Paper and coin money concept
Paper and coin money concept. Freepik

Stablecoins have been making headlines lately, largely due to the notoriety of Facebook’s Libra and the suspicions around Bitfinex and Tether. But how exactly do stablecoins work?

How do they keep that supposed 1:1 ratio with the backing currency? What is the business model of a stablecoin? Who issues the coins? Who controls the supply?

These questions and a lot more will be answered in this article.

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What you’ll learn

  • The purpose of stablecoins.
  • How stablecoins are currently used.
  • The types of stablecoins (with examples).
  • How each type of stablecoin works.
  • The business model of stablecoins.
  • Will stablecoins stand the test of time?

The purpose of stablecoins

As it stands, cryptocurrencies have a huge problem – extreme volatility. While some have successfully used that to amass wealth, others have suffered a lot. This incapability of cryptocurrencies to act as a safe store of value is at the core of what spurred the creation of stablecoins.

Not all exchanges offer fiat currency pairs and when times are bad, people want to exit the digital assets market, but also keep close so they can re-enter quickly when the good times come. The problem with constantly exchanging digital assets for fiat currency is the large fees that are charged and the lack of availability.

As the crypto market constantly fluctuates between an uptrend and a downtrend, regularly exchanging cryptocurrency for fiat can prove to be a costly enterprise. Enter stablecoins.

As a cryptocurrency, transfers between stablecoins and commercial cryptocurrencies are quick, cheap, and seamless. Not only that, stablecoins provide an easier and more accessible way for exchanges to offer solutions to customers looking to stash their assets in a less volatile currency.

In short, stablecoins were created to meet the demand for a stable cryptocurrency that is pegged to a less volatile asset, is easy to exchange for normal cryptocurrencies, and comes with low transaction fees.

The types of stablecoins and how they work

Aside from the most popular fiat-backed stablecoins, other types such as commodity-backed and cryptocurrency-backed also exist, as well as the completely different seigniorage-style stablecoin. While the purpose of all of them is price stability, they all achieve it in different ways.

Fiat-backed stablecoins

Fiat-backed stablecoins are exactly what they sound – cryptocurrencies backed by one or more fiat currencies, more frequently USD and EUR. The most notable and somewhat infamous example is Tether (USDT and EURT).

It is backed by both USD and EUR on a 1:1 ratio, meaning each USDT is set to cost just about $1 and each EURT is set to cost just about €1. Here’s how the balance is kept in check – we will use USDT as an example.

The only way USDT can be issued is when someone goes to the official Tether website, passes the verification process, and then purchases USDT using USD. If they invest $100, they will get 100 USDT and thus increase the total supply of USDT in circulation by 100.

The $100 go into the bank account of Tether where it is kept until someone decides to redeem their USDT, again through the Tether website. Once redeemed, they will receive as much USD as they have USDT and the USDT will be subsequently destroyed.

The problem here is quite obvious – what if Tether decided not to keep all the USD in the bank account, but rather spend or invest some of it wherever? The 1:1 ratio is then lost and USDT gets devalued.

Exactly this scenario has been at the core of the controversy surrounding USDT and the Tether company since no in-depth third-party audit has been conducted on their USD funds in storage.

From the Tether Transparency page we can see that there is enough USD and EUR to back all the USDT and EURT in circulation, but these numbers could easily be fabricated by the company, albeit no proof of that has been found so far.

Tether has denied all accusations, but have yet to provide a third-party thorough audit of their bank accounts, putting the public’s worries at ease. The apprehension around USDT has since dropped down as the price of the asset is stable around the target $1.

Tether is currently the largest stablecoin by far, holding a market cap of more than $4 billion – 4 times greater than all other fiat-backed stablecoins combined.

Business model

Fiat-backed stablecoins usually make profit on the fees they charge to manage the ecosystem. For instance, Tether charges 0.1% per fiat deposit and withdrawal, as well as $150 in Tether as a verification fee.

Examples

  • USDT and EURT by Tether
  • Libra by Facebook
  • TrueUSD, TrueGBP, TrueAUD, TrueCAD, TrueHKD, TrueSGD, all issued by TrustToken
  • GUSD by Gemini
  • USDC by Coinbase

Cryptocurrency-backed stablecoins

Backed by one or a basket of cryptocurrencies, these stablecoins are similar to fiat-backed stablecoins in that they are also backed by other currencies. However, the balance is kept in a completely different manner.

While fiat-backed stablecoins achieve balance by storing fiat currency in bank accounts, strongly depending on third-parties to guarantee security and liquidity, cryptocurrency-backed stablecoins achieve it through algorithms and utility. We will use Maker’s DAI as an example to explain how cryptocurrency-backed stablecoins work in general.

First of all, this type of stablecoin is more transparent than its fiat-backed cousin as everything is open-source, allowing anyone to see how the balance is kept in check with a simple a look at the smart contracts that enact it.

DAI is a stablecoin that is backed by ETH, however, the smart contracts that balance the ecosystem make it so 1 DAI always costs just about $1. How is this possible? How can a completely decentralized stablecoin remain, well, stable, merely governed by smart contract logic?

