11.4 Stablecoins: Types, Mechanisms, and Use Cases

Stablecoins are cryptocurrencies designed to maintain a steady value, often pegged to a fiat currency like the US dollar. They bridge the gap between volatile crypto markets and traditional finance, offering stability and fast, cheap transactions.

There are three main types: fiat-collateralized, crypto-collateralized, and algorithmic stablecoins. Each uses different mechanisms to maintain its peg, from holding reserves to smart contracts and complex algorithms. Popular examples include USDT, USDC, and DAI.

Types of Stablecoins

Overview of Stablecoins

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• Stablecoins are cryptocurrencies designed to maintain a stable value relative to a reference asset (often the US dollar)
• Aim to combine the benefits of cryptocurrencies (fast, cheap, borderless transactions) with the stability of traditional currencies
• Serve as a bridge between the volatile cryptocurrency market and the traditional financial system
• Play a crucial role in the decentralized finance (DeFi) ecosystem by providing a stable medium of exchange and store of value

Fiat-Collateralized Stablecoins

• Fiat-collateralized stablecoins are backed by traditional fiat currencies (USD, EUR) held in reserve by a central entity
• The issuing entity promises to redeem each stablecoin for one unit of the underlying fiat currency
• Tether (USDT) is the most well-known fiat-collateralized stablecoin, pegged to the US dollar
• Fiat-collateralized stablecoins rely on trust in the issuing entity to maintain adequate reserves and honor redemption requests

Crypto-Collateralized Stablecoins

• Crypto-collateralized stablecoins are backed by a basket of cryptocurrencies held in a smart contract
• The backing cryptocurrencies are often over-collateralized to absorb price fluctuations and maintain the stablecoin's peg
• MakerDAO's DAI is a prominent example of a crypto-collateralized stablecoin, backed by Ethereum and other cryptocurrencies
• Crypto-collateralized stablecoins are more decentralized than fiat-collateralized stablecoins but are still vulnerable to the volatility of the underlying cryptocurrencies

Algorithmic Stablecoins

• Algorithmic stablecoins maintain their peg through a complex system of smart contracts and incentives, without relying on collateral
• They use algorithms to automatically adjust the stablecoin supply based on market demand to maintain the peg
• When the stablecoin price is above the peg, the algorithm incentivizes users to burn stablecoins, reducing the supply and bringing the price down
• When the stablecoin price is below the peg, the algorithm incentivizes users to mint new stablecoins, increasing the supply and pushing the price up
• Examples of algorithmic stablecoins include Ampleforth (AMPL) and Empty Set Dollar (ESD)

Stablecoin Mechanisms

Pegging Mechanisms

• Stablecoins maintain their peg to a reference asset through various mechanisms depending on the type of stablecoin
• Fiat-collateralized stablecoins maintain the peg by holding an equivalent amount of fiat currency in reserve and allowing users to redeem stablecoins for the underlying fiat currency
• Crypto-collateralized stablecoins use smart contracts to automatically liquidate the backing cryptocurrencies if the collateralization ratio falls below a certain threshold
• Algorithmic stablecoins rely on algorithms to automatically adjust the stablecoin supply based on market demand to maintain the peg

Stablecoin Arbitrage

• Stablecoin arbitrage is the practice of exploiting price differences between a stablecoin and its reference asset to generate profits
• When a stablecoin's price deviates from its peg, arbitrageurs can buy the stablecoin when it is undervalued and sell it when it is overvalued, pushing the price back towards the peg
• Arbitrage opportunities can arise due to market inefficiencies, differences in liquidity across exchanges, or temporary imbalances in supply and demand
• Arbitrage plays a crucial role in maintaining the stability of stablecoins by ensuring that their price remains close to the intended peg

Popular Stablecoins

USDT (Tether)

• USDT is the most widely used fiat-collateralized stablecoin, pegged to the US dollar
• Tether claims that each USDT is backed by one US dollar held in reserve, although this has been subject to controversy and scrutiny
• USDT has the highest market capitalization among stablecoins and is widely used as a trading pair on cryptocurrency exchanges
• Despite its popularity, Tether has faced criticism over its lack of transparency and failure to provide regular audits of its reserves

USDC

• USDC is a fiat-collateralized stablecoin issued by Circle and Coinbase, pegged to the US dollar
• USDC is fully backed by US dollar reserves held in segregated accounts, with regular audits to ensure transparency
• USDC has gained popularity due to its regulatory compliance and the reputation of its issuing entities
• USDC is widely used in the DeFi ecosystem for lending, borrowing, and as a stable medium of exchange

DAI

• DAI is a crypto-collateralized stablecoin issued by MakerDAO, pegged to the US dollar
• DAI is backed by a basket of cryptocurrencies (primarily Ethereum) that are locked in a smart contract called a Collateralized Debt Position (CDP)
• Users can create DAI by depositing collateral into a CDP and borrowing DAI against it, while paying a stability fee to maintain the loan
• DAI maintains its peg through a combination of over-collateralization and autonomous feedback mechanisms that incentivize users to maintain the stability of the system
• DAI is a key component of the DeFi ecosystem, used for lending, borrowing, and as a stable medium of exchange

Stablecoin Challenges

Regulatory Concerns

• Stablecoins face increasing regulatory scrutiny due to their potential impact on financial stability and monetary policy
• Regulators are concerned about the lack of transparency surrounding the reserves backing some stablecoins, as well as the potential for stablecoins to be used for money laundering and other illicit activities
• The issuance of stablecoins by private entities raises questions about the appropriate level of regulatory oversight and whether stablecoins should be subject to similar regulations as traditional financial instruments
• Regulatory uncertainty surrounding stablecoins can hinder their adoption and integration with the traditional financial system
• Some regulators have proposed treating stablecoins as securities, which would subject them to more stringent regulation and disclosure requirements
• Central banks are exploring the possibility of issuing their own digital currencies (CBDCs) as a response to the growth of stablecoins and to maintain control over monetary policy