What are stablecoins?

Stablecoins are a category of cryptocurrencies specifically designed to maintain a constant value. 

Unlike other leading cryptocurrencies such as Bitcoin (BTC) and Ethereum (ETH), which are notorious for their price volatility, stablecoins are designed to maintain a fixed value. 

Different types of stablecoins use different mechanisms to keep their value pegged to a certain value or the value of traditional fiat currencies, commodities, or other types of assets.

There are three main classes of stablecoin: 

• Cash-collateralized stablecoins
• Crypto-collateralized stablecoins
• Algorithmic stablecoins

Traders use stablecoins to attempt to avoid price volatility without having to convert their digital assets back to cash.

Today, there are dozens of active stablecoin projects, though only a small handful account for a majority of all stablecoin trading volume. 

In 2022, a report found that stablecoin transaction volume had surpassed Mastercard and American Express’ annual payments volume — illustrating the growing global demand for these types of assets.

Stablecoins can be useful for crypto traders who might want to reduce their exposure to volatile cryptocurrencies without having to exit the crypto market.

Additionally, stablecoins that aim to track the price of specific fiat currencies like the US dollar or Euro, serve as a bridge between traditional finance and the world of decentralized finance (DeFi). Stablecoins achieve this by facilitating easy, quick and reliable transfers across borders.

Many stablecoins, such as Tether (USDT) and USD Coin (USDC), claim to be backed by reserves of traditional fiat currencies like the US dollar. 

Large holders of stablecoins who wish to redeem them for fiat currencies do so against these reserves the stablecoin issuer claims to keep. When a redemption is made, an amount of tokens is burned equal to the amount of fiat currency redeemed. Similarly, when a trader wants to put a large amount of fiat into the crypto space, they may do so via stablecoins and the stablecoin issuer will use those funds to keep reserves that will attempt to maintain the price fiat equivalent of the new tokens issued. 

Within the decentralized finance (DeFi) ecosystem, individuals use stablecoins to lend, borrow, and earn interest on their crypto assets. The intended price stability of these coins is essential in DeFi protocols, where users need a reliable unit of account for their financial activities and to mitigate risks such as impermanent loss. Users of DeFi protocols that use stablecoins could suffer losses if that stablecoin fails to maintain its intended price.

All stablecoins aim to follow the price of another asset. However, they don’t all accomplish this in the same way. 

This means that some stablecoins may offer unique forms of risks that others may not face. These risks can lead to the price fluctuations stablecoins aim to avoid. 

Understanding how different types of stablecoins operate is an important first step to choosing the right stablecoin that fits your specific needs.

Here is a more detailed overview of how the leading types of stablecoins work.

Cash-collateralized stablecoins are cryptocurrencies which often claim to be backed by underlying government currencies (like USD or EUR) and “cash equivalents.” The majority of these cash equivalents are treasury bills. Often simply referred to as treasuries, these are government issued debt, which like fiat currency, is backed by holders’ faith in the government that issued it. The treasuries that back stablecoins are typically stored in a traditional financial institution like a bank or qualified custodian.

These types of Stablecoins aim to maintain a consistent price by having reserves that are equal in value to the amount of tokens in circulation, denominated in the currency the token aims to track in price. The issuer then issues more tokens when they receive more fiat currency in their reserves, and burns tokens when tokens are redeemed in order to receive fiat currency back.

This type of stablecoin rose to prominence in 2014 when startup Tether Limited released USDT, a cryptocurrency designed to track the price of the dollar which could be traded 24/7 on the global crypto market. As of today, Tether remains the most widely used stablecoin around the world and the largest stablecoin by market cap. 

If you want to learn more about USDT, check out our Kraken Learn Center article What is Tether (USDT)?

Like USDT, other ‘cash-collateralized’ stablecoins are typically managed by a central operator, who tracks their circulation and allows users to mint and redeem tokens in their custody. Tether also issues and manages a stablecoin that follows the price of the Euro called EURT.

In many cases, the reserves that issues claim back cash-collateralized stablecoins are regularly audited by a third party. This can help to ensure that the amount of tokens in circulation is equal to the reserves held by the firm, thereby building confidence in the stablecoin.

After Tether, USD Coin (USDC) is the second largest cash-collateralized stablecoin project in terms of market cap. After debuting on the Ethereum blockchain in 2018, USD Coin has since expanded to natively support many of the leading blockchain ecosystems including Algorand (ALGO), Polkadot (DOT), Solana (SOL), Stellar (XLM) and Tron (TRX). 

