As should be evident by now, a stablecoin is a type of digital token designed to maintain a stable value based on an underlying pegged asset. These assets can include fiat currency, precious metals, commodities, or a combination of these (e.g. a basket of fiat currencies).

The purpose of a stablecoin, like USDt, is to provide a relatively stable digital store of value compared to the volatility experienced by not only other cryptocurrencies but other fiat currencies like the Argentine peso, which lost 97% of its purchasing power between 2012 and 2022.

Essentially, a stablecoin acts as a bridge between traditional assets and Bitcoin, enabling users to transact with greater confidence and predictability.

As for how they maintain this price stability, let's take a look…

The majority of stablecoins often choose to use a fiat currency as their peg, with the US dollar being one of the more popular fiat currencies by which to peg to. For this reason, we'll dive into fiat-backed stablecoins first. However, there are multiple types of stablecoins, such as commodity-backed and algorithmic, which we will also explore.

Stablecoins are designed to maintain a stable value relative to a pegged asset. When it comes to fiat-backed stablecoins, like USDt, the simplest way for the token to maintain its value is for the issuer of the token to hold the currency the token is pegged to in a 1:1 ratio.

Sounds a little confusing? Don't worry. Here is an example:

Suppose you have $50 US and want to send this money to your friends and family using USDt. To initiate this process, you log into your online exchange and trade your $50 US dollars for $50 USDt. However, this exchange doesn't merely conjure up $50 worth of fresh USDt. Instead, periodically, when the exchange's USDt reserves run low, the issuer, in this scenario, Tether, generates new USDt for the exchange in return for USD. The USD backs these newly created USDt tokens. This ensures that each circulating $1 USDt is substantiated by equivalent cash or cash equivalents.

With this in mind, when you acquire USDt, it's not a freshly minted issuance. Rather, at a prior point, the exchange swapped USD for USDt, which you're now acquiring from the exchange. As time progresses and more users purchase USDt, the exchange's reserves dwindle while its USD holdings expand. This prompts the exchange to once again communicate with Tether to generate additional USDt in exchange for USD.

This system of "backing" stablecoins with a reserve of assets is designed to provide stability and confidence to users, as it ensures that the stablecoin's value is tied to a tangible asset. In the event that everyone holding USDt decides to exchange their tokens for US dollars, the reserves held by Tether should be sufficient to cover the demand and prevent a loss in the value of the USDt.

Now, it is worth noting that not all stablecoins are created equal. Some, from a functionality standpoint, operate differently, whereas others may have different levels of collateralization or decentralisation, which can impact their stability and reliability as a store of value. Regardless, they’re all trying to achieve the same result: a stable price.

Although most of these institutions are heavily regulated and audited to ensure that they are trustworthy, this centralised approach does pose a potential risk.

For instance, as these stablecoins rely on not only a centralised issuer but also financial institutions to manage the currency held in reserves, if any of these entities were to fail, there is the potential for a decline in the value of the stablecoin and the publics loss in confidence in the issuer.

Consider USDC, the second most popular stablecoin after USDt. When Silicon Valley Bank collapsed in March 2023, USDC temporarily lost its 1:1 peg to the USD and traded as low as $0.88. That's a 12% loss of purchasing power overnight, which is concerning for something meant to be stable in price. The reason behind this drop in price was that Circle, the issuer of USDC, had kept a portion of its reserves at Silicon Valley Bank. As a result, when people caught on, they began to sell their USDC holdings out of fear that Circle would be unable to honour all redemption requests. Luckily for Circle, the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC) intervened and guaranteed all the bank's deposits. This meant that Circle would not lose its reserves, and USDC quickly recovered to $1. However, it could have easily gone the other way, leaving USDC a relic of the past. With this in mind, it's important to research the different stablecoins available before choosing to invest or trade.

Despite these shortcomings, the majority of trusted stablecoins are fiat-backed. Tokens like Tether’s USDt use this backing method and regularly move $5 billion or more daily.

Let's now take a look at the next type of stablecoin…

Just like fiat-backed stablecoins, commodity-backed stablecoins enable tangible assets deemed of value in the physical world to enter the digital world.

However, unlike fiat-backed stablecoins, which rely on government-issued currencies as their backing, commodity-backed stablecoins use assets such as precious metals, stocks, or even real estate.

In the case of a commodity-backed stablecoin, the issuer, typically in collaboration with a financial institution, would acquire physical assets, holding them as reserves while issuing stablecoins equivalent in value to these assets. The stablecoin owner can then trade their tokens without needing to handle the underlying physical asset or, in some cases, exchange their tokens for the physical commodity if needed.

