What are stablecoins and how do they work?

By Philip Hoey
Updated 23 May 2024

A stablecoin is a cryptocurrency designed to maintain a steady value by being tied to a more stable asset like a traditional currency or gold. While cryptocurrencies such as bitcoin and ether are appealing for their ability to allow anyone to make payments without the need for a trusted middleman, they often suffer from unpredictable and volatile prices that can make them difficult for everyday use.

Unlike traditional currencies like the U.S. dollar or gold, whose values tend to change gradually over time, cryptocurrencies can experience wild fluctuations in value that make it hard for people to plan ahead and feel secure about their money’s worth.

Key Takeaways

  • Stablecoins are cryptocurrencies that try to stabilize their value by linking them to an external reference.
  • Compared to more volatile cryptocurrencies, stablecoins are more helpful in exchanging value.
  • Stablecoins can be tied to things like the U.S. dollar or the price of commodities such as gold.
  • To maintain price stability, stablecoins use reserve assets as collateral or algorithmic formulas to control the supply of coins.
  • Regulators are keeping a close eye on stablecoins due to the rapid growth of the $153 billion market and the potential impact it could have on the broader financial system.

What Kinds of Stablecoins Are There?

Central banks work hard to maintain stability and keep prices relatively steady regarding government-issued fiat currencies. With stablecoins, that same stability can be achieved by the network through a few different methods, such as being backed by a physical commodity like gold, algorithms, or fiat currencies issued by governments.

In fact, stablecoins often rely on government-backed fiat currencies like the U.S. dollar to create reserves that keep them stable. Some funds may be invested in short-term corporate debt or government-backed obligations to ensure these reserves are redeemable and properly backed.

These reserves make it possible for stablecoins to remain stable. Various mechanisms are used to achieve this stability, including fiat backing, crypto back-in, commodity backing, and algorithmic backing.

We’ll explore each of these in more detail in the following sections.

Fiat-Backed Stablecoins

Fiat-backed stablecoins keep reserves in fiat currencies, such as the U.S. dollar. Typically, there’s one dollar in reserve for every token in circulation, either in cash or cash equivalents. Central entities maintain these reserves and work with regulators to ensure compliance while regularly auditing their funds.

To purchase stablecoins directly from the issuer, users must complete KYC and Anti-Money Laundering (AML) checks, much like those required by exchanges. This process involves providing personal information, including a copy of government-issued identification.

Once in circulation, anyone can send and receive stablecoins, but the central issuing entity may be able to freeze funds at specific addresses. In the past, stablecoins have been frozen when issuers cooperated with law enforcement investigations or attempted to recover stolen funds.

Cryptocurrency-Backed Stablecoins

Cryptocurrency-backed stablecoins are those backed by other cryptocurrencies. They can be issued to track the price of the underlying cryptocurrencies or the price of a fiat currency. Additionally, a crypto-backed stablecoin can be issued by protocols to launch one asset on a different blockchain.

For instance, Wrapped Bitcoin (WBTC) is a stablecoin backed by Bitcoin issued on the Ethereum blockchain. Balancing mechanisms on the blockchain are used to ensure price stability in cryptocurrency-backed stablecoins that track the value of a fiat currency.

These stablecoins are overcollateralized to guarantee they can maintain their peg even during periods of high market volatility. Overcollateralization means that the assets backing a stablecoin are worth more than the stablecoins in circulation.

For example, $1,000 worth of Ether may be held in reserve by a user to collateralize the $500 value of a cryptocurrency-backed stablecoin. To ensure stability, frequent audits, and monitoring tools are used.

Cryptocurrency-backed stablecoins are more decentralized than fiat-backed stablecoins, as they can be created through automated smart contracts with no central entity controlling them.

Commodity-Backed Stablecoins

Commodity-backed stablecoins are digital tokens representing real-world commodities, such as precious metals, oil, or real estate, and are supported by reserves held by a central entity.

