat currency value of gold, silver, copper, oil, and other commodities changes over time. 

As previously mentioned, all stablecoins are risky to a certain extent. Commodity-backed stablecoins suffer from the same problems and challenges as fiat-backed stablecoins; they’re backed by a central authority that could undergo regulatory scrutiny, the reserve could be poorly managed, frequent audits are needed to ensure the commodities exist, etc. (more on this in the Pros and Cons of Different Stablecoins).

Algorithmic Stablecoins (UST, AMPL, FEI)

As opposed to non-algorithmic stablecoins, algorithmic stablecoins are not backed by external assets. Rather, they programmatically keep peg based on computer-generated supply changes, arbitrage opportunities, and more.

Algorithmic stablecoins do not need collateral because the program itself is supposed to keep the peg, not a cash, cryptocurrency, or commodity reserve. And the algorithms that control the peg are made public, so there is no need to trust a third-party.

Let’s look at Terra’s UST as an example.

UST, like all cryptocurrencies, has a certain supply and demand. As the demand goes up and the supply remains the same, the price goes up. As the demand goes down and the supply remains the same, the price goes down. Stablecoins are designed to keep peg with an external reference point, in this case the U.S. dollar. But how does a single UST remain $1 USD when the demand for UST increases?

In order to keep peg, UST is linked to Terra’s speculative asset, LUNA. As UST demand increases, LUNA is burned (or removed from the total LUNA supply) in order to mint (or increase the supply of) UST. As UST demand decreases, the opposite happens. As the supply of UST increases or decreases with demand, the price remains constant at $1 USD per UST.

For an in-depth explanation, see the video below (note: the burn mechanism has changed since the release of this video, as no more LUNA is set aside for the community pool; it is all burned):

 

 

Algorithmic stablecoins have most of the same problems and challenges as standard cryptocurrencies. The algorithm could be poorly designed, the smart contract could break, other technical failures could theoretically happen, etc. (more on this in the Pros and Cons of Different Stablecoins).

Are Stablecoins Cryptocurrencies?

Stablecoins are a specific type of cryptocurrency that utilize algorithmic or non-algorithmic stabilizing mechanics or cash and asset reserves to maintain parity with an external reference point, like the U.S. dollar or gold. 

Unlike non-stablecoin cryptocurrencies, stablecoins attempt to solve the problem of volatility in the crypto space by offering users a safe and stable way to transact on the blockchain.

Let’s compare stablecoins and bitcoin for a more in-depth discussion of what stablecoins are and how they’re different from other cryptocurrencies.

Stablecoins vs Bitcoin

Bitcoin (BTC) is a virtual currency that uses peer-to-peer blockchain technology to allow users to transact in a trustless environment on the internet. It has a limited supply and the demand for BTC has skyrocketed over the last 10 years. This has caused Bitcoin’s price to rapidly increase from under $500 USD in 2015 to, at one point, over $69,000 in 2021.

Imagine paying for a pizza with Bitcoin (this actually happened in 2010). On May 18, 2010, Laszlo Hanyecz bought two pizzas for 10,000 BTC. In 2010, 10,000 BTC was equivalent to about $40 USD. As of the time of this writing, those two pizzas are worth nearly $400 million. That’s some expensive pizza!

If those same two pizzas were purchased with stablecoins in 2010 (this wasn’t possible, as stablecoins were first invented in 2014), that same $40 worth of USDT would be $40 USD as of the time of this writing.

Due to their stability: 

  • Stablecoins are suitable for most business transactions, while Bitcoin is only suitable for asset exchange.
  • Stablecoins have a predictable value many years in the future, while Bitcoin is a speculative asset that experiences volatile price cycles.
  • Most stablecoins are centralized and controlled by a central authority, while Bitcoin is decentralized.
  • Most stablecoins are regulated, while Bitcoin is fairly unregulated (to a certain extent by federal governments).
  • Stablecoins have a wide range of use cases and are safer during market crashes, while Bitcoin is slow to transact with and sees massive value swings.

In summary, stablecoins are used for specific purposes that require a certain level of confidence in their value over time. Bitcoin can be used as a store of value, an investment, and even collateral for loans, but it is not a good idea to buy pizza with it.

What Are Stablecoins Used for?

Stablecoins are used across most blockchains, protocols, exchanges, and even some merchant transactions.

They’re good for swapping for other cryptocurrencies, purchasing real-world goods, supporting blockchain networks, and more. As more merchants participate in crypto networks, the use cases for stablecoins increase. Eventually, the goal is to replace fiat currencies with stablecoins.

