Understanding Stablecoins: Security and Stability for Crypto Investors

Stablecoins represent a crucial innovation in the cryptocurrency world, offering a solution to the volatility issues that characterize many digital currencies. Unlike their more fluctuating counterparts like Bitcoin or Ethereum, stablecoins aim to maintain a stable and predictable value by being backed by various types of tangible or digital assets.

Definition and objectives of stablecoins

Stablecoins are cryptocurrencies designed to minimize volatility by being backed by stable assets such as fiat currencies (for example, the dollar or the euro) or commodities (such as gold). Their purpose is twofold: to provide security and stability for daily transactions and to facilitate access to financial services without the drawbacks of extreme price fluctuations.

Stablecoins have two main goals. First, they strive to bring together the best of both worlds: on one side, the ease, safety, and speed we appreciate in cryptocurrencies, and on the other, the stability found with traditional money.

Secondly, they offer a solid option for those who want to avoid the highs and lows of the crypto market. This makes it simpler to buy and sell, send funds, and use new financial services, without worrying about sudden price changes.

Stablecoins can be categorized into several types according to their stabilization mechanism: those backed by fiat currencies (like the US dollar), those supported by other cryptocurrencies, and finally, algorithmic stablecoins that use complex mechanisms to adjust supply and maintain price stability. Each approach has its own advantages and challenges, reflecting the diversity and ongoing innovation within the cryptocurrency ecosystem.

Categories of Stablecoins

1. Centralized Stablecoins (off-chain):

Centralized stablecoins represent a category of cryptocurrencies that play a fundamental role in the digital finance ecosystem. Issued and rigorously managed by centralized organizations, these stablecoins are uniquely tied to the value of fiat currencies such as the US Dollar (USD) or the Euro (EUR), or to other types of tangible assets. This linkage is maintained off the blockchain (off-chain), meaning the assets that support the value of the stablecoins are not stored or managed on the blockchain itself, but are instead kept and administered by the issuing entity in traditional financial institutions or by qualified custodians.

For each unit of stablecoin issued by these entities, there is a guarantee that equivalent amounts of real currency or assets of similar value are available in the issuer’s reserves.

This promise creates a value anchor, aiming to ensure that the price of the stablecoin remains stable and closely aligned with the asset or currency to which it is indexed, regardless of the usual fluctuations in the cryptocurrency market.

Centralized stablecoins thus offer an essential bridge between the traditional and digital financial worlds, facilitating cross-border transactions, access to decentralized finance (DeFi), and participation in the global blockchain economy, while minimizing exposure to the volatility often associated with cryptocurrencies.

Among the centralized stablecoins, we find:

• USDT (Tether): A popular stablecoin backed by the US dollar, managed by Tether Limited.

• USDC (USD Coin): Issued by Circle, this stablecoin is also backed by the US dollar.

• BUSD (Binance USD): A stablecoin backed by the US dollar, created in partnership between Binance and Paxos.
• TUSD (TrueUSD): Managed by TrustToken, TUSD is backed 1:1 by the US dollar.
• Pax Dollar (USDP): Backed by fiat currencies.

2. Decentralized Stablecoins Backed by Other Cryptocurrencies (on-chain):

Decentralized stablecoins represent a significant advancement in the pursuit of financial stability within the cryptocurrency ecosystem. Unlike centralized stablecoins, these stablecoins operate entirely on the blockchain and derive their value from collateral provided by other cryptocurrencies. This decentralized approach offers transparency, relying on automated mechanisms and smart contracts to manage operations and value adjustments.

A unique feature of these stablecoins is their requirement for over-collateralization, a process where the value of the cryptocurrencies deposited as collateral exceeds the value of the stablecoins issued. This over-collateralization acts as a buffer against the volatility of the cryptocurrency market, ensuring that the stablecoins can maintain a stable parity with the fiat currency to which they are indexed, even in the face of significant market fluctuations.

In practice, this means that if a user wants to obtain $100 in stablecoins, they might need to deposit cryptocurrencies worth more, for example, $150, to account for potential price movements.

Among the decentralized stablecoins, we find:

• DAI (Dai): Issued by MakerDAO, DAI is a stablecoin over-collateralized by cryptocurrencies, operating in a decentralized manner.
• LUSD (Liquity USD): Issued by the Liquity protocol, LUSD is supported by over-collateralization in ETH without centralized governance.

3. Algorithmic Decentralized Stablecoins :

Algorithmic stablecoins mark a remarkable innovation in the digital currency domain, offering a stable alternative without directly relying on reserves of tangible or digital assets.

This method allows for adaptability and responsiveness to market fluctuations without the need for physical or digital collateral.

The operation of these stablecoins is based on intelligent automation: if the price of the stablecoin deviates from its target value, the algorithm reacts. For a price above the target, it increases the supply of tokens, pushing the price down. Conversely, if the price falls below the target value, the algorithm decreases the supply, helping the price to rise.

Imagine that algorithmic stablecoins are like thermostats in a house. A thermostat adjusts the heating or air conditioning to maintain the temperature at a comfortable level, regardless of whether it is very hot or very cold outside.

Similarly, an algorithmic stablecoin adjusts its own “temperature” – that is, its quantity in circulation – to keep its price stable, even when the “weather conditions” of the cryptocurrency market change drastically.

Take the example of a stablecoin that always wants to be worth 1 dollar. If suddenly, many people want to buy this stablecoin, its “price” starts to climb above 1 dollar because it becomes “hot”. To cool things down and bring the price back to 1 dollar, the stablecoin’s algorithm “opens the windows” by creating more stablecoins, increasing the supply to meet the demand and cool the price.

Conversely, if people start to sell the stablecoin en masse and its price “cools” by falling below 1 dollar, the algorithm “turns on the heat” by reducing the supply of stablecoins. It can do this by encouraging people to “burn” their tokens in exchange for a reward, thus reducing the number of stablecoins in circulation and pushing the price back up.

However, the model of algorithmic stablecoins is not without risks. Confidence in the stability of the stablecoin relies entirely on the efficiency of the algorithm and its ability to react correctly to changing market conditions.

Among the algorithmic stablecoins, we find:

• USDD (Tron USD): A stablecoin on the Tron network, aiming to maintain its parity with the US dollar through algorithmic mechanisms.
• FRAX (Frax): The first fractional stablecoin, combining collateralization and algorithmic adjustments for stability.
• sUSD (Synthetix USD): Issued from the Synthetix protocol, it allows users to create and trade “synths”, which are digital assets representing the value of other real assets or cryptocurrencies.

Conclusion

Stablecoins play an indispensable role in the world of cryptocurrencies, offering essential stability and facilitating a smoother transition to a global digital economy. Whether through their ability to act as a bridge between traditional currencies and cryptocurrencies or their role in decentralized finance innovation, stablecoins are destined to play an increasingly central role in the adoption of cryptocurrencies. As the sector evolves, their importance in ensuring financial stability and in facilitating access to innovative financial services will only increase, marking a significant step in the maturation of the blockchain space.