Gold is the most commonly used collateralized commodity for these stablecoins. However, it’s important to note that the value of these commodities can fluctuate, potentially causing the stablecoin’s value to decrease.

One of the benefits of commodity-backed stablecoins is that they make it easier for people to invest in assets that might otherwise be difficult or expensive to obtain, such as gold bars or other tangible assets.

These stablecoins can also be helpful for those who want to swap tokens for cash or gain custody of the underlying asset.

Algorithmic or Hybrid Stablecoins

Algorithmic or hybrid stablecoins use complex algorithms to maintain their value and prices. They work like central banks, using smart contracts to balance the blockchain’s supply and demand of funds.

When the price of the stablecoin goes above the target value, the algorithmic stablecoin buys assets, and when the price drops below the target value, it sells assets. However, some algorithmic stablecoins can lose their peg during unexpected events like black swan events because of market volatility.

To maintain stability, an algorithmic stablecoin system reduces the number of tokens in circulation when the market price falls below the value of the fiat currency.

On the other hand, if the token’s price is higher than the fiat currency’s price, new tokens are issued to bring the stablecoin’s value down.

Non-Collateralized or Seigniorage-Style Stablecoins

Non-collateralized or seigniorage-style stablecoins are similar to algorithmic stablecoins but don’t require any collateral or reserves. Instead, they rely on complex processes to adjust the supply of their coins based on supply and demand.

These stablecoins self-collateralize, meaning they don’t need any backing to mint new tokens. For example, if the price of stablecoin A falls to $0.70, there is more supply than demand. The algorithm buys stablecoin A with seigniorage, reducing supply and bringing the price back to $1.00.

If the price remains below $1.00 and there aren’t enough earnings to buy more supply, seigniorage shares are issued. Users invest in the expansion of the supply of non-collateralized stablecoins.

Conversely, if the price rises above $1.00, the algorithm generates more tokens, increasing supply until the price falls below $1.00. This results in profits referred to as “seigniorage.”

What Is the Purpose of Stablecoin?

The purpose of stablecoins is to provide stability to the volatile cryptocurrency market by offering a cryptocurrency with a stable value pegged to a stable asset or currency.

Stablecoins aim to solve the problem of cryptocurrency’s price volatility, making it challenging to use cryptocurrencies as a medium of exchange, a unit of account, or a store of value. Stablecoins achieve price stability through various mechanisms, such as collateralization with fiat currencies or commodities, algorithmic balancing, or non-collateralized seigniorage-style processes.

The stable value of stablecoins makes them a valuable tool for trading and investing, as they offer a way to avoid the wild fluctuations in value associated with traditional cryptocurrencies.

Stablecoins also provide the potential for increased access to financial services for individuals and businesses in areas with unstable currencies, where stablecoins can provide a more stable alternative.

Overall, the primary goal of stablecoins is to combine the stability of fiat currencies with the efficiency and innovation of blockchain technology.

Why are Stablecoins Important?

Bitcoin is the most well-known cryptocurrency, but its price can be incredibly volatile, with fluctuations as high as 50% in just a few months. This unpredictability can be advantageous for traders but can make day-to-day transactions difficult, as purchases become risky for both the buyer and seller.

Stablecoins have found a way to increase its functionality and features by pegging itself to currency. People who hold cryptocurrencies as long-term investments want to avoid being remembered for buying an item costing thousands of Bitcoins.

Meanwhile, merchants want to avoid being stuck with a loss if the value of a cryptocurrency falls after they accept it as payment. For a currency to function as a medium of exchange, it must remain relatively stable, ensuring it will keep its value in the short term.

In contrast, traditional fiat currencies like the US dollar typically experience less than 1% daily movement in forex trading.

Stablecoins vs Traditional Currencies

Stablecoins and traditional currencies are both types of money, but there are some important differences between them. Stablecoins are a type of digital currency that’s designed to maintain a stable value, usually pegged to a fiat currency like the US dollar or the euro.

