Stablecoins have come into question for crypto investors over the recent struggles some projects have had keeping their value. For an asset as volatile as crypto, folks wonder how these projects manage to keep their value under normal conditions.
For most stablecoin projects, the token's value comes from the underlying system rather than market forces.
What Is a Stablecoin?
A stablecoin is a cryptocurrency token with a set value based on a pegged asset such as fiat currency, gold, precious stones, etc. In other words, a stablecoin is a cryptocurrency that bridges physical fiat or assets onto the blockchain.
The goal of a stablecoin is to give blockchain users a stable way to store the value of their crypto. Anyone who has interacted with the crypto space knows about its volatility. So, by creating something pegged to something with a constant value, crypto holders can stabilize a part of their holdings.
Most stablecoin projects elect to use a fiat currency as their peg. Because of this, many exchanges have set up their automated market makers to create trading pairs between cryptocurrencies and these stablecoins.
How Do Stablecoins Keep Their Value? 4 Stablecoin Pegging Types Explained
Not all stablecoins use the same method to keep their value. While many of these projects use fiat to create their peg, the systems creating that peg can be different.
1. Fiat-Backed Stablecoins
One of the most common ways to peg a stablecoin is by holding the currency the token wants to peg itself to. Creating a system where users can trade their real-world money for the stablecoin at a 1:1 ratio ensures that the stablecoins never produce more tokens than the backer has in holdings.
Most of these projects rely on a third-party financial institution to manage the currency held by the project. These institutions go through heavy regulation and several audits to prove to their users that they are worthy of being trusted.
However, that is the biggest problem with these stablecoins. Because these stablecoins require a centralized authority to run everything, users have to trust the institution will be honest about their holdings. Given that Bitcoin, the original cryptocurrency, was designed to get away from centralized financial systems, this type of stablecoin undermines the original intent of crypto.
Still, many trusted stablecoins are fiat-backed. Projects like USD Coin (USDC) and True USD (TUSD) use this backing method and have large market caps despite the shortcomings.
2. Commodity-Backed Stablecoins
Rather than using a physical currency as its peg, commodity-backed stablecoins instead use other assets for their backing. The type of asset depends on the project, though. Precious metals like gold, stocks, and even real estate are all examples of assets being experimented with by these types of stablecoins.
Much like fiat-backed projects, commodity-backed stablecoins bring the value of other asset classes into the crypto space. A third party receives ownership of the asset and distributes an equal value of stablecoin to the seller. At any time, that seller can return their stablecoins for the underlying asset at the asset's new price.
And, like fiat-backed projects, these stablecoins rely on a centralized institution for their operations, meaning they have many of the same weaknesses. However, commodity-backed stablecoins also have to factor storage into their operational costs.
Most fiat currencies have adapted to the online banking space, meaning that storage for most fiat just comes down to a digital ledger in a bank. Commodities work differently since a physical commodity like gold or real estate takes up space. Projects pegged to these commodities have to factor in safe storage for these assets as well as the usual audit and personnel costs to stay afloat.
3. Crypto-Backed Stablecoins
There are other ways to peg a stablecoin than just physical assets. Some stablecoin projects set up reward infrastructure to convince users to exchange their crypto for stablecoins, creating crypto-backed stablecoin projects.
In these projects, everything happens on the blockchain. Users trade their crypto for stablecoins, usually by locking their crypto into collateralized loans to receive a portion of their crypto's value in stablecoin. Because the price of crypto can change radically, these loans run the risk of being liquidated to keep the value of the stablecoin constant.
These systems use smart contracts programmed to respond to different inputs from users or other contracts. While smart contracts make it possible for everything to run automatically, they can also be a vulnerability.
Smart contracts only work as well as the code used to make them. If the coder makes a mistake or the blockchain has a loophole built into how it handles smart contracts, bad actors can go into these contracts and steal the funds inside them. Indeed, faulty smart contract programming has been the route of some of the biggest crypto heists.
Still, this is an issue with any decentralized platform, not just these stablecoin projects. Crypto-backed stablecoins try to create these tokens in a decentralized way.
4. Algorithm-Backed Stablecoins
Finally, some stablecoins use a Seigniorage-style distribution system to manage the token, known as algorithmic stablecoins. Much like how central banks control the creation and destruction of currency today, governments used to mint currency or levy taxes on currency creation based on their whims.
While the term refers to older money practices, the concept is the same where an algorithm manages the supply and peg for the stablecoin. There are no assets backing the stablecoin, meaning that the supply is dependent on how many people buy, sell, or otherwise use the stablecoin.
Much like crypto-backed stablecoins, these projects work entirely on the blockchain. While the algorithm requires maintenance from a team of developers, the project maintains governance channels that allow stablecoin holders to dictate the project's direction.
However, these projects have a flaw: algorithms aren't perfect. If something happens in the market that causes a major disruption to the stablecoin's market maker, it can depeg the stablecoin from its intended value. This is what happened to Terra's UST stablecoin, which caused both Terra Lab's blockchain projects, Luna and UST, to crash.
Stablecoins Use Backing to Keep Their Value
Whether a currency, asset, or algorithm backs a stablecoin, these projects keep their value via a value-backing system. Without this system, stablecoin projects wouldn't have the maintained value that the otherwise volatile crypto market appreciates about them.
Each of the backing methods has its pros and cons, showing how stablecoins are far from a solved problem in cryptocurrency.