Stablecoins: What they are and why they work

Stablecoins provide stability. The clue’s kinda in the name, right? 

In fact they are designed to solve one of the biggest challenges in crypto right now: the volatility of currency valuations.

Assets such as bitcoin can fluctuate wildly in price from day to day, because they don’t have anything tangible to fall back on. In other words, their value is totally subject to the whims of the market.

Stablecoins, in contrast, are usually pegged to underlying assets, so their value is held steady. This provides a best-of-both-worlds solution for traders: the democracy of crypto and the solidity of old-world currencies.

Why are many crypto currencies volatile?

All currencies, whether fiat or crypto, are controlled by the basic law of supply and demand.

Currencies are traded for one another on the open market; the more demand there is for a particular currency, the more its value goes up.

However, traditional fiat currencies do not exist in isolation: they are intrinsically linked to the countries that issue them. 

When deciding whether to buy and sell currencies, traders will consider the issuing country’s economic performance, its resources and its political stability. This was seen in 2016, when traders rushed to sell their pounds because they thought Brexit would dent Britain’s future trading prospects.

What’s more, central banks can pull certain levers to manipulate the supply-demand balance of their currencies. For example the US Federal Reserve can manipulate the value of the dollar by printing more money (which causes its value to drop) or raising interest rates (which causes its value to rise).

Crypto doesn’t have these backstops. Coins and tokens aren’t underpinned by countries or central banks: the only thing that matters is the reputation of the currency itself. This is supply and demand in its purest form.

However, this brings challenges. Traders’ perception of a particular currency can change in an instant, due to the emergence of alternative ‘flavour of the month’ currencies, panic whipped up by negative media coverage, or hype on social media.

What’s more, there’s far less crypto floating around than old-world fiat currency. Right now, there are around 19 million bitcoins in circulation, but around 1.2 trillion US dollars. So if people rush to sell bitcoin, it will have a far bigger effect than a sell-off of dollars.

This combination of a ‘pure’ supply-demand model and relatively low trading volumes has seen the value of crypto currencies oscillate wildly. 

Again, we can look at bitcoin for an example. In the last twelve months, the value of the currency has fluctuated between $29,790 and $66,936. 

In other words, its value has fluctuated by more than 100%.

This places limits on what crypto can be used for. Sure, we can trade coins and tokens on crypto exchanges, but many people are reluctant to use them as a store of value (in other words, an asset that can be stored up and exchanged in future) because they don’t know how much each asset is really worth. 

And it’s practically impossible to use crypto as a means of exchange in the real world, because neither buyer or seller has faith in the currency.

Ok, so how do stablecoins work?

 

This is quite a tricky one to answer because there are over 200 different kinds of stablecoins in circulation, and they are all pegged to different types of underlying asset.

 

  • Some are pegged to currencies (like USDT, which is tied to the US dollar).
  • Others are pegged to commodities like gold.
  • Some are even pegged to other cryptocurrencies.

However, the principle is the same: the coin is tied to something else, an asset that is supposed to be stable. And when this underlying asset moves, the coin follows (a handful of stablecoins are actually pegged to nothing at all, but most of these projects have failed).

 

This same tactic has been witnessed in the real world. In the olden days, countries would tie their currency to gold, a policy known as the ‘gold standard’, and many emerging countries have since pegged their money to the US Dollar. 

 

The idea is to give traders reassurance that the currency has tangible value. The underlying asset acts as a kind of anchor, preventing the currency from straying too far.

How is the value of the stablecoin controlled?

 

This is an important question. To remain in sync with its underlying asset, the stablecoin requires a mechanism that will adjust its value quickly and efficiently.

 

Each asset has its own mechanism. Some stablecoins are based on centralised controls; these include USDT, or Tether, the most popular stablecoin as of right now. 

USDT is issued by a central entity which has engaged a network of traders (known as merchants) to keep the price in check. If the value of 1 USDT goes above $1, then these merchants can use their real-world dollars to mint USDT, causing the supply to increase (and thus create inflation). If the value of USDT goes below $1, these same merchants can use their dollars to buy USDT, then burn it to receive fiat greenbacks.

 

Another popular stablecoin is, rather confusingly, called UST. However, its modus operandi is very different. 

Unlike USDT, UST is decentralised, which means its value is not controlled by a single body of traders. And although it is pegged to the dollar, it is actually backed by a crypto currency, known as Luna. Traders maintain UST’s peg by minting and burning reserves of Luna, and anyone can take part – no matter their crypto experience.

 

In both these examples, traders are motivated by the chance to make quick profits. If the price of the currency rises above its peg, the traders can sell it for an inflated value. If it goes below the peg, they can acquire the currency at a discount price and burn it for quick rewards.

 

These are just two of the many, many different mechanisms used to keep stablecoins in check. It’s not worth explaining them all here, but the point is that they’re seriously complex and have taken a long time to plan!

Does this mechanism work?

Yes. If you look at a chart showing the value of USDT over the last 12 months, it has remained almost perfectly in sync with the real-world greenback: its value has remained within a range of $0.995 and $1.015. So USDT-holders know exactly how much their currency is worth now, and what it will be worth in the future.

As well as providing a tradeable asset, currencies like USDT can serve as both a store of value and a means of exchange in the real world. In other words, they can fulfil all the functions crypto was meant to deliver.

Ok, so know you’ve read the explainer…

… Why not invest using stablecoins on our platform? In fact, if you’ve already got some USDT in your wallet (and well done if you have!) you can lend them to DeversiFi and receive 19% yield, which is far better than any interest you can get in the old fiat world right now.

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