A Detailed Walkthrough of How Stablecoins Work
In the world of cryptocurrencies, stablecoins play a very important role. These stablecoins serve as the secure, not so volatile friend of all other cryptocurrencies like BTC, ETH, and BNB for example. In this overview, you will learn what stablecoins are, how they work, and why they are important for the whole crypto ecosystem.
But first, let’s take a look at a recent example of how unstable stablecoins can be. Iron Finance, a partial-collateralized algorithmic stablecoin on Polygon and Binance Smart Chain suffered from a phenomenon called a “bank run”. In the scenario of a bank run, an asset provider starts offering more loans than the reserve they have. This is exactly what happened with IRON and TITAN.
The partially collateralized IRON token suffered serious fluctuations, despite being pegged to the US dollar. This volatility is absolutely uncharacteristic for a stablecoin, and can only occur under a combination of unfavorable conditions. In this case, the price for one IRON token, which was supposed to revolve closely around $1, plummeted to values below fifty cents. To understand why this happened we’re going to take a broader look at the mechanics and algorithms behind stablecoins.
What is a stablecoin?
In brief, stablecoins are cryptocurrencies whose value is backed by, or in other words tied to, a more stable asset or commodity. Some of the most widely used stablecoins are USDC, USDT, DAI, and FRAX. Each of these are in value tied to the US dollar. However, there are also stablecoins tied to euro.
There are numerous possibilities to ensure the stability of a stablecoin’s value. We’ll get into more detail about the different types of stablecoins in the next section.
The first-ever stablecoin was called BitUSD. Charles Hoskinson and Dan Larimer created BitUSD in 2014. It was issued on the BitShare blockchain. BitUSD laid the foundation for future stablecoins and put the concept on the map.
Since then many other stablecoins have made it to the global marketplaces. One of the most important goals stablecoins set out to achieve is to bridge the worlds of traditional and decentralized finance. Stablecoins aim to limit the volatility usually associated with cryptocurrencies, while still offering anonymity and decentralization of blockchain technology.
Backing stablecoins – types
There are several different ways in which backing works for stablecoins. Depending on the way backing stablecoins is structured, the tokens can be distributed among the following categories:
Fiat-backed stablecoins came first. BitUSD is a stablecoin pegged or tied to the US dollar. This means that each BitUSD token has a value equal to one US dollar. Fiat-backed cryptocurrencies are increasingly popular among investors of all kinds because of their relatively low volatility.
Tokens like USDT and USDC are used not only as an investment opportunity but also as an important asset in DeFi and decentralized applications. Fiat-backed cryptocurrencies can be tied to any traditional fiat currency like the US dollar, the Euro, or the Pound. Examples of fiat-backed cryptocurrencies include:
- Gemini Dollar
- Paxos Standard
Crypto-backed stablecoins function in a similar fashion to fiat-backed ones. However, the main difference here is that backing stablecoins with crypto is that all processes happen on the blockchain. While fiat-based currencies require off-chain algorithms to perform the pegging, crypto-backed currencies rely on smart contracts which execute algorithms on-chain.
Crypto-backed stablecoins work on the principle of collateralization. The most famous example would be MakerDAO, which issues DAI. Another example, many such stablecoins rely on additional collateral tokens. If we take Iron Finance – IRON is the stablecoin, while TITAN is the collateral token. Collateral tokens are locked up in smart contracts, ensuring that loan-takers have an incentive to repay their loans. Additionally, collateralization is in fact the process that ensures the stability of the token. Examples of crypto-backed stablecoins include:
- DAI – tied to the dollar
- wBTC – tied to bitcoin
- EOSDT – tied to the dollar
Instead of relying on fiat or crypto, asset-backed stablecoins are tied to the value of an asset or commodity. In most cases, the preferred commodity is gold, however, there are stablecoins tied to other precious metals like silver and platinum.
Asset-backed stablecoins function in the same way as fiat-backed ones, except for the collateral behind them. In essence, stablecoins tied to commodities and assets allow investors to efficiently digitize their capital in said assets. Some of the more prominent asset-based tokens include:
Why are stablecoins important?
Stablecoins are an important piece in the cryptocurrency and blockchain ecosystems. On the one hand, they are a very desirable investment opportunity because of the increased stability compared to traditional tokens.
On the other hand, stablecoins play a vital role in the flourishing DeFi environment we’re experiencing at the moment. Stablecoins are essential for the functionalities of many yield farms, swap services, and other decentralized apps. While unfortunate events like the crash of IRON do happen, many protocols are actively working on further ensuring the security of their investor’s assets.
Stablecoins provide an essential service and often ensure the liquidity of DeFi platforms.