One of the world’s largest asset managers projects that the stablecoin market will tip $3 trillion in the next four years, a staggering 22x leap from today.
Putting this adoption in context requires understanding the role stablecoins play in financial markets, including their utility, use cases, and how their blockchain properties push financial services innovation.
What is a stablecoin and how does it work?
A stablecoin is a private-issued digital asset pegged to the value of a fiat currency or commodity, such as USD, EUR, or gold. Stablecoins may be pegged to multiple asset values as well, and provide “stable” value over time by tracking the value of the underlying asset.
The primary aim of stablecoins is to combine the instant processing and security of cryptocurrency transactions with the steady value of traditional currencies or assets. While stability is the goal, it is not guaranteed nor without risk. In the past, some stablecoin projects have de-pegged from their underlying assets.
Still, stablecoins can offer security, immediate payment processing, price stability due to backing by fiat currency reserves or other assets, and enable private transactions.
What types of stablecoins exist?
Stablecoins exist most commonly in three varieties, differing based on their mechanisms for maintaining stability. These include:
Fiat-Collateralized Stablecoins
Crypto-Collateralized Stablecoins
Algorithmic Stablecoins (Non-Collateralized)
Below, we describe each and offer insight into common uses.
Fiat-Collateralized Stablecoins
These stablecoins are backed by a reserve of fiat currency at a 1:1 ratio. For each stablecoin issued, an equivalent amount of fiat currency is held in reserve. This direct backing by fiat currencies, alongside an ability to be redeemed for the fiat currency equivalent, promotes stability and helps ensure that the value of the stablecoin remains constant. Popular issuers include Circle (USD Coin or USDC) and Tether (USDT), with others like Paypal USD (PYUSD) coming onto the scene more recently. These types of asset-backed stablecoins maintain their stability by holding reserves of fiat currencies or other financial assets.
Crypto-Collateralized Stablecoins
These stablecoins are backed by other cryptocurrencies. Since the reserve cryptocurrency may also be volatile, such stablecoins often “over-collateralize”, meaning they hold a larger amount of the reserve asset than the stablecoin issued to account for value fluctuations. In some cases, stablecoins can be overcollateralized with ratios up to 200%.
These stablecoins may rely on mechanisms like smart contracts to maintain their peg, including algorithms that automatically manage coin supply in response to demand shifts or the value of the collateral. A notable example is DAI, by MakerDAO, an Ethereum-based protocol which is pegged to the US dollar, but backed by Ethereum and other cryptocurrencies.
Algorithmic (Non-Collateralized) Stablecoins
Purely algorithmic stablecoins, sometimes referred to as unbacked crypto assets, are not backed by any actual assets. As such, this variety relies on a working mechanism based on algorithms and programmable smart contracts to maintain their peg.
To ensure stability, an algorithm automatically manipulates the supply of the stablecoin in response to demand shifts. Notable examples by market capitalization include USDD and USDX.
What stablecoin utility use cases exist?
Each version offers various utility across the financial system and supports use cases ranging from daily transactions to complex financial operations. In many cases, stablecoins can create a bridge between cryptocurrencies and predictable value needed for everyday use in traditional finance and beyond.
Fiat-Collateralized Stablecoin Utility
Daily Transactions and Payments: Dependable stability makes them suitable for everyday transactions and offers a digital alternative to traditional fiat currencies (i.e. cash) without the volatility of cryptocurrency. For example, a crypto payment plug-in with e-commerce giant Shopify now supports USDC payments for millions of platform vendors. Additionally, Visa is now supporting stablecoin settlement capabilities.
Cross-Border Payments and Remittances: Stablecoins simplify and speed up international money transfers with lower fees and more transparency compared to traditional banking systems.
Trading Pairs in Cryptocurrency Exchanges: Serve as a stable asset against which the value of other cryptocurrencies can be traded, facilitating easier exchange and valuation.
DeFi (Decentralized Finance) Applications: The primary role of fiat backed stablecoin in DeFi is to provide a stable medium of exchange and store of value for participating in lending, borrowing, and yield farming activities.
Crypto-Collateralized Stablecoin Utility
DeFi Integration: Offer a seamless fit into DeFi applications for buying, lending, borrowing, and earning interest, all while maintaining stable value. As an ERC-20 token, for example, DAI works with any Ethereum-based dApp, wallet, protocol, or platform.
Collateral for Crypto Loans: Users can collateralize other cryptocurrency holdings to mint these stablecoins, using them for various purposes without having to sell their original assets.
Smart Contract Enabled Financial Operations: Their operation on smart contract platforms allows for innovative financial operations, like automated loan repayments and algorithmic-driven savings accounts.
Algorithmic (Non-Collateralized) Stablecoin Utility
Experimentation in Monetary Policy: They represent a frontier in experimenting with digital monetary policies, where supply can be adjusted algorithmically based on market conditions, mimicking central bank operations, but in community-consensus led ways.
Scalability and Decentralization: Without the need for collateral, they can potentially offer a more scalable and decentralized approach to stable value in the digital economy.
Innovative DeFi Mechanisms: Can introduce new DeFi mechanisms that leverage their unique supply elasticity, from algorithmic lending rates to dynamic yield farming strategies.
What are the differences between CBDCs and stablecoins?
Central Bank Digital Currencies (CBDCs) and stablecoins are both forms of digital currency, but they differ significantly in their backing, issuance, and intended use.
CBDCs are digital currencies issued and governed by a nation’s central bank, making them a digital form of a country’s existing fiat currency. Because they are backed by the government, they maintain legal tender status in the issuing country.
A primary goal of CBDCs is to improve the efficiency of the payment systems, enhance financial inclusion, and maintain the sovereignty of national currencies. While stablecoins represent the fiat dollar issued by a central bank, CBDCs are the digital dollar.
According to the World Economic Forum, reasons countries are exploring CBDCs include preventing the “fragmentation of the payment landscape into CBDCs, stablecoins and private crypto assets.”
To recap: primary differences between these two asset types are:
Issuer type (central banks vs. private entities)
Backing and stability mechanisms (government-backed vs. asset- or algorithm-backed)
Regulatory frameworks (extension of a fiat currency vs. decentralized, between crypto market participants.)
The Future State of Finance
Across the global financial ecosystem, the future looks bright. New value form factors like stablecoins and CBDCs mean advances ranging from cashless payments and new consumer products, to transaction settlement, market interoperability, and simplified financial operations. While infrastructure and adoption must still grow, the future state of frictionless value-exchange is nearer now than ever before.
Download our latest whitepaper to learn more about the impact and potential of stablecoins and other digital assets.
