What are stablecoins, and how do they work?

Crypto is incredibly volatile. When everyone is trying to reach for the moon, there will always be turbulence along the way. But a few cryptocurrencies aim to do the exact opposite. They try to keep their prices steady and solid. The Earth, the crypto's moon. These are called stablecoins. Wait, that's actually a brilliant idea for a project. Make a stablecoin token pair where the stablecoin is named after the Earth and the token is named after the moon. But as Luna goes into free fall below a dollar. Oh, it fell below a dollar today. Absolutely. Wild Terra halting their network for a second time, Luna and UST face extinction. Oh, shit. Yeah. We'll explain why that happened a bit later in the video. Because that involved a special type of stablecoin called an algorithmic stablecoin. Before we get into that, we need to first understand what a stablecoin actually is. Hi, I'm Jackson Dumont, Director of Video at cointelegraph. In this video, we'll explain how stablecoins work and why they're one of the most crucial parts of crypto. If you haven't done so already, please consider leaving a Like and clicking that subscribe button. We are the leading media for news coverage and education. Let's start with a simple definition. A stablecoin is a cryptocurrency whose value is tied to an outside asset, such as the US dollar or gold. This tie is called a peg and it stabilizes the price. For example, the company Tether issues a US dollar pegged stablecoin called USDT at a one to one ratio to the US dollar. One USDT equals one USD. That means if Tether wants to mint 10 billion USDD tokens, they need to have $10 billion in reserve. They. They can't just mint money out of thin air. That right is reserved for the US Government. This collateral keeps the one to one peg because it ensures people are able to redeem their USDT tokens for actual US dollars at any time. Despite this, maintaining the peg can sometimes be difficult. But more on that later. So you might be thinking that stablecoins just sound like copies of other assets. And you're right, that's exactly what they are, but with one key difference. Get ready for it. Here it comes. They're on the blockchain. Never gets old. But even though I've said this in a lot of videos, the distinction is pretty important because it gives the underlying assets some unique properties. Minimal volatility. As we are all well aware, the crypto space is incredibly volatile. Cryptocurrencies can pump 10x or just as easily lose all their value overnight. In this world of chaos, there needs to be a stable benchmark where investors can keep their money safe from risky price action. Let's say crypto enters a bear market where every coin is crashing, kind of like what happened in the first half of 2022. There needs to be a place in the ecosystem or on chain where investors can hold tokens that don't lose value. Exiting the crypto ecosystem into real world assets for every trade for will be far too costly and time consuming. So it only makes sense that most trading pairs are against US dollar peg stablecoins like usdt because the US dollar is the global reserve currency. If the crypto market is a machine, then the US dollar PEG stablecoins are the grease that keep it running. They are the benchmark against which most other cryptocurrencies are measured. Without them, the crypto market would collapse. Be youe Own bank this brings us to the next unique feature of stablecoins. You don't need a bank to hold them or transfer them. This opens up a world of opportunities. Imagine you live in Venezuela where the recorded inflation rate at the start of 2022 was 1,198%. That means that the official currency of Venezuela, the Bolivar, is losing value faster than any other currency in the world. The absolute last thing you want to be doing is holding that currency. But maybe your local bank doesn't let you open an account for any currency other than Bolivar's. Or maybe you don't even have a local bank. What can you do? Well, you can go online to a crypto exchange and buy a USD, Euro or even gold backed stablecoin. Now your money is sitting in a far more stable currency. This will help you fight inflation and not lose the purchasing power of your money. Low fees, no border. But maybe that's not enough. You need some extra money from your cousin who moved to Canada and you need it fast. You don't have time to deal with slow wire transfers and exorbitant exchange fees. Instead your cousin can send you a stablecoin directly to your own wallet, not a bank's. Within minutes for a very small fee. Easy peasy. Problem solved. Now you can see just how powerful tool stablecoins can be. And this is only because these cryptocurrencies exist on global decentralized networks that are not controlled by governments, banks, corporations or any other centralized entities. The hardest part is helping people understand how to use it. So now that we know what Stablecoins are good for how do they actually work? Well, we can break things down by dividing stablecoins into four different categories, Fiat backed, commodity backed, crypto backed and algorithmic. Fiat backed stablecoins work exactly as we explained a bit earlier. In the USDD example, fiat collateral must always be in a one to one proportion to the number of tokens issued. The collateral is held in reserve