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What are stablecoins?

The beginner’s guide to 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

All of these types of stablecoins are available on exchanges like Kraken. Traders regularly use stablecoins 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.

What are stablecoins


Why do stablecoins have value?

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

Additionally, stablecoins pegged to 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 of value across borders.

Many stablecoins, particularly fiat-collateralized ones like Tether (USDT) and USD Coin (USDC), are backed by reserves of traditional fiat currencies like the US dollar. 

For each unit of stablecoin in circulation, there is usually an equal amount of fiat currency (or cash equivalent) held in reserve. This backing provides users with confidence that they can redeem the stablecoins for their stated value at any time. This allows stablecoins to essentially act as digital representations of fiat money within the blockchain space.

Within the decentralized finance (DeFi) ecosystem, individuals use stablecoins to lend, borrow, and earn interest on their crypto assets. The 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.

How Do Stablecoins Work?


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. It also means that some stablecoins can be more prone to the price fluctuations they 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

Cash-collateralized stablecoins are cryptocurrencies backed 1-to-1 by an underlying government currency (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.  

Because every unit of this stablecoin in circulation is typically backed by the equal amount of fiat currency held in reserve, the stablecoin’s price usually follows a consistent value.

This type of stablecoin rose to prominence in 2014 when startup Tether Limited released USDT, a dollar-backed cryptocurrency designed to trade 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 back cash-collateralized stablecoins are regularly audited by a third party. This helps to ensure that the amount of tokens in circulation is equal to the reserves held by the firm, thereby building confidence in the stablecoin and further proving its value in the market.

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 

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

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 to maintain their pegs. If prices increase above their pegs, 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 peg, the algorithm burns (permanently removes) tokens in circulation until prices realign.

Other types of algorithmic stablecoins rely on a secondary native token to maintain its peg. This second token has a free-floating price that changes based on market demand and not pegged to 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 its peg, 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 to restore its peg.

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.

That being said, there are still working examples of algorithmic stablecoins that operate in different ways than UST. These include Ampleforth and Yam.

Why Use Stablecoins?


Users may be interested in purchasing stablecoins as they offer all the benefits of traditional cryptocurrencies, such efficiency and transparency, while  also protecting holders from price volatility. 

Further, like other cryptocurrencies, stablecoins are borderless, programmable and easy to transfer at low cost. This makes stablecoins a valuable alternative to traditional banking institutions. 

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


Useful Resources

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.

Start buying stablecoins


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

Click the button below to create your account and buy stablecoins on Kraken today!

 

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