Aside from all the common ways standard U.S. dollars are used, let’s take a look at how to use stablecoins for cryptocurrency and decentralized finance (DeFi) with staking rewards, yield farming, and liquidity providing.

Stablecoins and Staking

Staking a cryptocurrency is a common practice for Proof of Stake networks. Without unpacking all of the complicated mechanisms that go into staking stablecoins, the important part for now is that staking allows users to earn an additional percentage on their assets.

Think of staking like an interest-bearing savings account. The user deposits a certain cryptocurrency (in this case a stablecoin), the network uses that asset in some way, and in return, the user is rewarded with an annual percentage yield. 

In reality, the staked stablecoins are entered into a staking pool, which then uses a consensus mechanism called Proof of Stake to put the stablecoin to work in verifying transactions on the blockchain.

Consider the following simplified example:

User A has $10,000 USD worth of USDT. The current USDT annual percentage yield, or APY, is 3.12 percent on Binance. If User A deposits all his or her USDT into the Binance staking pool, he or she is rewarded $312 USD worth of USDT per year. That’s it. There is no further action required by User A except to claim his or her rewards.

What’s the downside to stablecoin staking? The standard risks are: technological failures, on-chain contract security issues, hacks, etc. And the stablecoins are locked for a certain number of days. The time frame differs depending on the staking pool and token used, but users should expect a delay in receiving their funds back after unstaking. Stake at your own risk.

Stablecoins and Yield Farming

Yield farming is another way to earn an annualized percentage yield on stablecoins. Avoiding the technical language as much as possible, yield farming is similar to lending out money to another user with interest. 

While similar to staking in its simplicity, what is actually happening to the user’s assets is different. Yield farming utilizes automated market makers, or AMMs, to lend and borrow to and from users on the platform or protocol. 

How this works for users is nearly identical to staking.

First, deposit an asset (in this case a stablecoin) into the protocol. The protocol stores the asset and utilizes AMMs, or smart contracts using algorithms to allow for digital asset trading, to send assets in its pool to lenders and borrowers. The deposited asset earns interest over time, and the user who deposited the asset is rewarded for his or her contribution. All the user has to do is claim the rewards.

The risks to yield farming are similar to staking risks, but also include liquidation risks, impermanent loss risks, and composability risks. It is beyond the scope of this article to highlight what those risks are and how to avoid them. Yield farm at your own risk.

Stablecoins and Liquidity Providing

Liquidity providing is another way to earn interest on cryptocurrency assets. This process involves both stablecoins and another cryptocurrency, typically of the more volatile nature.

Yield farming and liquidity providing are similar, but liquidity providing involves depositing two cryptocurrency assets and receiving LP (liquidity providing) tokens in return. LP tokens can then be deposited into the platform or protocol to earn rewards from user swap fees.

Here’s how it works:

User A has $5,000 USD worth of USDT and $5,000 USD worth of ETH. User A deposits both assets into the protocol and the protocol returns LP tokens worth $10,000 USD. The LP tokens are then deposited into the liquidity pool. Users swap between USDT and ETH, and each time a user makes this swap, a small fee is taken by the protocol. The fees are returned to the liquidity providers (the person who added the LP tokens to the protocol). All User A has to do now is claim his or her rewards.

The risks to liquidity providing stablecoins are nearly identical to yield farming risks. There are risks of impermanent loss, smart contract risks, protocol failure risks, and more. Provide liquidity at your own risk.

Are Stablecoins Safe? Can Stablecoins Crash?

Stablecoins are relatively safe compared to the rest of the cryptocurrency landscape, but it is possible for stablecoins to crash or fail.

As far as safety is concerned, stablecoins are designed to stay pegged to a certain external reference point. As long as this peg is maintained, stablecoins are the safest cryptocurrency in the space with regard to price fluctuations.

During bear markets, when a majority of cryptocurrency assets plummet in value, stablecoins should stay consistent. But it is not always guaranteed with all stablecoins.

Centrally-backed stablecoins are at the mercy of increased regulatory scrutiny, which typically means they’re safer for users. If, however, regulators decide to ban stablecoins in the future, it could spell disaster for the centralized assets. Even in that event, stablecoins like Tether (USDT) should have enough fiat currency in its reserve to pay out all stablecoin holders 1:1 with the U.S. dollar. 

Decentralized stablecoins are less impacted by regulatory concerns, especially those in the United States. But they’re either backed by speculative assets like Ether (ETH) or math equations. If Ethereum fails, Ether-backed stablecoins are doomed to fail. If algorithmic stablecoins lose peg for extended periods of time, there is no reserve to fall back on.