In short, what keeps DAI in check is game theory. The guys over at Maker have come up with a clever structure that makes it possible for reasonable actors to always balance the system in a way that 1 DAI costs just about $1. Sounds unbelievable and yet, here’s proof.

This is the price chart of Ethereum from 2018:

Ethereum price chart 2018
Ethereum price chart from 2018. CoinMarketCap

That year Ethereum peaked at about $1,350 and crashed to less than $100 towards the end of the year. And yet, here is the price chart for DAI from 2018:

DAI price chart from 2018
DAI price chart from 2018. CoinMarketCap

Despite Ethereum losing more than 90% of its value, DAI remained stable, always close to that target $1 valuation. In order to explain how DAI keeps the balance in check, we first need to take a look at how DAI tokens are created.

First of all, DAI is a simple ERC20 token and as such can be traded easily for other Ethereum-based digital assets. Similar to Tether, there’s only one place DAI can be created and that is from the DAI dashboard – of course, you can purchase DAI on a lot of other exchanges.

Unlike Tether however, the process is completely decentralized and does not require third-parties, though it is somewhat complex. The biggest difference to fiat-backed stablecoins is the fact that creating DAI basically means taking out a loan against your own Ethereum deposits. Here’s how it works.

Through smart contracts, anyone can deposit ETH into the DAI ecosystem, which is then turned into PETH (pooled ETH). PETH can be used to create a collateralized debt position (CDP), which locks your PETH and allows you to draw DAI in return.

The key feature here is that, you cannot draw more than 60% of the value of the ETH you deposit. For instance, if you deposit $1,000 worth of ETH, you cannot draw more than 60% of it i.e. more than 600 DAI.

The higher the percentage of the collateral that is drawn out in DAI, the riskier the CDP becomes since a drop in the price of Ethereum will make it harder for the debt to be paid as the collateral’s valuation in dollars drops.

More specifically, whenever DAI’s price is above $1, people are incentivized to create DAI since they will essentially make free money by selling the created DAI instantly on an exchange. On the opposite side of the equation, when DAI is below $1, investors are incentivized to close their debt positions since it is cheaper for them to do so.

The tug of war between these two scenarios is what keeps the DAI ecosystem stable. Reasonable actors will always go for the free money that can be made on the arbitrage and thus always keep the system in check.

An amazing “side effect” from the way the DAI ecosystem is set up is decentralized margin trading. Imagine that you are quite sure that Ethereum’s price will go up soon, but you don’t have the capital to purchase a lot of ETH.

Through the DAI ecosystem, you can deposit ETH and then draw out DAI. Then you can use the DAI to purchase ETH on an exchange. You can then use the new ETH to draw even more DAI and then purchase ETH with the freshly drawn DAI. And on and on. Effectively, the DAI ecosystem allows you to perform margin trading without any third-party governance.

The final unanswered question is how the DAI ecosystem knows the price of ETH in order to value the assets in dollars. The value of ETH in USD comes from oracles. A dozen oracles provide pricing data so the ecosystem is not dependent on any single one of them.

In short, cryptocurrency-backed stablecoins use smart contracts and utility to balance their ecosystems. Through a cleverly-designed game-theory-based structure, the price of their digital assets is kept stable, pegged to other cryptocurrencies or real-world assets, all without the need for any third-party governing entities.

Business model

Cryptocurrency-backed stablecoins make money from fees. For instance, the DAI ecosystem also includes the Maker (MKR) token, which gives voting rights to holders and is used to pay a fee when closing off CDPs.

That fee is called a stability fee, which currently sits at 4%. For example, if you took a 500 DAI loan against $1,000 ETH in collateral, when repaying the loan, you will need to pay back the 500 DAI + 4% of $500 in MKR.

The MKR is then burned, effectively increasing the price of the token since there is now less of it in existence. The Maker team controls a large portion of MKR tokens, which are used to keep the project going.

Examples

Commodity-backed stablecoins

These stablecoins are quite similar to fiat-backed stablecoins, but instead of using fiat currency, they use commodities such as gold and silver to achieve stability for their digital assets.

The main difference to fiat-backed stablecoins is that these commodities are far less likely to be inflated since it is much harder to mine gold or silver whereas fiat currencies can be literally created out of thin air.

To illustrate how commodity-backed stablecoins work, we will use the example of Digix (DGX). Like any other digital asset, DGX can be purchased on many crypto exchanges, but the only way the tokens are minted is through the Digix marketplace.

Interestingly enough, DGX can be purchased with Ethereum and DAI, with the condition that 1 DGX represents exactly 1 gram of gold. At this point you might be wondering where the gold comes from?

It comes from ValueMax, a gold bullion provider based in Singapore. The physical gold is stored by The Safe House, an ISO 9001 certified custodian vault, again based in Singapore.

