Definitions and Context
What are stablecoins? Why are they important? What makes them stable?
In the narrowest sense, a stablecoin is a cryptocurrency that has its price pegged to a fiat currency (e.g. USD) and is fully backed by reserves denominated in the same fiat currency. More broadly, a stablecoin can be defined as a digital asset that has mechanisms to maintain a low deviation of its price from a target price.
Since the invention of bitcoin and other cryptocurrencies, a major obstacle for their wider adoption and recognition as proper currencies, particularly as means of exchange and units of account, has been the instability (volatility) of their price in relation to fiat currencies. Therefore, if we are serious about creating cryptocurrencies that are really currencies, we must seek to create stablecoins in the broader sense, to overcome the obstacle of volatility.
Various mechanisms can contribute to a stablecoin’s stability. Ultimately, they are all grounded on the basic economic principles of supply and demand. If demand for buying/selling stablecoins is higher than the current supply of sale/purchase orders, this supply must be increased to avoid an increase/decrease in the stablecoin’s price.
Backing the stablecoins by reserves and using these reserves to actively buy and sell stablecoins for prices close to the target price is currently the most common stabilization mechanism. This mechanism is not exclusive to stablecoins; it can be seen in pegged national currencies such as the HKD (Hong Kong Dollar). Centrally operated fiat-pegged fiat-backed stablecoins such as USDT and USDC use variations of this mechanism that may differ, for instance, on the actual composition of the reserves and with whom the operator interacts to buy and sell stablecoins. As long as the stablecoin is fully backed by reserves in the currency to which it is pegged and the operator can react quickly enough to variations in the demand, it is easy to see that stability will be guaranteed. Typically, the reserves will not be kept all in cash in a vault, safe or bank account, but rather partly in interest-bearing financial instruments such as bonds. The returns from such investments provide revenue for the operator. The risks associated with these investments may imply that the stablecoin may eventually lose its full-backing, compromising the stability in the long-term. Lack of liquidity of these investments may cause the operator to be unable to react quickly enough to changes in demand, compromising the stability in the short-term. Another source of revenue are the fees or spread practiced when buying and selling the stablecoin. For example, if the operator sells USDT for 1.005 USD and buys USDT for 0.995 USD, it has a revenue of 1 cent for every USDT that it buys and then sells, while keeping the price stable within the range between 0.995 and 1.005. The main drawback of fiat-backed stablecoins is that it requires trust on the entities keeping the reserves. This is not only a theoretical concern. Lack of transparency about the reserves and skepticism about its full-backing claim, combined with inefficient stabilization measures by Tether, have actually already caused USDT to trade for as low as 0.91 USD.
Interestingly, issues related to transparency of the reserves do not arise when the backing asset is a cryptocurrency on a public blockchain. For example, Wrapped BTC (WBTC) is a stablecoin issued on the Ethereum blockchain, pegged to BTC and backed by BTC held on the Bitcoin blockchain. Because Bitcoin is a public blockchain, anyone can see how much BTC is available in the reserves backing WBTC. Such wrapping can be considered a major application of stablecoins, since it enables inter-operability between blockchains through bridges. In the particular case of WBTC, it enables users to essentially use (an asset pegged to) BTC on Ethereum’s contracts. Nevertheless, despite the transparency, there are still issues related to the custody of the backing assets. Bridges are currently one of the weakest points in blockchain security. They have been subject to many hacks that stole an estimated total of 2 Billion USD worth of backing assets up to August 2022, and such thefts amounted to an estimated 69% of total funds stolen in 2022.
The asset backing the stablecoin does not need to be the same asset to which the stablecoin is pegged. In particular, stablecoins pegged to USD and backed by cryptocurrencies are possible. When the backing asset’s price falls, the stablecoin may cease to be fully backed. This is an inherent risk that cannot be completely avoided. Nevertheless, in order to reduce its probability, crypto-backed stablecoins typically aim for a generous surplus of reserves to cushion price falls.
Crypto-collateralized stablecoins are similar to crypto-backed stablecoins, with the subtle but important difference, however, that cryptocurrencies are used to provide, instead of reserves, collateral for stablecoin-denominated loans. Similarly to how a house that serves as collateral in a mortgage does not count as reserves in the bank that is providing the loan, the collateral provided for the issuance of a crypto-collateralized stablecoin does not count as reserve. Due to the lack of reserves, pure crypto-collateralized stablecoins resemble an extreme form of fractional reserve banking (with a fraction of 0%). Unlike commercial bank money (i.e. money in a bank account), which can be exchanged at any time by anyone holding it for central bank money by withdrawing cash from the bank’s reserves, crypto-collateralized stablecoins cannot be exchanged for anything by withdrawing from the stablecoin contract’s reserves, simply because there are no reserves. When interacting with the contract, users can only use stablecoins to repay their own loans and recover their own collateral or to bid in auctions for liquidated collateral from others.
Although backing and collateralization facilitate stability and tend to increase the public’s trust on the stability, it is not impossible to achieve stability without backing or collateralization. To see this, consider that a central bank digital currency (CBDC) would be pegged to the central bank’s fiat currency and, like the fiat currency itself, would not need to be backed by anything, by definition of fiat. And, despite this, it would nevertheless be stable in relation to the prices of goods and services, at least in the short term, just like their associated fiat currencies in countries that enjoy low inflation. Central banks achieve stability of their fiat currencies (and of their CBDCs) by adjusting the circulating supply. For instance, they may print more money to increase the supply and they may increase the base interest rate to encourage people and financial institutions to buy bonds, thereby temporarily taking money out of circulation. Unbacked stablecoins may implement similar stabilization mechanisms.
With all types of stablecoins, various degrees of automation of the stabilization mechanisms, both on-chain and off-chain, are possible. Stablecoins with a high degree of automation, especially through on-chain contracts, are often called algorithmic. Note that "algorithmic" just means that the stabilization mechanisms follow a well-defined algorithm. It does not mean, as is sometimes claimed, that the stablecoin is unbacked or uncollateralized, although some are.