They’re different from traditional currencies like the US dollar or the euro, which are issued by governments and their value is determined by supply and demand in the market.

Traditional currencies can be affected by various factors, such as inflation, interest rates, and political events, which can cause fluctuations in their value.

On the other hand, stablecoins are less volatile and more stable because they’re backed by reserves of the underlying currency or use algorithms to adjust their supply.

Stablecoins are often used to facilitate transactions on blockchain networks because they provide a stable value that’s not subject to the same level of volatility as other cryptocurrencies. Meanwhile, traditional currencies are still widely accepted for a range of transactions and remain the primary medium of exchange in most countries.

Do Stablecoins Have any Drawbacks?

Stablecoins seem safer than regular cryptocurrencies with no backing, but they still come with risks. Here are some of the potential risks you should consider:


Stablecoins must be stored somewhere, in a digital wallet, with an exchange or broker. However, this presents risks, as the platform might need to be more secure or have vulnerabilities.

Counterparty Risk

Despite being decentralized, several parties are involved in a stablecoin transaction, including the bank where the reserves are kept and the organization issuing the stablecoin to users. If they don’t take proper measures, such as ensuring security or proper reserving, the stablecoin’s value could be at risk.

Reserve Risk

The reserves backing a stablecoin are crucial for its value, and with them, the issuer can guarantee the stablecoin’s value with full confidence.

Lack of Confidence

Let’s assume hard assets, such as cash, don’t fully back a stablecoin; it could suffer a run and lose its peg against its pegged currency. This happened to TerraUSD in May 2022, when its price broke and spiraled downward, losing traders’ confidence.

According to Citrano, the primary risk of stablecoins is that the reserve currencies still need to be full. Ideally, the issuer should have enough reserves in cash or other highly liquid, safe investments to fully support the stablecoin. Anything less than 100% introduces risk.

What are the Most Popular Stablecoins?

Stablecoins are cryptocurrencies that aim to maintain a stable value, typically by being pegged to a traditional currency like the US dollar. Here are some of the most popular stablecoins:

Tether (USDT)

The world’s first and largest stablecoin by market capitalization, USDT claims to be backed 100% by a mix of assets, which can be viewed by users or interested parties on its website.


The second-largest stablecoin, USDC, is also pegged one-to-one to the US dollar and is backed by US dollar assets held in US-regulated financial institutions.

Binance USD (BUSD)

Developed by Binance and Paxos, BUSD is the third-largest stablecoin and is pegged to the dollar on a one-to-one basis. It claims to be 100% backed by an equal amount of US dollars and Treasury bills.

Dai (DAI)

The fourth-largest stablecoin is also pegged to the US dollar, but US dollars do not back it. Instead, it’s supported by a combination of various crypto assets.


Developed by TrustToken, TUSD is the fifth-largest stablecoin and is fully backed by the US dollar, which makes it the first regulated stablecoin of its kind.

A Comprehensive List of Popular Stablecoins

  • USD-pegged
  • Tether (USDT)
  • True USD (TUSD)
  • Gemini Dollar (GUSD)
  • USD Coin (USDC)
  • Paxos Standard (PAX)
  • Binance USD (BUSD)
  • DAI
  • HUSD
  • sUSD (SUSD)
  • mStable USD (MUSD)
  • Ampleforth (AMPL) (algorithmic)


  • Binance GBP Stable Coin (BGBP)


  • Stasis Euro (EURS)


  • BiLira (TRYB)


  • Binance KRW (BKRW)


  • CACHE Gold (CACHE)
  • Tether Gold (XAUt)
  • Paxos Gold (PAXG)


  • Petro (PTR) (oil-backed)
  • Libra (basket backed)

Why do People Choose Stablecoins Over Cryptocurrencies Like Bitcoin?

Stablecoins are designed to be relatively stable cryptocurrencies because they claim to be supported by fiat currency. This gives investors confidence that each token will always sell for one dollar.