There is stablecoin insurance for an extra layer of protection against catastrophic events.

Each stablecoin has its own level of safety and security. The general rule of thumb is that the higher the market cap and the longer the stablecoin has been in existence, the more likely it is that it won’t fail. 

But there is always the extraordinary chance of smart contract failures, blockchain hacks, mismanaged reserves, etc. As always, trade at your own risk.

Stablecoin Interest Rates 2022

Stablecoin interest rates, or the annualized percentage yield offered for staking, yield farming, or liquidity providing, is constantly changing based on market conditions. Below is a list of some of the top spots to find interest rate opportunities:

These exchanges are listed based on market popularity. This is not necessarily an endorsement of the exchange’s or protocol’s safety and security. Trade at your own risk.

List of Stablecoins 2022

Below are the 10 most popular stablecoins by market cap:

*Last updated: Jan. 26, 2022

Stablecoins Total Market Cap
Tether (USDT) $78 Billion
USD Coin (USDC) $48 Billion
Binance USD (BUSD) $14 Billion
TerraUSD (UST) $11 Billion
Dai (DAI) $9.5 Billion
TrueUSD (TUSD) $1.4 Billion
Pax Dollar (USDP) $944 Million
Neutrino USD (USDN) $513 Million
Fei USD (FEI) $419 Million
Gemini Dollars (GUSD) $250 Million

Where to Buy Stablecoins

Stablecoins can be purchased through centralized or decentralized cryptocurrency exchanges, the latter of which is typically referred to as a DEX. Below is a list of the top centralized and decentralized exchanges and which of the top 10 stablecoins they offer to users:

These exchanges are listed based on total volume traded or percentage of total market share. This is not necessarily an endorsement of the exchange’s or protocol’s safety and security. Trade at your own risk.

Centralized Exchanges

Exchange Stablecoins Offered
Binance USDT, USDC, BUSD, UST, TUSD, USDP
Coinbase USDT, USDC, UST (non-native), DAI, TUSD
FTX USDT, DAI
Kraken USDT, USDC, DAI
KuCoin USDT, USDC, UST, DAI, TUSD, USDN
Huobi Global USDT, USDC, UST, DAI, TUSD
Gate.io USDT, UST, DAI, FEI
Bitfinex USDT, USDC, DAI
Gemini USDC, UST, DAI, GUSD
Crypto.com USDT, USDC, BUSD, DAI, TUSD, GUSD

Decentralized Exchanges

Decentralized exchanges list all tokens, assuming there is a valid liquidity pool available for traders to perform swaps. Available chains in parentheses. 

What Are the Best Stablecoins?

The best stablecoins are the ones that fit a certain user’s risk tolerance, preferences, and financial goals the most. There is no single best stablecoin. There are certain stablecoins that are better for low-risk traders, others that are better for earning interest, and others that are better or worse for various different scenarios.

There is also the centralized and decentralized debate. For some, the decentralization of the entire financial system is important, and relying on centralized stablecoins goes against that pursuit. For others, it doesn’t matter. 

When considering which stablecoin is the “best,” make sure to complete the question. Which stablecoin is the best in terms of market cap? As of the time of this writing, USDT. Which stablecoin is the best in terms of decentralization? As of the time of this writing, UST.

Understanding the basic pros and cons of each type of stablecoin can help to determine which is the “best.”

 

Pros and Cons of Different Stablecoins

The pros and cons of different stablecoins are vast. Pros can be cons and cons can be pros depending on perspective.

Below is a chart to help show which stablecoins are best for which risk tolerances and financial goals:

Type of Stablecoin Pros Cons
Fiat-Backed Highest Market Caps, Long History in Crypto, Regulation Increases Safety for Users, Reserves With 1:1 U.S. Dollar Ratio At the Mercy of Traditional Financial Systems, Risks of Inflation, Requires Frequent Audits of Centralized Companies
Cryptocurrency-Backed Avoids Regulation From Centralized Entities Requires Extra Collateral to Keep Peg, Backed by Volatile Assets, Multiple Points of Failure 
Commodity-Backed Regulation Increases Safety for Users, Reserves With 1:X Commodity Ratio, Hedges Against Inflation of Fiat Currency At the Mercy of Traditional Financial Systems, Requires Frequent Audits of Centralized Companies, Pegged to Semi-Volatile Assets
Algorithmic Avoids Regulation From Centralized Entities, Run by Public Smart Contracts, Does Not Need Collateral to Operate Properly No Reserve to Back True Value of Issued Stablecoins, Short History in Crypto

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