What are Stablecoins? How Do They Work?

What if I tell you that there is one type of cryptocurrency which value is always equivalent to one dollar. Would you believe me? Well, it exists, and this type of crypto is known as a stablecoin.

A stablecoin (or stable coin) is a type of crypto asset whose value remains locked (or “pegged”) to the value of a certain fiat (or government-issued) currency, such as the US dollar, the euro, and even NZ dollars.

Check out the prices for these popular stablecoins in New Zealand: NZDD, USDT, USDC. What do you notice about their price?

When it comes to NZDD, the price for 1 NZDD is always 1 NZD.

When it comes to USDT and USDC, while their prices appear to fluctuate in NZ dollar terms, these crypto tokens always cost 1 United States Dollar. Try comparing the USDT/NZD rate over time versus the USD/NZD exchange rate, if you still don’t believe me.

But most cryptocurrencies are volatile, so how come stablecoins are… stable?

Continue reading below to find out how stablecoins work.

How stablecoins work (the fast explanation)

Stablecoins keep their stable value because they are backed by something. The reason why each NZDD is valued at $1 is because each NZDD token is backed by a real-world asset worth $1, locked in a local bank inland.

You can look at exactly how much money there are backing the entire supply of NZDD tokens in circulation right here on NZDD.com. Look for a monthly report of their Proof of Reserve, which proves that there is sufficient collateral that backs every unit of NZDD.

Here is one such example:

As you can see, there is at least $820,202 backing 820,202 units of NZDD, making it fully collateralised, and thus stable.

Now, here comes all the disclaimers that we must legally say to you about NZDD and stablecoins in general:

1. Stablecoins can temporarily or permanently be valued higher or lower than their “target value”.

This is known as “depegging“. When a stablecoin is sold for more than its target value, it means buyers are becoming impatient and want to desparately get their hands on the stablecoin before anyone else. The opposite can also happen, when holders lose confidence in the stablecoin, and want to quickly exchange it for something else.

2. Not all stablecoins are backed fully by cash or cash equivalents.

Some stablecoin issuers use short-term debt to back part of their supply of stablecoins. While short-term debt can be considered a low-risk type of debt, there is always a very small chance that the borrower cannot pay the debt, making it slightly more risky than simply holding onto cash.

3. NZDD is created by the founders of Easy Crypto and is managed by ECDD, Ltd.

This is why for the most part we’ve been focusing on this particular stablecoin with enthusiasm. It’s a really cool concept that came into reality. Check out the full story of NZDD if you’re curious.

How stablecoins work (in greater detail)

Stablecoins like NZDD are a type of stablecoins known as “fiat-collateralised stablecoins“. While the issuers work within a regulated environment and work closely with banks to keep their stablecoins’ value stable, not everyone is a fan.

Some crypto users prefer absolute separation from anything related to the government. After all, Bitcoin was invented to offer an alternative financial system that is independent of any government body. For this group of people, fiat-collateralised stablecoins are risky.

Luckily, there are alternatives:

Crypto-collateralised stablecoins

Owing to the potential risks of a centralized issuer of stablecoins, crypto-collateralised stablecoins were conceived, and live entirely on the blockchain. New stablecoins of this variant are created by locking in cryptocurrencies as collateral.

A stablecoin such as Dai is still pegged to the US dollar, but it is backed by Ether on the Ethereum blockchain. This means, in order to create new Dai, you will need to deposit your Ether in a smart contract. The Ether that you use as collateral is then completely locked in.

The code of the smart contract handles the exchange and redemption, without the need for a trusted third-party, and high solvency is always guaranteed.

A question remains, how will a stablecoin retain its value in the volatile crypto world?

MakerDAO (DAI) softly maintains its value relative to the US dollar using a series of financial incentives to the Ethereum network participants, such as interest rates, price differences with fiat currency, arbitrage (i.e. price differences between crypto exchanges), and the economics of supply and demand. 

The Dai depends on rational agents who buy/sell/borrow/return DAI to keep the value of the stablecoin within an acceptable range, thus a larger market cap will always be beneficial for crypto-collateralised stablecoins. 