Singapore-based The Safe House gold bullion storage center
Singapore-based The Safe House gold bullion storage center. The Safe House

The ecosystem also includes an independent auditor, Inspectorate at Bureau Veritas, who audits the gold assets of Digix every quarter. You can check out the current asset list of the Digix ecosystem on their Proof of Provenance page.

Whenever anyone wants to redeem gold for their DGX, the need to go through a process of recasting – only instances of 100g or 1,000g can be redeemed. After the process is initiated, you will have to physically go to the vault within 30 days to receive the gold bullion you requested.

In short, commodity-backed stablecoins use precious metals to back their stablecoins, betting on the stability of the total supply of the backing commodities.

Business model

Commodity-backed stablecoins make profit on fees. For instance, the DGX ecosystem charges 0.13% transaction fee (capped at 1 DGX) on all transfers of DGX.

They also used to charge a demurrage fee for holding DGX amounting to 0.60% per annum, but have since deactivated that part of the business model as the team promised to do so from the start of the project.

Examples

Seigniorage-style stablecoins

The last type of stablecoin is quite different to the others we covered. These stablecoins try to emulate a central bank economy by manipulating the total supply via algorithms. Seigniorage is the profit made by a government on issuing currency i.e. the difference between the face value of the currency and productions costs.

Similar to cryptocurrency-backed stablecoins, the logic that keeps the balance in check is kept on-chain, enforced by smart contracts. The key feature of these types of stablecoins is the complete lack of collateral.

One notable example is Basis, who managed to raise $133 million, but due to regulatory hurdles decided to shut down the project in December 2018. Using a simplified example, here’s how this type of stablecoin works.

Let’s say that the goal is to keep the stablecoin at around $1. In the case when the price goes below $1, meaning the supply of the stablecoin is higher than the demand, smart contracts buy the stablecoin, thereby lowering the total supply and pushing the price upwards.

if the price still remains under $1 and there are no resources left to purchase more and reach the target price, smart contracts issue bonds, which are then sold to the public. These bonds promise seigniorage profits to buyers i.e. people are investing in the growth of the ecosystem and betting that they will make a profit from collected seigniorage.

If the stablecoin starts trading above $1, smart contracts mint additional tokens and then sell them to the public, increasing the total supply until the price returns to $1.

Believe it or not, ever since gold stopped being used as collateral giving birth to fiat currencies, this strategy of manipulating the money supply to achieve certain economic goals is at the core of central banking systems around the world.

In short, seigniorage stablecoins try to imitate modern central banking systems, manipulating the money supply via a complex set of smart contract logic that tries to keep the market stable.

Business model

Seigniorage stablecoins make money, well, from seigniorage. When the price of the stablecoin is above target, more tokens are minted and sold to the public to lower the price.

When the price is lower than the target, profits are used to purchase back some of the stablecoins in circulation, lowering the total supply and thus increasing the price of the asset. If profits are not enough to get to the target price, bonds are issued and sold until stability is achieved.

Examples

Will stablecoins survive?

High volatility is currently one of the biggest problems cryptocurrencies face. While stablecoins solve that problem to an extent, what place do they have if (or when) crypto market volumes become so big that digital assets start competing with everyday fiat currencies in terms of price stability?

Why use a stablecoin such as USDT or USDC when Bitcoin no longer drops/jumps 10 – 15% in a day? Cryptocurrencies becoming a stable store of value might just spell the end for fiat-backed and commodity-backed stablecoins, unless they can evolve to provide some sort of exclusive utility.

Cryptocurrency-backed stablecoins on the other hand are quite unique in their approach to stability, providing unique opportunities to market participants. I don’t really see this type of stablecoin being made obsolete if crypto market volatility drops substantially. The concept of being able to draw loans and do margin trading without the need for any third-parties is simply exceptional.

Summarily, stablecoins were created to solve a potentially-temporary problem of volatility. Some types might not persist through if this problem goes away, while other types might be able to adapt/evolve in order to stay relevant.

Summary

Stablecoins have met the demand for less volatile cryptocurrencies, providing an easy and cheap way for people to store their assets in a stable environment. The different types of stablecoins all aim for stability, but achieve it in very different ways.

Fiat-backed stablecoins use stores of fiat currency to secure the value of their digital assets, strongly relying on third-parties. Commodity-backed stablecoins are similar, but rather use precious metals to guarantee the value of their digital assets, seemingly betting on the less volatile nature of commodities due to their minting difficulty.

Then there’s cryptocurrency-backed stablecoins that provide utility in the form of loans and margin trading alongside a stable digital asset, balanced out by on-chain code. Finally, seigniorage stablecoins aim to imitate a modern central banking system by manipulating the money supply via smart contract logic, eliminating the need for collateral.

Stablecoins mostly generate revenue from fees collected on various actions that govern their ecosystems, some collecting the fees in fiat currency, others relying on utility tokens or established digital assets.

While stablecoins are quite popular at the moment, a common criticism arises – will they still be around if the crypto market loses some of its extreme volatility? Some types of stablecoin might be good, while others might be forced to evolve in order to survive.

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