What Is Stablecoin? How Do Stablecoins Work?

Stablecoins are one of the most essential assets in Crypto, and yet arguably the most overlooked one. Even though Stablecoins have been widely used by every Crypto user, they have never been fully understood in detail.

That is why in this article, I will introduce you to a deeper understanding of Stablecoins, including their definition, different types of Stablecoins, comparison to other assets, as well as how to optimize them for profits.

What is Stablecoin?

Stablecoin is defined as a cryptocurrency with its value denominated to a specific commodity (Gold, Silver,...) or Fiat (Dollar, Euro,...). This eases the move of cash flow on Crypto, considering its extremely high volatility as well as the non-existence of original Fiat currencies here.

At the moment, there are approximately 81 Stablecoins within the Crypto market (according to Coingecko), each possessing a different mechanism and pegged value. We will go deeper into this in the following few sections.

How do Stablecoins work?

In order for Stablecoins to work, they must be able to maintain their denominated value. At the moment, most Stablecoins are denominated in USD. This is understandable as the USD is currently the biggest Fiat currency.

To keep the price fixed at a specific value, various methods have been developed; with each way comes a corresponding type of Stablecoin. The most common and most efficient approach up to this moment is to back Stablecoins with actual Fiat currencies at a ratio of 1:1.

Stablecoin Understanding

Are Stablecoins safe?

First of all, let’s talk about the safety of Stablecoins in terms of their prices. As their name implies, they are “Stable” in price. Compared to other cryptocurrencies which are normally volatile in value, Stablecoins can be considered a safe asset to hold. Stablecoins are also known as store-of-value assets.

However, the foremost importance of a Stablecoin is its ability to maintain the peg value. To say whether a Stablecoin is safe or not, this aspect should be taken into consideration.

Here is an example of how DAI is a safer (and hence, better) Stablecoin than USDP by looking at their price spreads. While DAI was able to keep the price spread around only 1% at its fully-developed stage, USDP had the number at more than 4%.

While 4% seems like a small number, it is of massive significance for a Stablecoin. Even 1% is a huge matter for a big Stablecoin like DAI. If DAI is down by 1% in price and cannot recover, $872M will be lost instantly.

So to conclude: Overall, Stablecoins are safe. However, it is recommended to use top Stablecoins like USDT, USDC, or UST as they have been market-tested multiple times. Hence, you can assure that they won’t fluctuate too much in price.

Why buy Stablecoins? Why are Stablecoins important?

As mentioned at the beginning of the article, Stablecoins are one of the most important assets in Crypto. Similar to Fiat currencies, they can be used to store value, provide a numerical account, and facilitate exchange within the Crypto market. Therefore, they are the primary tool to maintain Crypto’s financial system and economy.

There are a few reasons why you would want to buy Stablecoins:

• To use them as a medium of exchange. Stablecoins can be used to buy and sell other cryptocurrencies or even real-life assets.
• To participate in the Crypto market. As mentioned earlier, Fiat currencies and commodities like Gold or Silver do not exist in Crypto. Hence, in order to get involved with Crypto, the first thing you have to do is to buy Stablecoins.
• To hedge against volatility as a store-of-value asset. Unlike other cryptocurrencies, Stablecoins are and should be fixed in price. As a result, they are a perfect type of asset to hold, especially when the market is volatile.

What are Stablecoins used for?

Apart from the aforementioned utilities of Stablecoins, they are also used for various other purposes:

• Farming: You can provide liquidity and farm with Stablecoins. Current Farming APYs usually range from 30% to 100%.
• Staking: Similar to farming with lower risk, staking allows you to earn yields with Stablecoins. Current Staking APYs usually range from 4% to 20%, depending on the platform and Stablecoin you use.
• Lending: There exists massive demand for borrowing Stablecoins in Crypto as investors want to leverage their profits. Hence, Lending is also of great interest. Lending Stablecoins in DeFi has arisen strongly ever since the success of Anchor, which provided a 20% fixed interest rate for supplying Stablecoins.

Risks of Stablecoins

Even though Stablecoins are normally safe as said, they still bear the risk of Losing their pegged value. As the Crypto market is still immature and at the development stage, most assets are still illiquid and vulnerable to volatility. Stablecoins are no exception. Even MIM - a 6th ranked Stablecoin, cannot maintain its pegged value sustainably.

This usually happens with Crypto-backed Stablecoins and Algorithmic Stablecoins, especially the latter one. Losing a few percentages in value might be terrible for a Stablecoin, but not as getting its price to an absolute zero. This has been the case for a large number of Algorithmic Stablecoins, taking BAC as an example.

How Stablecoins compare to other currencies

Fiat vs. Stablecoins

Fiat currencies and Stablecoins have a lot in common, mainly in their primary use case. Here is a detailed comparison between the two:

Altcoins vs. Stablecoins

Stablecoins are more often compared with Altcoins as they are the two most popular types of cryptocurrencies. Let’s take a look at how they are different:

Types of Stablecoins

As mentioned above, there are 4 types of Stablecoins, each having a different mechanism for maintaining its pegged value. In the next sections, I will go into detail about every type.

Fiat-backed Stablecoins

Fiat-back Stablecoins are Stablecoins being backed 100% by Fiat currencies. This is currently the most used type of Stablecoins, with USDT and USDC being the two biggest Stablecoins.