For more technical details, see MakerDAO’s whitepaper on the Dai stablecoin.

The inherent weaknesses of crypto-collateralised stablecoins

As with anything that lives on a decentralised network, there is no customer support or regulators that can help you recover lost funds if, for example, you sent your crypto to the wrong address, or if you are unable to pay back your Dai and seek to refinance your loans.

Smart contracts aren’t “smart” in a sense that they know exactly what each human user needs.

Smart contracts are strict computer programs that are incorruptible and immutable by anyone, and provide no leeway unless the programmer has made an error in the creation of the smart contract to begin with.

Other examples of crypto-collateralised stablecoins include Synthetix (SNX), EOSDT, and Money On Chain.

Algorithmic stablecoins

The latest additions of crypto stablecoins evolved from experimental thinking — what if stablecoins don’t actually need collateral?

Algorithmic stablecoins allow AI and price-sensitive algorithms to dynamically change the supply of the stablecoin in circulation, such that each holder still has the same purchasing power even if the total supply and demand for the stablecoin changes.

There are various protocols that attempt to stabilise the value of these coins at a target price. Ampleforth stablecoin uses what’s called a rebasing function, which essentially increases or decreases the balances of every holder’s wallet in order to regulate the unit price per coin owned. 

The inherent weaknesses of algorithmic stablecoins

The aforementioned mechanisms are cutting-edge technology even in crypto-economics, and it takes time for investors to understand and to see their effectiveness. A great number of algorithmic stablecoins emerged in 2020; the technology still requires time to prove itself before it can capture a significant market share. 

The reason why you’re hearing them a lot on the news lately is that these stablecoins are still undergoing large volatility as the market cap is still small. Naturally, the algorithm will incentivise rational agents to stabilise the price by buying and selling the stablecoins. This is good for traders, but probably not good for the average investor. 

As you would expect, those who profit off the “algorithmic stablecoin market” tend to be the most vocal. We would need to wait a few more years until the ‘hype’ settles and the stablecoin reaches its fullest potential.

Update in 2024: Many algorithmic stablecoins have either failed or lost traction. We highly recommend you to do careful research on this type of stablecoins.

What is a collateral?

Now that we’ve covered the different classification of stablecoins, let’s take a closer look the concept of collateral itself.

When we deposit our hard cash into a bank, we essentially tell the bank to promise us that they’ll pay on our behalf when we use their debit card or online banking services. The bank effectively ‘translates’ our hard cash into a number on our account’s balance sheet.

Stablecoins, however, don’t work the same way. When you go to an exchange, you don’t deposit money for stablecoins. You offer collateral in exchange for stablecoins.

This collateral can be anything from crypto assets, commodities (e.g. gold), or simply fiat currency. This collateral is used by the issuer to help other users redeem stablecoins back into equal-value asset.

Technically speaking, the stablecoin is a debt (an IOU), whereby in giving this IOU to a recipient, you’re essentially promising to the recipient that the purchase will be paid for in fiat currency, as soon as the seller redeems the stablecoin.

Yes, it does sound like you are borrowing stablecoins against an asset, be it a cryptocurrency, fiat currency, or other. Therefore, when you choose to buy a stablecoin, always remember this:

The power of a stablecoin lies in the solvency of the issuer, in how well can they redeem the stablecoin for assets of equal value.

Takeaways

The beauty of stablecoins is that they are crypto assets that are used to interact between the mysterious realm of the blockchain and the familiar financial system that has built our society for so long. 

Ultimately, it is up to you to decide where your wealth will reside. Do you prefer a regulated stablecoin that has the benefit of blockchain technology for time and cost-efficient transactions? Do you believe in the power of the blockchain economy and the immutability of code? 

Get started: Click here to buy or sell stablecoins at Easy Crypto.

We hope this article has been insightful for those of you just jumping into the crypto space, or even seasoned traders looking to diversify their investment portfolio.

For the latest information, updates, and insights on all things, crypto explore the Easy Crypto Hub to deepen your understanding of cryptocurrencies.