How Stablecoins Work to Maintain Their Peg
Stablecoins use two main approaches to maintain their peg: asset-backed reserves and algorithmic controls. These digital currencies peg their value to stable assets like the US dollar, which helps create stability in the often volatile world of cryptocurrencies. Many people ask, how does a stablecoin work in practice? The answer lies in their rapid growth and adoption.
The stablecoin market has expanded quickly over the past five years, showing a 77% compound annual growth rate. As of 2024, the market cap stands at over $250 billion, with transfer volumes reaching $27.6 trillion.
| Metric | Value |
|---|---|
| CAGR of Stablecoin Market Cap | 77% |
| Market Cap as of 2024 | Over $250 billion |
| Stablecoin Transfer Volume | $27.6 trillion |
Key Takeaways
- Stablecoins maintain their value by pegging to stable assets like the US dollar, providing users with a reliable currency option.
- There are two main types of stablecoins: asset-backed, which rely on real-world assets, and algorithmic, which use smart contracts to adjust supply.
- Stablecoins enhance trading efficiency by allowing quick transfers between exchanges without worrying about price fluctuations.
- Users should regularly assess the risks associated with stablecoins, including the quality of reserves and the stability of the underlying assets.
- Staying informed about regulations and best practices can help users manage risks and benefit from stablecoin technology.
How Does a Stablecoin Work
Stablecoin Definition
A stablecoin is a type of digital currency designed to keep its value steady over time. Developers create stablecoins to answer the question: how does a stablecoin work in a world where prices often change quickly? They peg the value of each stablecoin to a stable asset, such as the US dollar or gold. This peg helps users trust that one stablecoin will always be worth about the same as one unit of the chosen asset.
Stablecoins use different mechanisms to keep their value stable. The table below shows how each type works:
| Type of Stablecoin | Mechanism Description |
|---|---|
| Off-chain collateralized | Backed by real-world assets, with custodians holding reserves equal to the number of coins issued. |
| On-chain collateralized | Uses blockchain to secure backing directly on the ledger, without traditional banks or custodians. |
| Algorithmic | Uses algorithms and smart contracts to adjust supply and demand, with no physical reserves. |
| Rebase mechanism | Changes the total supply based on market conditions, balancing value through supply adjustments. |
| Seigniorage-style models | Uses a mix of stablecoins and extra tokens to keep the price steady, often with fractional reserves. |
Purpose of Stablecoins
Stablecoins play a key role in the crypto ecosystem. They answer the question, how does a stablecoin work to make trading easier and safer? Traders use stablecoins to move money quickly between exchanges without worrying about price swings. In countries with unstable local currencies, people use stablecoins as a safer store of value.
The table below highlights the main differences between asset-backed and algorithmic stablecoins:
| Type of Stablecoin | Mechanism | Backing Assets |
|---|---|---|
| Asset-backed stablecoins | Supported by real assets, redeemable at a fixed rate | Fiat currencies, commodities |
| Algorithmic stablecoins | Adjust supply using algorithms, no physical backing | Not backed by physical assets |
Stablecoins also help increase liquidity and trading efficiency. For example:
- Monthly settlement volume for stablecoins in cross-border payments has exceeded $60 billion.
- Usage grows by 20% to 30% each month, showing rising adoption.
- In places like Venezuela, stablecoins offer a reliable alternative to local money.
How does a stablecoin work to maintain their peg? By using these mechanisms, stablecoins provide much-needed stability in the fast-moving world of digital assets.
Asset Backed Stablecoins
Collateral and Reserves
Asset backed stablecoins use reserves and collateral to keep their value steady. These stablecoins rely on stabilization mechanisms that connect each token to a real-world asset. The most common types include fiat-collateralized, commodity-backed, and crypto-collateralised stablecoins. Each type uses a different method to maintain their peg and provide stability.
| Type of Stablecoin | Description |
|---|---|
| Fiat-Collateralized Stablecoins | Pegged to fiat currencies like the U.S. dollar, with reserves held to assure value. |
| Commodity-Backed Stablecoins | Pegged to commodities like gold or oil, often held by third-party custodians. |
| Crypto-Collateralised Stablecoins | Backed by other cryptocurrencies, typically over-collateralized to manage volatility. |
Stablecoin reserves play a key role in these stabilization mechanisms. Fiat-collateralized stablecoins, such as USDT and USDC, hold cash or cash equivalents in regulated banks. Crypto-collateralised stablecoins, like DAI, use blockchain technology to show all transactions and collateral levels. This on-chain visibility increases transparency and trust. Some asset backed stablecoins use innovative designs, such as dual-class structures, to improve risk management and capital efficiency.
Asset backed stablecoins follow strict reserve management practices. They use regulatory frameworks to ensure transparency and security. These practices help users trust the value of each stablecoin and support the overall stability of the system.
