Fiat-backed stablecoins, explained

Fiat-backed stablecoins are cryptocurrencies that aim to hold a 1:1 peg with fiat currencies such as the U.S. dollar or Euro. 

Stablecoins of this nature are backed by fiat currencies or cash equivalent assets, such as US Dollars or short-term Treasury Bills, respectively. 

Stablecoins combine the efficiency of blockchain technology with the stability of fiat currencies, providing a transparent, cost-effective, and faster alternative to traditional remittance services while serving as a gateway to traditional finance.

Among various types, fiat-backed stablecoins overwhelmingly dominate the market, offering seamless interaction with both centralized and decentralized platforms and minimizing operational hurdles for investors.

A wide variety of fiat-backed stablecoins are available in the crypto market today, yet their adoption remains heavily concentrated around a select few leaders. 

Below, we highlight some of the most prominent stablecoins pegged to the U.S. Dollar and Euro:

• Tether (USDT): Tether is the largest U.S. Dollar pegged stablecoin by market cap, and the third-largest cryptocurrency by market cap behind Bitcoin (BTC) and Ethereum (ETH). While it has endured numerous regulatory challenges since its inception in 2014, it remains the stablecoin of choice for crypto investors and futures contracts by a significant margin. Investors can use Tether across 14 different blockchains and bridge the stablecoin between chains. Tether also serves individuals and businesses through cross-border transfers, remittances and banking the unbanked. Reserves are reportedly made up of U.S. Treasury Bills but also include precious metals, loans and BTC. 
• USDC (USDC): Launched in 2018 and also pegged 1:1 to the U.S. Dollar, USDC is the second-largest stablecoin by market cap and is widely used as collateral in decentralized finance and, to a lesser degree, for trading on centralized exchanges. USDC publishes detailed monthly attestations conducted by Deloitte, which audit their liabilities and assets (with the latter mostly consisting of U.S. Treasury Repurchase Agreements). USDC has also experienced difficulties on occasion, notably when it depegged in 2023 after a contagion event connected to the collapse of Silicon Valley Bank.
• Stasis Euro (EURS): EURS is the largest stablecoin pegged to the Euro by market cap. After launching in 2021 on a handful of chains, over 100M EURS were issued in the following year before going on to qualify for MiCa compliance and an EMI-license in 2023. Stasis provides daily statements and is 100% backed by liquid Euro balances stored in Central Bank accounts.
• Euro Coin (EUROC): Issued by Circle, the same company that created USDC, EUROC is a MiCA-compliant Euro-backed stablecoin, supported by the same monthly attestations detailing cash reserves. EUROC is available on Avalanche, Base, Ethereum, Solana, and Stellar, but has less than 0.5% of the daily volume of USDC.

The ability to trade in and out of a fully backed crypto asset with a stable value boasts a number of advantages:

1. A medium of exchange: Being able to realize profits and trade using a crypto asset that will hold its fiat value is particularly useful, especially when not everyone can trade back into their local fiat currency.
2. DeFi: Stablecoins are an important part of the decentralized circulatory system, allowing users to earn yields, trade and participate in various protocols. Much of the DeFi ecosystem is collateralized in USDT and USDC. 
3. Transparency: Because every coin can be accounted for using a blockchain, users can hold issuers to account with regards to circulating supply and reserves. Independent auditors can easily review coins issued. Companies issuing stablecoins can also comply with law enforcement to freeze assets involved in illegal activity. 
4. Remittances: Stablecoins offer a cheaper, faster and more frictionless alternative to traditional remittance services, making them popular for foreign workers worldwide.
5. Trad-Fi On ramp: Because companies like Tether and Circle are regulated entities, they provide individuals and businesses from traditional finance with increased confidence to enter the cryptocurrency space.
6. Liferaft: If you live in a nation where your native fiat currency is experiencing hyperinflation or debasement, stablecoins may offer a solution for protecting their purchasing power. Argentina, a nation recovering from high inflation, previously held the record for most stablecoin transactions globally.

Fiat-backed stablecoins do, however, have some important caveats that should to be understood before interacting with these types of crypto assets:

1. Centralization: Anyone holding stablecoins has to trust the issuing company will act appropriately. This trust can be easily shaken by the mere suggestion of poor management or actual foul play. Further, open-source blockchains champion the notion of immutability and being permissionless. Fiat-backed stablecoins represent the very antithesis of this philosophy, because companies like Tether have frozen assets and (effectively) reversed transactions in the past. 
2. Regulation: Stablecoin companies remain in the crosshairs of US and EU regulators. Should the U.S. government decide to enforce particularly punitive measures against one or more of these companies, this could potentially result in a huge exodus away from stablecoins and destabilize the crypto ecosystem. 
3. Reserves: Failing to maintain adequate reserves poses an existential threat to fiat-backed stablecoins. Even the slightest indication of insolvency could trigger a panic-driven surge in redemptions, similar to a bank run. If the reserves backing the stablecoin are insufficient or illiquid to meet redemption demands, some holders may risk losing part or all of their exposed capital in the resulting fallout, though the exact consequences remain uncertain.
4. Systemic Failure: Every blockchain can fail to operate as it should as a result of a smart contract exploit or some other unforeseen flaw. A failure, bug, exploit or other issue with these smart contracts may lead to a failure in their ability to allow tokens to be redeemed for any underlying collateral, which could cause the stablecoin to de-peg. 
5. Transparency: While anyone can easily track supply and activity, stablecoin users are somewhat dependent on the issuers themselves being transparent. In 2021, Tether was fined $18.5M by the state of New Yew for various transgressions relating to its supposed reserves. Later in the same year, Tether received another fine of $41M by the CFTC for “...omissions of material fact.”

To learn more about stablecoin quality risks, take a look at S&P Global’s 2023 “Stablecoin Stability Assessment,” where it rated several prominent stablecoins across a range of metrics. 

Of the coins mentioned above, USDC the assessment ranked higher than Tether.

There are two ways an individual can purchase and redeem fiat-backed stablecoins.

The first and perhaps less common route is to go directly to the stablecoin issuer. 

If your local fiat currency is supported, you may follow these steps to convert it into the equivalent stablecoin:

1. Select which stablecoin you want to use. Consider carefully the utility and liquidity of the coin as well as the reputation, transparency and reliability of the issuer. 
2. Complete the necessary KYC, which is likely to be mandatory. 
3. Deposit your fiat currency into the issuer's bank account, following any instructions to the letter.
4. The company will then issue the stablecoins to your supplied wallet address. 
5. The stablecoins can then be deployed as you see fit. 
6. You can, if you wish, redeem the stablecoins back into fiat currencies by returning them to the issuer.
7. If the coins are redeemed, they will be removed from circulation, and the corresponding amount of fiat will be returned to your bank account. 

The second and likely more common way of exchanging fiat for a stablecoin is by using a centralized trading platform, such as Kraken. 

1. Choose a reputable and regulated platform that enables fiat deposits. 
2. Create an account, completing any required KYC. 
3. Deposit your fiat into the platform using a suitable method. 
4. Once the funds have cleared, you are ready to convert them into your stablecoin of choice. 

Fiat-backed stablecoins account for a huge part of the market capitalization and transactional activity in the crypto ecosystem. Internally, they play an invaluable role as a stable medium of exchange, collateralization of margined futures contracts, and in decentralized finance. Externally, stablecoins enable large traditional entities to more easily participate in the space and allow for more efficient cross border payments and remittances. 

Now that you understand how fiat-backed stablecoins work, why not explore these assets on Kraken?

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