To issue this type of Stablecoin and ensure their peg value is maintained, they have to be backed by Fiat currencies at a ratio of 1:1. This means that, for example, to issue 1 USDT, asset(s) of 1 USD in value have to be put into Tether’s reserves.

Commodity-backed Stablecoins

Commodity-backed Stablecoins work similarly to Fiat-backed Stablecoins. The only difference is in their pegged value:

• Fiat-backed Stablecoins represent the price of Fiat currencies.
• Commodity-backed Stablecoins take scarce metals like Gold or Silver as the standard.

At the moment, the most popular peg value for Commodity-backed Stablecoins is Gold. A few examples of this Stablecoin type are Tether Gold (XAUT) and PAX Gold (PAXG). For these tokens, 1 ounce of Gold equals 1 XAUT or PAXG.

Crypto-backed Stablecoins

Crypto-backed Stablecoins, also known as Decentralized Stablecoins, are Stablecoins that do not rely on real-life assets to maintain their pegged value. Instead, they utilize crypto assets directly, hence making the Crypto market more capital-efficient and liquid.

The mechanism that most Crypto-backed Stablecoins implement is over-collateralizing: Users (or protocols) mint Stablecoins when there is an overvalued value of assets deposited as collateral. This way, it is guaranteed that the Stablecoin token will always be backed with assets worth more than itself, eliminating the possible loss in case the Stablecoin cannot maintain its peg.

MakerDAO is the most prominent protocol in this sector. MakerDAO enables minting DAI, a Crypto-backed Stablecoins, by overcollateralizing about 150%. Up to this moment, over $14B has been locked in MakerDAO, making DAI the current biggest Crypto-backed Stablecoin.

CUSD, a stablecoin which is developed by Coin98 team is also one of this category. CUSD is fully backed by BUSD and USDC, so users can fully convert/redeem 1:1 with BUSD and USDC at any time. CUSD is a crucial component of Coin98's multi-chain ecosystem since it makes it simple for users to transfer assets between different chains.

Learn more about CUSD: Introducing CUSD

Algorithmic Stablecoins

It can be clearly seen that all the above types of Stablecoins have to maintain their pegged value by keeping money or assets in reserves. This, however, makes Stablecoins difficult to scale in quantities, thus leading to capital inefficiencies.

Algorithmic Stablecoins have been developed in an attempt to tackle this challenge. Algorithmic Stablecoins are Stablecoins that rely entirely on algorithms to maintain their pegged value. Therefore, no capital is needed to issue this kind of Stablecoin, resulting in the ease of producing and expanding it.

There are currently 3 types of Algorithmic Stablecoins:

• Rebase: Sustain price by modifying token supply accordingly. If the token goes up in price, it will go up in supply and vice versa. A few Rebasing Algorithmic Stablecoins: AMPL, BASE.
• Seigniorage: Implement 2-3 tokens to sustain the price of the primary Stablecoin through seigniorage processes. A few Seigniorage Algorithmic Stablecoins: UST, BAS, FEI.
• Fractional: A combination of Fiat-backed Stablecoin and Seigniorage Stablecoin. This type of Stablecoin sustains price by partially requiring Fiat-backed Stablecoins like USDC and complementing the system with the 2-token-model. An example of Fractional Algorithm Stablecoin: Frax Finance.

How to buy Stablecoins

At the moment, Stablecoins have been immensely widespread in Crypto. As a result, there are now numerous ways to buy Stablecoins. Here are some recommendations:

• CEXs: Via CEXs, You can buy Stablecoins with every supported cryptocurrency as well as Fiat money. Recommended CEXs: Binance, Coinbase,...
• DEXs: You can also buy Stablecoins through DEXs. It is recommended to buy Stablecoins through Stableswap AMM DEXs to minimize slippages, such as Curve Finance (Multichain), Ellipsis (BSC), Mobius (Celo),...
• Protocols: Instead of buying Stablecoins directly, you can mint them via supported protocols like MakerDAO (minting DAI), Terra (minting UST), Abracadabra Money (minting MIM),...

How to invest in Stablecoins

There are a variety of ways to invest and make profits with Stablecoins. Each of these ways has its own risk/reward, so you should consider carefully before following any.

Notice that all the methods below require the involvement of DeFi. DeFi contains high risks, including protocol risk and smart contract risk. Select carefully which platform you will be using.

This is in no way financial advice. You should be responsible for your own fund and actions.

Yield Farming

You can farm Stablecoins to earn yield, using either the Stablecoin pair or Stablecoin-Altcoin pair. This way of Stablecoin investment bears the highest risk/reward since Impermanent Loss may occur.

Some notable Stablecoin farming platforms:

• Curve Finance: 3 - 35% APY.
• Convex Finance: 2 - 28% APY.
• Saber Finance: 3 - 20% APY.
• Ellipsis Finance: 4 - 70% APY.

Staking

Staking is a safer way to earn with Yield Farming, hence lower return on investment. You can stake Stablecoins on either CEXs like Binance or DeFi protocols like Yearn Finance or Stargate Finance.

• Binance: 3 - 13% APY.
• Yearn Finance: 2 - 22% APY.
• Stargate Finance: 4 - 6% APY.

Lending

Lending, or supplying Stablecoins, works absolutely similarly to Staking. The only difference is their concept of how the supplied Stablecoins will be used. Some lending protocols you can use to supply Stablecoins:

• Anchor: 18.5% APY.
• Aave: 2 - 7% APY.
• Compound: 1 - 2% APY.