Crypto 101: What are Stablecoins and how do they Work?

A set of cryptocurrencies called stablecoins have been developed whose value is tied, or "pegged", to the value of other, less-volatile assets.

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The intraday value of cryptocurrencies can be highly volatile, which makes them attractive to speculators but often unsuitable for use as a means of value transfer. To compensate for this, a set of cryptocurrencies have been developed whose value is tied, or “pegged”, to the value of other, less-volatile assets, often the US dollar.

What is a Stablecoin?

These cryptocurrencies, called stablecoins, aim to minimize price fluctuations and provide stability in their value. Some of the best-known stablecoins include Tether (USDT), US Dollar Coin (USDC), and Binance USD (BUSD).

How Do Stablecoins Work?

Because crypto values are determined by markets, it’s impossible to simply declare that any one token is worth one US dollar, for example. Instead, each must use one or more mechanisms for maintaining the price at the pre-determined level. The three primary methods are: fiat backing, crypto collateralization and algorithmic.

Fiat-Backed Stablecoins

Fiat-backed stablecoins are literally backed by the issuers’ reserves of cash on deposit at regulated financial institutions. Thus, fiat-backed stablecoins are in theory as stable as the currencies they are pegged to. Regular audits are conducted to verify these reserves and maintain transparency.

As safe as fiat backing sounds, it’s not a guarantee. In March of 2023, fiat-backed USDC became briefly de-pegged when it was questioned whether the 7% of its reserves on deposit at Silicon Valley Bank might be lost as a result of that institution’s insolvency. USDC dropped as low as $0.88 before rebounding when it was revealed that those reserves were not in danger of being lost. Still, that incident demonstrated that a fiat-backed stablecoin’s stability is also dependent on the stability of the institutions holding the associated reserves.

In the absences of such black swan events, fiat-backed stablecoin prices tend to maintain their value to within less than 0.0001% of the peg.

Crypto-Collateralized Stablecoins

Crypto-collateralized stablecoins are a staple of decentralized finance (DeFi) and are backed by a pool of other cryptocurrencies held as a guarantee. The value of the collateral is usually higher than the stablecoin supply, to account for the same value volatility that makes stablecoins needed to begin with. Smart contracts govern the collateralization process, ensuring that the value of reserves is maintained at required levels relative to the stablecoin supply. Should the collateral value fall below a specified threshold, these smart contracts cause either the addition of collateral or the liquidation of a portion of the stablecoin, in order to maintain necessary ratios.

An example of a crypto-collateralized stablecoin is DAI-USD (DAI), which tends to maintain its value to within 0.0002% of its peg.

Algorithmic Stablecoins

Algorithmic stablecoins achieve price stability through the interplay of smart contracts programmed to generate arbitrage opportunities to incentive selling when the market wants to push the coin’s value above the peg and buying when the market would push it below. Using this method, efficient, highly liquid algorithmic stablecoins often maintain their value to within about 0.002% of the peg.

A well-known exception was Terra (UST), an algorithmic stablecoin which became depegged from the dollar when unprecedented selling outpaced the algorithm’s equilibrium-maintaining capacity. While UST’s price initially dropped by only two cents, the reverberations ultimately had catastrophic consequences for both UST and its sister token, LUNA.

Evertas Reduces the Risk of Custodial Crypto

By reducing uncertainty due to price volatility, stablecoins facilitate a broad range of very practical crypto-based transactions that would otherwise be impractical. Stablecoins have proven a very positive development in the crypto ecosystem.

Similarly, Evertas seeks to catalyze mass adoption in the Web3 ecosystem by reducing the uncertainty confronting crypto custodians, such as exchanges. We accomplish this by insuring private keys against loss, primarily due to hacking, theft or technical failure. In that way, we too have a role in moving blockchain technologies closer to the mainstream by making the environment safer for financial institutions and institutional investors. As cryptonatives, this is philosophically important to us. We invite you to learn more about the custodial crypto insurance options Evertas offers.