What is a stablecoin?
In plain words
Most cryptocurrencies are like the currency of a faraway country with a jumping exchange rate. One price today, another tomorrow. A stablecoin is built the opposite way: its job is not to rise or fall, but to hold one price, usually one US dollar. Hence the name, since stable means steady.
The easiest way to think of it is as a dollar in your phone. The same figure on the screen as an ordinary dollar, only it is kept in a crypto wallet rather than in a bank account.
Why might you need it? If your local currency is melting away to inflation, a stablecoin is a way to keep savings in dollars without opening a dollar account at a bank. If you need to send money to family abroad, it goes in minutes rather than days. If you are a freelancer paid from another country, it is easier for the client to send a stablecoin than to deal with an international transfer.
Keep one thing in mind, which we will come back to: stability is a promise, and promises are kept in different ways and sometimes break. Below we will look at exactly how a stablecoin holds its price and why understanding the difference matters to you.
Deeper
The main question — what backs a stablecoin
The promise that one stablecoin equals one dollar works only when something stands behind the token. That something is called backing, meaning what the issuer is prepared to support the price with. There are three ways, and they differ greatly in reliability. This is a simplified map, since mixed models exist too, combining reserves, crypto collateral, and real-world assets.
The first way is backing with real money, which is called fiat backing. For every token issued, the issuing company holds roughly one dollar or its reliable equivalent in accounts. You can swap the token back for a dollar with the issuer, but direct redemption usually follows the issuer’s terms, for example only for large vetted clients and above a certain threshold. Most holders simply sell the token on the market. This is how the largest stablecoins work, USDT and USDC. The key point here is whether the issuer shows its reserves honestly and verifiably. If there are actually fewer reserves than tokens, the promise is empty.
The second way is backing with other crypto. Here the token is backed not by dollars in a bank, but by cryptocurrency locked in a smart contract, and with a surplus. That surplus is called over-collateralization. To hold a stablecoin at one dollar, crypto worth, say, one and a half is frozen. This is run not by a bank but by a protocol and its community, and for DAI that is the Sky ecosystem. The collateral today is also more often mixed, not only crypto but also real-world assets. The plus here is transparency, since much is visible right on the blockchain. The minus is the dependence on the quality and price of what is held as collateral.
The third way is stablecoins with no real backing, which are called algorithmic. This is the trickiest and most fragile kind. Behind the token there are neither dollars nor crypto, and the price is held only by an algorithm and people’s faith that it will work. As long as everyone is calm, it looks elegant, but the moment trust wavers, there is nothing left to hold the price with.
This has already happened, and it is important for a beginner to know. A stablecoin called UST held the dollar through a link with another coin, LUNA. The system promised to exchange one for the other at a fixed price. In May 2022 trust departed, UST broke away from the dollar, the LUNA coin lost almost all its value nearly instantly, and about 18 billion dollars burned up in a matter of days1. The takeaway is simple: if a stablecoin has no real backing, its stability can evaporate, and the word algorithmic should be read as elevated risk.
What a stablecoin is pegged to, not only the dollar
Most often a stablecoin holds the dollar’s price, but that is not the only option. There are ones pegged to the euro, for example EURC. The idea is the same, a steady price, just a different reference point. So when you meet a stablecoin, it is useful to look at two things at once. The first is what backs it. The second is what it is pegged to.
What to remember about a stablecoin
There is no simply reliable stablecoin. Reliability is assembled from verifiable things, and you can look at them yourself.
The first is backing and transparency. Does the issuer show what backs the token, and does someone independent confirm it. For fiat coins this is the reserves page and reports.
The second is the right to redeem. Backed and you will be able to swap the token back are not the same thing. The issuer sets the redemption terms, and they are not the same for every holder.
The third is who holds control. Behind fiat stablecoins there is a company, which means it can technically freeze funds. In crypto-backed ones, code and a community rule. This is not good or bad, these are just different risks.
The last thing, and the most important one: the word stable does not mean risk-free. A break from the price, which is called a depeg, has happened even to large coins. A stablecoin is more convenient than ordinary crypto for storing and transferring, but it is not a risk-free instrument.