by a central issuer or financial institution. Regulators require these issuers to frequently disclose the reserves to make sure they always have enough backing for the tokens they mint. Commodity backed stablecoins work in a similar fashion. These stablecoins are collateralized with physical assets like precious metals, oils and estate rather than with currencies. The stablecoin's price reflects the value of its underlying asset. For example, each token of Paxos Gold Pax G represents 1 ounce of gold. However, because the prices of these stablecoins are tied to commodities, they are more volatile than their fiat pegged brethren. Two of the most popular commodity backed stablecoins are Tether Gold and Paxos Gold. Holders of these stablecoins can sell them for cash or the underlying gold. This facilitates investments in assets that may otherwise be out of reach locally. However, both fiat backed and commodity backed stablecoins require a central issuer to provide collateral for each token. In the world of cryptocurrency, we seek to decentralize as much as possible. Crypto backed stablecoins seek to do just that by using smart contracts instead of relying on central issuers. If you're not sure what smart contracts are, check out our video here. As the name suggests, crypto backed stablecoins use other cryptocurrencies as collateral. When you purchase these stablecoins you lock your crypto in a smart contract and then the smart contract gives you tokens of equal representative value. This is called a collateralized debt position. The prominent stablecoin in this category is dai. Usually these kinds of crypto backed stablecoins require over collateralized positions. Essentially you have to put more crypto into the smart contract than you are taking out. This is to protect you against price price fluctuations which could cause liquidation. However, sometimes even over collateralization doesn't save users from liquidation during extremely volatile market conditions. The final category of stablecoins are algorithmic stablecoins. These are the newest types of stablecoins to emerge and they are still finding their footing. To put it lightly, contrary to previous categories, algorithmic stablecoins do not use fiat or crypto as collateral. Instead of they use a complex system of Algorithms and smart contracts to manage the supply of tokens in circulation, thereby controlling the price. When the price of the stablecoin deviates below its peg, tokens are burned from the circulating supply, pushing the price back up. Conversely, when the price of the stablecoin goes above the peg, tokens are minted into the circulating supply, pulling the price back down. Terra was a great example of this. It combined a governance token called Luna with a suite of fiat pegged stablecoins such as ust. Terra incentivized its users to take advantage of small differences in price of the same asset across different marketplaces. Essentially, if UST was valued at $1.01 instead of $1, users could burn $1 worth of Luna to mint $1.01 worth of UST. Investors could then sell the UST for $1.01, earning a profit of $0.01 for their efforts. Burning Luna tokens reduced the number of overall tokens left in circulation, making them more scarce and therefore more valuable. By minting more UST tokens, it had the effect of diluting the existing tokens in circulation and bringing the overall price back down down to its $1 level. Ideally, users would keep this process going until the UST value decreased back to $1. The opposite would occur if UST fell below $1. Think of it like a seesaw, constantly trying to balance itself. The problem is that this system failed big time. It crashed the whole market. What happened was this. A lack of demand for UST drove the price below its $1 peg. Traders saw this opportunity and began burning UST for $1 worth of Luna, which was then sold for a profit. So far, everything was working as intended. However, the continued selling of Luna led to its price plummeting, not only canceling out the arbitrage opportunity, but increasing the amount of Luna in circulation while the price continued to crash. Investors saw the system crashing and immediately tried to sell their holdings, which only caused the prices to crash even faster. When the dust settled, Luna and Ust had lost a mind boggling 100% of their value in just a few days, costing investors billions of dollars. This event was a sobering reminder that even experiments aimed at stability can have devastating consequences. But it also goes to show just how key stablecoins are in the crypto ecosystem. They are faster than banks, transcend borders and oil the crypto machine. Imagine if an even larger stablecoin like USDT or USDC suddenly collapsed. A Black Swan event like that would make the UST fiasco look like a walk in the park. And remember, those stablecoins are issued by centralized corporations. They look safe for now, but they still have a single point of failure and are at the mercy of the regulators. Who knows what could happen? The need for a decentralized stablecoin hasn't gone away. And although Luna failed, that failure will pave the way for better, smarter stablecoin systems. When that happens, Cointelegraph will be here to cover it. I'm Jackson Dumont. If you enjoyed this video, please leave a comment below on what you'd like to see me cover next.