When investors believe that the stablecoin is worth one dollar, the price should let that be known. They’ve been considered a haven for investors worried about the market’s instability.

It can be challenging to cash out cryptocurrency quickly during market turbulence because many exchanges only allow for buying and selling cryptocurrencies, not fiat currency. Stablecoins offer a solution since they live on most exchanges and maintain the value of a single fiat currency, providing a temporary refuge for investors.

They act as blockchain-enabled versions of the dollar. However, it’s important to note that their value needs to remain stable to function as a haven for investors.

What can you Do With Stablecoins?

There are a lot of things you can do with stablecoins, but here are our top 5 things you can do with stablecoins.

Avoid Volatility

The value of cryptocurrencies can change rapidly, making it difficult to predict their worth. Stablecoins are pegged to a more stable currency, so buyers and sellers can be more confident that their tokens won’t suddenly skyrocket or plummet.

Trade and Save With Ease

Stablecoins don’t require a bank account and are simple to transfer. Their value can be sent anywhere in the world, even to places where the local currency is unstable, or the U.S. dollar is hard to obtain.

Earn Rewards

With stablecoin investments, it’s easy to earn rewards with higher returns than traditional banks offer.

Transfer Money Cheaply

Despite their ability to hold high value, stablecoins are cheap to transfer. In some cases, people have sent up to a million dollars’ worth of USDC with transfer fees costing less than a dollar.

Send Money Internationally

Stablecoins like USDC offer fast processing times and low transaction fees, making them an excellent option for sending money anywhere in the world.

How Safe are Stablecoins?

When it comes to stablecoins, safety is critical. To ensure that a stablecoin is trustworthy, it’s essential to read the protocol’s features carefully. This means checking their reserve reports and being extremely cautious if they don’t provide any.

Tether, for example, has faced criticism for its reserve disclosures. While the company showed more reserves than liabilities in its March 2021 report, a closer look reveals that less than 4% was actual cash.

The network held most of the reserves in short-term corporate debt, which could decline in value quickly during an emergency. This means that unless a stablecoin commits to holding 100% of its reserves in cash, there’s no way to assure users that the cash will be there when needed.

While Tether has reduced its holdings of some non-cash assets since the 2021 report, it still relies on commercial paper for 30% of its reserves as of the fourth quarter of 2021. The U.S. Commodity Futures Trading Commission fined Tether $41 million in 2021 for false statements about its stablecoin being backed 100% by fiat currency.

However, Tether has stated that it will continue to decrease its reliance on this funding. Ultimately, the best guarantee of a stablecoin’s safety is widespread acceptance. In the U.S., dollars are the only widely accepted currency for goods and services.

In summary, when considering stablecoins, it’s essential to carefully evaluate the issuer’s reserve reports and understand what is backing the coin. Non-cash assets like short-term corporate debt may not hold up during an emergency.

Tether has faced criticism for its reserve disclosures and was fined by the U.S. Commodity Futures Trading Commission. To ensure the safety of a stablecoin, widespread acceptance is critical, and dollars remain the only widely accepted currency in the U.S.

The Future of Stablecoins

Stablecoins are an excellent choice for people who want to own cryptocurrencies but also want the reliability and predictability of fiat currencies. The stablecoin market is worth almost 140 billion U.S. dollars, with Tether being the most valuable stablecoin.

Tether is pegged to the U.S. dollar and has a total market value of just over 66 billion U.S. dollars. However, some people call for more regulation of stablecoins because of their rapid growth and ability to impact the traditional way of doing things and the financial system.

Stablecoins are the most direct competitors to fiat currencies, which are strictly regulated by central banks and governmental bodies. This may lead to increased scrutiny of stablecoin providers as they offer new financial products and platforms while replacing traditional fiat currencies.

What are stablecoins?

What are stablecoins?

By Philip Hoey - min read
Updated 23 May 2024
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