Redemption and Issuance
Issuers of asset backed stablecoins use clear stabilization mechanisms to keep the value of each token close to its peg. When someone wants to buy a stablecoin, the issuer creates new tokens and adds more assets to the stablecoin reserves. When someone wants to redeem a stablecoin, the issuer removes tokens from circulation and releases the underlying asset.
The process for redeeming asset backed stablecoins follows industry standards:
| Section | Description |
|---|---|
| 6(1) and (2) | Issuers must redeem stablecoins at par upon valid requests, without imposing onerous conditions or excessive fees. |
| 6(4) | In case of insolvency, holders have rights to direct asset disposal for pro-rata redemption and claim for shortfalls. |
| 3.2.3 | Redemption requests must be honored within one business day unless prior approval is obtained. |
| 3.2.4 | Reasonableness of fees is assessed based on operational costs and industry practices. |
| 3.2.5 | Redemption must coincide with a decrease in the par value of outstanding stablecoins. |
Issuers must honor redemption requests quickly, usually within one business day. They cannot charge excessive fees or create difficult conditions. If the issuer faces insolvency, holders can claim their share of the assets. This process helps maintain their peg and protects the value of the stablecoin.
Asset backed stablecoins use these stabilization mechanisms to keep their value stable. They rely on strong reserve management and transparent practices. Stablecoin reserves and clear redemption rules help users trust the system and support the stability of digital assets.
Algorithmic Stablecoins
Algorithmic stablecoins use computer programs to control their supply and help keep their value close to a target, such as one US dollar. These digital currencies do not rely on physical assets or reserves. Instead, they use algorithms and smart contracts to manage how many tokens exist in the market. This approach aims to create stability without the need for banks or custodians.
Supply Adjustment
The main idea behind algorithmic stablecoins is to adjust the number of tokens in circulation based on market demand. When the price of a stablecoin rises above its target, the system creates more tokens. When the price falls below the target, the system removes tokens from the market. This process helps the stablecoin maintain its peg.
The table below shows how supply adjustment works in practice:
| Mechanism | Action Taken | Purpose |
|---|---|---|
| Supply Increase | More tokens created when prices rise | To meet increased demand and stabilize price |
| Supply Decrease | Tokens reduced when prices fall | To decrease supply and restore peg |
| Arbitrage Incentives | Traders buy/sell based on price | To help maintain the target value |
Algorithmic stablecoins often use incentives to encourage traders to buy or sell tokens when the price moves away from the target. For example, if the price drops below $1, the system may offer rewards to users who buy and hold the stablecoin. If the price goes above $1, the system may allow users to create new tokens and sell them for a profit. These actions help bring the price back to the desired level.
Smart Contracts
Smart contracts play a key role in the operation of algorithmic stablecoins. These self-executing programs run on blockchains and follow rules set by the creators. They handle the minting and burning of tokens automatically, based on real-time price data.
Minting and burning are two important mechanisms that help algorithmic stablecoins maintain their peg. When the price rises above the target, the smart contract mints new tokens and releases them into the market. When the price falls below the target, the contract burns tokens, removing them from circulation. This process can include fees, which influence how users interact with the system.
The FRAX stablecoin provides a good example of how these mechanisms work. Users pay fees when they mint or burn FRAX. The protocol also uses a collateral ratio, which changes based on the price of FRAX. If the price moves away from $1, the system adjusts the collateral ratio to help restore stability. This dynamic approach shows how algorithmic stablecoins can use smart contracts to manage supply and demand.
However, not all algorithmic stablecoins have succeeded in keeping their value stable. Some projects have failed to maintain their peg due to market forces or design flaws. The table below lists several examples:
| Project Name | Outcome | Time Period |
|---|---|---|
| Empty Set Dollar | Swift downfall due to market forces | 2020 |
| Basis Cash | Met with a swift downfall | 2020 |
| Luna (UST) | Credit collapse leading to decline | 2020 – May 2022 |
| Beanstalk | Failed to capture significant market traction | Post-2022 |
Regulatory challenges also affect algorithmic stablecoins. Unlike asset-backed stablecoins, which follow strict rules and oversight, algorithmic stablecoins often face unclear or even prohibitive regulations. The table below compares their regulatory status:
| Type of Stablecoin | Regulatory Status |
|---|---|
| Algorithmic Stablecoins | Excluded from the regulatory framework; potential lack of clarity and possible prohibition. |
| Asset-Backed Stablecoins | Subject to a comprehensive licensing regime with specific requirements and oversight by HKMA. |
Algorithmic stablecoins offer a unique way to maintain their peg and provide stability in the crypto market. They use supply adjustment, smart contracts, and incentives to manage price changes. However, their success depends on careful design, strong community support, and clear regulations.
