Stablecoin Currency Explained | Purpose, Types, What Is It? How Does It Work? What Does Peg Mean?

4 min read

Stablecoin Definition

Purpose Of Stablecoins

Stablecoins function as cryptocurrencies whose respective values are pegged to an underlying currency, commodity, or another financial instrument. Most often, stablecoins exist to maintain a stable value over time and provide a solid alternative to those unwilling to risk the elevated volatility of major coins such as Bitcoin or Ethereum.

The two largest stablecoins by market capitalization, Tether (66 billion USD currently) and USD Coin (56 billion USD), came to massive popularity through their mandates of remaining pegged to the US dollar.

They succeed by capitalizing on three central pillars:

1.         Operate as a medium of exchange, not speculation

2.         Maintain a peg to an external asset throughout all market situations or cycles

3.         Hold reserve assets or utilize a tested algorithm able to maintain supply

When one of these fails, the stablecoin fails. For example, Terra Luna famously crashed after holders lost confidence in the coin’s ability to maintain its peg.

Speculations abound concerning the reason. Was it from a seemingly arrogant refusal to use fiat reserves? Or was it all down to an organized attack against one of its co-founders? Either reason remains possible, and each highlights the risk inherent to a digital asset yet to be perfected.

This article dives into the nuances of stablecoins against more popular cryptocurrencies and the types of stablecoins. Let’s get to it.

Stablecoins Pegged To An Asset

Like the name, these coins operate with the primary intention of remaining stable. Their value derives not from the speculation of unbacked cryptocurrencies inherent to Bitcoin or Ethereum but from the performance of the pegged asset.

Any stablecoin forms a digital representation of something else, most often a fiat currency, and amongst currencies, most often the US dollar. It’s the digital copy of a hard asset.

Let’s break down the three pillars discussed above.

Stablecoins Are Currency | Exchangeable To Fiat

Within crypto portfolios, stablecoins form the “cash” portion. Stablecoins are currency. They must remain exchangeable to fiat currency, for example, at any time—with this conversion effectively guaranteed through sufficient reserves.

Popular cryptos enjoy no such banking. Instead, they grow or decline in value according to the general market’s sentiment towards them, the soundness or popularity of their underlying “proof-of” consensus mechanisms, the competition, inflation, money supply, and so on.

Since popular cryptos typically do not represent equities or similar assets having balance sheets, income statement, or cash flow statements, investing here translates to speculating.

Stablecoins Must Maintain A Constant Peg

A peg refers to maintaining a constant ratio relative to an external asset. The most common peg remains “1:1” (one-to-one) against the US dollar.

How a stablecoin maintains this peg is up to the crypto, though the final say goes to the relevant regulator. There are algorithmic or crypto-based methods for keeping this peg, yet nothing surpasses actual fiat reserves. For example, if a hypothetical coin has 1 million coins in circulation, then it should have 1 million US dollars with an approved custodian.

Stablecoins Should Have 100% Fiat Reserve

Stablecoins earn their appeal by targeting risk-conscious yet crypto-friendly investors. Risk must remain limited.

With the advent of upcoming regulation in the USA and the EU, regulators intend to pressure stablecoins to adopt either a 100% fiat currency reserve or close to it. Any fractional reserve banking here shall ultimately be elevated well above that for a traditional fiat currency; above 100% is also likely in this competitive and developing space.

Types of Stablecoins

While stablecoins do vary, there are four common types of underlying collateral structures: fiat-backed, crypto-backed, commodity-backed, and algorithmic.

Fiat-Backed (Off-Chain)

This is typically 1:1 against fiat currency, the most popular form, and the one likely to earn regulatory approval. Since the backing remains a non-crypto asset, it’s also referred to as an off-chain asset or coin.

Fiat collateral remains in reserve within a financial institution, giving this stablecoin a centralized proponent. For more casual investors, centralized vs. decentralized matters little. Yet stronger crypto enthusiasts may want to stick to the guide ethos of crypto that is decentralization.

Crypto-Backed (On-Chain)

These coins are backed by another cryptocurrency instead of fiat. Since everything stays within crypto, this type of stablecoin is referred to as on-chain.

However, the reserve cryptocurrency is likely prone to higher volatility. The target stablecoin is then over-collateralized. Instead of keeping 100% of its value in reserve, you’ll often find 150% to 200%.

For example, MakerDAO’s Dai stablecoin is pegged to the US dollar at a 1:1 ratio but 150% of the value of the Dai coins issued is retained by MakerDao through Ethereum. It’s best to think of it as a loan of Dai coins granted only after sufficient Ethereum is received.

Algorithmic

These coins may or may not utilize reserve assets. Instead, they rely upon supply and demand factors to control its price through contracting or expanding supply when needed. The algorithms behind their respective coins determine supplies and drive prices.

However, this approach remains by far the most risky. If the algorithm fails, then the coin becomes virtual trash overnight, like with Terra Luna.

Further, algorithmic coins may utilize a reward-based system paying returns when above their set pegs. What happens then, if a coin

Courtesy of DeFi, NFT & Web3 Insights by The Defiant

Commodity-Backed

Like with fiat, these coins use external assets to safeguard their values. You can have collateral such as gold, oil, real estate, or another underlier.

Naturally, the values of these coins fluctuate more widely than seen with fiat-backed counterparts. For this reason, the most popular commodity continues to be gold. Paxos Gold enables holders to exchange their coins for cash or physical gold with each coin representing one ounce.

Tether Stablecoin Holds Peg In Crypto Bear Market

Despite their emerging nature, stablecoins continue to showcase a bright future ahead. Newer crypto investors may see algorithmic coins as too speculative—and rightly so—but fiat-backed coins are earning their way into modern portfolios.

This year’s bear market provides an opportunity and the first real test for stablecoins worldwide. While Bitcoin falls by more than 50% year-to-date, Tether continues to uphold its peg and the case why it should be part of your portfolio.

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