If you want to learn more about USDC, check out our Kraken Learn Center article What is USD Coin (USDC)?

Crypto-collateralized stablecoins are collateralized by one or more cryptocurrencies.

These assets generally lack a central administrator. Instead, they rely on open-source software to enable borrowers to lock crypto assets (thus collateralizing them) and generate new stablecoins in the form of loans.

To account for the volatility of the underlying cryptocurrency, these stablecoins are often over-collateralized. This means that the value of cryptocurrency backing the stablecoins is greater than the value of stablecoins in circulation.

If borrowers wish to redeem their locked cryptocurrencies, they have to return the stablecoins to the protocol, minus any gas fees that may be charged. 

Due to their design, the stablecoin supply cannot be altered by a single individual on the network. Instead, smart contracts are programmed to respond to changes in the market price of the locked assets.

Though others exist, the leading crypto-collateralized stablecoins on the market today is MarkerDAO’s DAI token

Algorithmic stablecoins are digital assets that rely on smart contracts to maintain their price peg. Some types of algorithmic stablecoins also utilize a secondary native token to regulate their price stability. 

Some algorithmic stablecoins, known as rebase tokens, automatically adjust their own circulating supplies in an effort to maintain the price of the asset they aim to track, such as the U.S. dollar. 

If prices increase above the price they aim to track, the algorithm automatically mints new tokens and distributes them to existing holders. This dilution helps to reduce the market price of the token. Conversely, if the price falls below the price they aim to track, the algorithm burns (permanently removes) tokens in circulation until prices realign.

Other types of algorithmic stablecoins rely on a secondary native token to help track a specific price. This second token has a free-floating price that changes based on market demand and does not attempt to track the price of any particular asset. An algorithmic mechanism allows holders to burn one token to receive the other at a fixed price at any given time.

This process means that if the stablecoin rises above the price it aims to track, e.g. 1 US Dollar, holders can exchange one dollar's worth of the secondary token for one unit of stablecoin, sell it, and profit from the difference until the price returns to one dollar.

If the stablecoin’s price falls beneath its one dollar value, stablecoin holders can burn their tokens for $1 worth of secondary tokens. This process allows them to secure a small profit and decreases the circulating supply of remaining stablecoins, helping the token to better track its price target. 

It is important to note that this particular type of stablecoin has historically been the most risky because of its vulnerability to manipulation and attacks.

In 2022, Terra Luna, one of the largest algorithmic stablecoin projects at that time, collapsed within a few short days. Known as a “death spiral,” it began when an investor or group of investors dumped a large volume of the platform’s algorithmic stablecoin TerraUSD (UST) on the market. This action caused UST’s price to unpeg from the US dollar, which, in turn, caused a cascade of other issues for the project.

When the dust settled, the project went from a market capitalization of around $60 billion to near-zero.

Investing in crypto assets is risky and each token can have its own set of risks. Although other general crypto asset risks may still apply to stablecoins, specific risks associated with stablecoins that may impact their price or value include:

Issuer Risk 

The issuer of the token could face regulatory or legal issues, become insolvent or face operational and other issues that lead to a 'depegging' or devaluation of the token. The issuer may also face operational or financial issues that lead to a failure in their ability to allow tokens to be redeemed for any underlying collateral.

The assets collateralizing the token may be held by financial institutions or other third parties which could become insolvent or face other failures which could result in a loss of the collateral associated with the token.

An algorithmic stablecoin could suffer a failure, bug, exploit or other issue which may cause the algorithm to fail.

Users may be interested in purchasing stablecoins to reduce their exposure to more volatile crypto assets.

Additionally, like other cryptocurrencies, stablecoins are borderless, programmable and relatively easy to transfer at low cost.

Kraken users can quickly transfer supported stablecoins DAI and USDT to their accounts and exchange them for other cryptocurrencies.

Looking to learn what technologies help power stablecoins? Head on over to the What is Blockchain Technology? page located in Kraken’s Learn Center for a deeper dive. 

If you are interested in learning more about the different types of cryptocurrency, you can visit Kraken’s Types of Cryptocurrency page.

Now that you have learned all about different types of stablecoins, are you ready to take the next step in your crypto journey?

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