Risks to Maintaining Their Peg
Causes of Peg Loss
Stablecoins face several risks that can threaten their ability to maintain their peg. The most common causes include insufficient reserves, poor collateral quality, and sudden market volatility. Algorithmic stablecoins often struggle when their supply adjustment mechanisms fail during periods of inflation or panic. Asset-backed stablecoins may lose their peg if the underlying stable asset becomes illiquid or loses value. Holders sometimes rush to redeem their tokens, especially when they fear inflation or doubt the quality of reserves.
The Bank for International Settlements has warned that the unchecked rise of stablecoins could threaten the public’s trust in money. For users to trust that stablecoin value will not budge, they need to know its collateral is verifiable, liquid, and of high quality. Adequately backed stablecoins are subject to runs by holders seeking to convert holdings back into dollars or whatever currency is backing it.
The table below highlights major peg loss events in recent years:
| Date | Event Description | Stablecoin(s) Involved | Peg Loss Details |
|---|---|---|---|
| Summer 2021 | Collapse of IRON Finance, impacting algorithmic stablecoins | IRON | Significant loss |
| May 2022 | Largest stablecoin collapse with UST and LUNA failing | UST, LUNA | Total collapse |
| 2023 | USDC briefly decoupled to $0.87 amid market panic due to SVB incident | USDC | Brief decoupling |
| 2023 | USDe caught in panic during the 10·11 crash | USDe | Significant loss |
| November 2023 | Another crisis following the USDe incident | USDe | Ongoing issues |
Impact on Users
When stablecoins lose their peg, users experience several negative effects. Many lose confidence in the ability of stablecoins to protect savings from inflation or maintain their value. Some may see their savings shrink if the stablecoin fails to keep its peg to a stable asset. The broader crypto market often reacts with increased market volatility and lower volatility in trading volumes. Users who rely on usd-pegged stablecoins to protect savings from inflation may face unexpected losses.
- Stablecoins face various risks that can lead to a loss of peg, particularly algorithmic stablecoins.
- A loss of peg can undermine user confidence, affecting their willingness to use stablecoins.
- The broader crypto market may experience instability as a result of decreased trust in stablecoins.
Recovery Strategies
Stablecoin issuers use several strategies to restore the peg and rebuild trust. Asset-backed stablecoins rely on transparent reserves and regular audits to reassure users about the quality of their stable asset. Algorithmic stablecoins adjust supply through smart contracts, aiming for lower volatility and renewed stability. Issuers communicate with users using secure channels and transaction monitoring. They often update their risk management policies to address inflation and market volatility. Many stablecoins use asset backing and algorithmic controls to maintain their peg and protect savings from inflation. Regular updates and strong security measures help restore user confidence and trust in the system.
Stablecoins maintain their peg through asset-backed reserves and algorithmic supply controls. Both methods help create stability in digital markets. Users should understand the differences between these approaches and stay aware of new regulations. The table below shows future trends in stablecoin regulation:
| Regulation | Description |
|---|---|
| GENIUS Act | Requires stablecoins to be fully backed by reserves, enhancing stability and reliability. |
| Stablecoin Ordinance (Hong Kong) | Mandates licensing for issuers, ensuring compliance with reserve requirements and AML/CFT systems. |
| MAS Framework (Singapore) | Establishes a licensing requirement for digital token service providers, ensuring compliance with reserve and operational standards. |
Users can protect themselves by following these practices:
- Conduct regular risk assessments.
- Monitor third-party providers for security.
- Plan for business continuity and incident management.
Staying informed and practicing due diligence helps users manage risks and benefit from stablecoin technology.
FAQ
What is a stablecoin and how does it work?
A stablecoin is a digital currency that keeps its price close to a target, like one US dollar. Stablecoins use reserves or computer programs to help maintain this price and offer users a reliable way to store and transfer money.
Why do people use stablecoins instead of regular cryptocurrencies?
Stablecoins help users avoid big price swings. Traders use stablecoins to move money between exchanges quickly. People in countries with unstable currencies often choose stablecoins for saving and spending because they trust the price will stay steady.
How do stablecoins maintain their peg during market changes?
Stablecoins use reserves or algorithms to control supply. Asset-backed stablecoins hold cash or other assets. Algorithmic stablecoins use smart contracts to adjust the number of tokens. These methods help keep the price close to the target and support stability.
Are stablecoins always safe to use?
Stablecoins can lose their peg if reserves drop or algorithms fail. Users should check if the stablecoin has strong backing and clear rules. Regular audits and transparent systems help protect users and keep the stablecoin’s value secure.
What happens if a stablecoin loses its peg?
If a stablecoin loses its peg, users may see the price drop below the target. This can cause losses and reduce trust. Issuers may use audits, supply changes, or better communication to restore stability and protect users.