Tether Gold (XAUt) is an example of a commodity-backed stablecoin whereby Tether holds one troy fine ounce of gold for each token issued. This ensures its price moves in sync with the price of the underlying commodity, in this case… gold.

What is interesting to note about XAUt is that token holders can track the company's gold holdings to ensure transparency, minimising any misconduct. Moreover, they can redeem their tokens for gold at any time, providing additional security and flexibility.

In light of this, in exchange for increased counterparty risk, XAUt offers several benefits over physical gold.

First, XAUt provides a more convenient and accessible way to invest in gold, as it is digital and can be easily traded and stored in digital wallets. This eliminates the need for physical storage and transportation costs associated with physical gold.

Second, it allows for fractional ownership, making it easier for investors to purchase smaller amounts of gold.

Why might one want this? In the physical world, buying a whole ounce of gold for $1900 would be out of reach for many. But 1/1000th of an ounce of gold is now achievable through fractionalising the tokens. In the digital realm, a claim to a spec of gold dust is achievable— something infeasible in the physical realm.

Lastly, XAUt is often more liquid than physical gold, which means it can be easily converted into fiat or bitcoin, enabling investors to quickly liquidate their holdings if needed.

However, just like fiat-backed stablecoins, commodity-backed stablecoins rely on a centralised institution for their operations, which makes them vulnerable to the same weaknesses. Additionally, these stablecoins have to factor in storage costs since physical commodities such as gold and real estate take up space. Therefore, you should expect to pay a small fee for the service.

Let's now have a look at the third form of stablecoin...

An algorithmic stablecoin is the final type of stablecoin we'll discuss and, just like the others, is designed to maintain a stable value.

Unlike other stablecoins backed by physical assets, algorithmic stablecoins use mathematical formulas or algorithms—often in conjunction with some assets—to regulate their supply in relation to demand to maintain price stability.

For those unfamiliar with the term algorithm, you can think of an algorithm as simply a set of rules to be followed. This may sound confusing, so let's look at one type of algorithmic stability mechanism, called the rebase method, as an example.

Let's say we release a new algorithmic stablecoin called AlgoCoin that uses the rebase method to ensure a price of $1. In such a scenario, AlgoCoin would automatically adjust the supply of tokens to maintain a stable price. This would be achieved by increasing or decreasing the supply of tokens based on the price change of the token.

If the price of AlgoCoin were above $1, the algorithm would increase the supply of tokens, effectively reducing the price of each token. Conversely, if the price of AlgoCoin was below $1, the protocol could somehow decrease the supply of tokens to increase the price of each token.

This method would ensure that the price of AlgoCoin remains stable over time while still allowing for fluctuations in market demand.

Now, it's important to note that reducing the circulating supply of a token, for example, by buying it automatically at market price or by destroying some supply with fees or storage costs, all without hurting its utility and thus its demand, is not as trivial as it may seem. When algorithmic stablecoins rely on complex rulesets to maintain their price stability, this makes them prone to technical and financial vulnerabilities. Which, if you follow the space, are taken advantage of regularly.

In May 2022, some traders exploited a vulnerability in TerraUSD (UST), one of the major algorithmic stablecoins. As a result, UST's value plummeted from $18.7 billion to under $100 million within a month, representing a staggering 99.5% decline.

With this in mind, while algorithmic stablecoins have gained attention for their potential to revolutionise the way we think about stable value in the digital world, it is important to note that they are still a relatively new concept and have been prone to bugs and vulnerabilities. As they are only partially, or at times, not backed by physical assets and rely heavily on developers and coding, as well as on delicate attempts at financial engineering, we recommend exercising caution and thoroughly researching before using any algorithmic stablecoins.

In conclusion, stablecoins offer a bridge between the traditional world and Bitcoin, enabling different tradeoffs between sovereignty and practicality. While there are three primary types of stablecoins—ones backed by fiat currency, precious metals, or algorithms—fiat-backed stablecoins are by far the most popular.

While stablecoins are often considered safe due to their “stable” nature, it's important to remember that they are not entirely risk-free. Since stablecoins rely on centralised issuers, i.e., Tether, and financial institutions, there is a potential for loss. To mitigate these risks, it is crucial to thoroughly research different stablecoins before investing. By doing so, you can make informed decisions and minimise the potential for unexpected losses.