While cryptocurrency has become increasingly popular over the past decade, a common complaint has been price volatility. Just this past week, the crypto space celebrated Bitcoin Pizza Day, the anniversary of Laszlo Hanyecz famously buying two large pizzas for 10,000 BTC, worth roughly $300,000,000 today.

While a reminder of how far cryptocurrency has come, it also points out some of the drawbacks of using a speculative asset as a currency. The solution to this problem is stable coins.

Stable coins are important because they are, well, stable. The price of a stable coin is pegged to, or matching, a different asset, typically the US Dollar but they can be pegged to other assets such as Euros, Gold, and Bitcoin. No one can deny that the crypto market can be volatile and many anticipate that the value will change in the future.

Volatility leads to swing trading and speculative holding but is not conducive to crypto’s use as a means for exchange. People are comfortable with fiat, or government issued currency. Stable coins are essentially fiat on the blockchain.

The Use Case of Stable Coins

If someone is holding a crypto currency that they expect to later go up in value, they will be reluctant to spend it because it will be worth more in the future. A store or vendor will be unwilling to accept cryptocurrency as payment if they believe there is a chance it will go down in value in the future.

In both these cases, the person spending the crypto will buy more, and the person accepting the crypto will sell for an asset they are more comfortable with. They will essentially trade the crypto for fiat after using the same crypto to purchase goods or services.

Stable coins are also useful when onboarding fiat to a centralized exchange such as Coinbase or Binance. If you need to make multiple transfers and move cryptocurrency around to purchase a specific token or coin, you don’t want to expose yourself to price volatility of different assets while you are waiting for transfers to complete.

The stability allows you to know that the value will stay the same during the process. You are speculating on a specific asset and should not worry about price fluctuations of unrelated assets in the meantime.

While stable coins are a useful and vital part of the crypto space, they are not made the same. There are different methods to create a stable coin and keep the price constant. It is important to understand how the stable coin you use works and what is going on behind the scenes to keep the pegged value.

Types of Stable Coins

Fiat-Backed

Fiat-backed stable coins are collateralized with a reserve of fiat currency to support the coin's value. Each coin in the circulating supply has a corresponding dollar in a bank account. At any time, for whatever reason, the coin can be exchanged for the reserve asset.

Since the fiat reserve resides off of the blockchain, this requires trust that the assets are there. The blockchain is inherently trustless because anyone can review the ledger; all transactions and wallets are on the blockchain. The reserve is typically independently audited and held outside of the governing body’s control.

Crypto-Backed

Crypto-backed stable coins are similar to fiat-backed stable coins. The reserve used as collateral to support the coin's value is cryptocurrency instead of fiat.

Since the reserve assets are held on the blockchain, it is possible to verify the holdings for yourself. This creates trust that the value of the stable coin will hold in the future. However, a reserve with a greater total value than the circulating supply backs the stable coin because of the volatility of cryptocurrency.

Algorithmic

Algorithmic stable coins use an algorithm to control the supply of the coin to keep its value constant. There may or may not be a reserve of assets supporting algorithmic stable coins. As the price deviates from the peg, a portion of the supply is bought and sold automatically.

Examples of Stable Coins

USDT

USDT, or Tether, is the most popular stable coin. It is the third largest cryptocurrency by market cap, behind Bitcoin and Ethereum. Initially launched in 2014, Tether was one of the first stable coins.

Tether Limited, a subsidiary of iFinex and sister company to Bitfinex, issues Tether. Since Tether has not released audits attesting to their reserves, there are questions whether Tether is fully backed or not.

USDC

USDC, or US Dollar Coin, is the second most popular stable coin and has the fourth largest market cap behind Bitcoin, Ethereum, and Tether. It was released in 2018. Centre, a company which consists of members including Coinbase, runs USDC. Fully reserved assets attested by Grant Thornton back USDC.

BUSD

BUSD is the Binance US Dollar stable coin. Paxos Trust Company serves as the custodian and issuer of BUSD. BUSD is approved by the New York State Department of Financial Services. Binance claims that each BUSD corresponds to a dollar in a bank account. Withum attests the reserve monthly.

UST

TerraUSD, or UST, is an algorithmic stable coin. It famously lost its dollar peg in May of 2022. The algorithm was supposed to use Bitcoin and Luna reserves to stabilize the price of UST at $1. The peg was unable to hold, which resulted in the loss of around $60 billion worth of value. The promise of a high yield for staking cryptocurrency enticed investors to the Terra ecosystem.

DAI

MakerDAO, a decentralized autonomous organization, maintains the DAI stable coin. The project is an example of decentralized finance in action.

DAI uses an overcollateralized loan. Users can borrow DAI after depositing a greater value of cryptocurrency as collateral. Users can withdraw the originally deposited cryptocurrency after repaying the borrowed DAI and interest. If the value of the deposited cryptocurrency used as collateral falls below a certain amount, the loan can be liquidated.

To keep the price of DAI at $1, MakerDAO controls the different types of cryptocurrency that can be used as collateral, the collateralized ratios, and the interest rates.

Conclusion

Stable coins play a huge role in facilitating transactions without being subject to market volatility. It is not always possible to convert between two cryptocurrencies but stable coins act as a go between.

There is increased scrutiny around stable coins and their actual stability because of the recent UST collapse. There have been calls for regulation regarding stable coins to provide more assurance to holders. Like all crypto, take the time to understand your stable coins so that you know what is going on with them and why they have their value.