How are stablecoins structured?

Stablecoin is a special type of cryptocurrency whose value is tied to real-world assets. Stablecoins can be backed by any liquid asset, such as real estate or workforce. Typically, stablecoins are pegged to USD, EUR, CNY, JPY, and sometimes to gold or oil. Due to this peg, stablecoin exchange rates are subject to less fluctuation compared to other cryptocurrencies. Undoubtedly, the leader in such pegs is the US Dollar.

Here are some of the most popular stablecoins:

• Tether (USDT)
• Binance USD (BUSD)
• USD Coin (USDC)
• Pax Dollar (USDP)
• Dai (DAI)
• TrueUSD (TUSD)

Typically, stablecoins do not have their own blockchain but exist as tokens on one or several popular blockchains. They were invented for the decentralized finance (DeFi) sphere, where all operations are possible only with tokenized assets. The issuance of tokens in such cases is governed by the rules embedded in the smart contract of that particular token.

The blockchains on which most stablecoins exist include Ethereum (ERC-20), TRON (TRC-20), BNB Smart Chain (BEP-20), EOS, AVAX C-Chain, Algorand, Solana, Polygon, Tezos, OMG Network, and others. These are the ecosystems where decentralized finance services need to be supported.

Before delving into the details, it's worth noting that stablecoins have their pros and cons.

Pros:

1. Stability in trading.
2. Peace of mind during transactions.
3. Easy liquidation for traders and investors in market downturns.
4. Insulation from high volatility.

Cons:

1. Market manipulation.
2. Possibility of lack of collateral.
3. Tendency to be more centralized.
4. Deviation from the target value, up to 5%, influenced by the market.
5. Subject to supervision by regulators.

Now let's examine the details more closely.

How is the peg achieved?

The most common method to maintain a fixed stablecoin price is by using fiat collateral. In this approach, the issuance of tokens in circulation is backed by an equal amount of fiat currency held by the issuer.

Tokens backed by fiat money are, in a way, debt instruments with their collateral typically stored by a third party, often a custodial bank.

This collateralization mechanism has the following advantages:

• Absolute price stability.
• Simplicity.
• High resistance to manipulation.

However, there are also several drawbacks:

• Centralization, where the issuer has complete control over the number of tokens and can freeze funds in accounts.
• The need for regular audits by independent auditors.
• Stringent regulation by the government of the currency to which the token is pegged.
• Complex withdrawal process.

An interesting fact: In 2017, a scandal surrounding Tether and its associated exchange, Bitfinex, occurred due to insufficient collateral. This event triggered a significant market crash. Attempts to audit the project failed to precisely determine whether the claimed amount of USD was held, leading to a series of other problems and the industry's first major crisis of trust. As a result, Tether and Bitfinex severed ties, and the latter lost its leading position in the market.

From a cryptocurrency perspective, stablecoins backed by fiat funds do not make much sense because they lack the independence and advantages of cryptocurrencies, which adds risk to holding fiat currencies.

But how can we avoid centralization?

It is possible to back stablecoins with certain cryptocurrencies. However, this method is very risky due to the high volatility of cryptocurrencies.

But there is a compromise solution where decentralized stablecoins have excess collateral as protection against high volatility, with most of them requiring collateral of 200%. Sometimes centralized stablecoins are used as collateral (for example, approximately half of DAI's reserves are held in USDC). This approach, on the one hand, protects against volatility, but on the other hand, reintroduces the risk of collateral lock-up by the issuer.

Therefore, as an alternative, it has been proposed to use automated algorithms that adjust the value by regulating the ratio of the number of issued tokens to the collateral value.

If the price of your token rises above $1, it means there is excessive demand. The algorithm increases supply by creating new tokens until the supply and demand levels normalize, stabilizing the price.

When the price drops below $1, it indicates an oversupply of tokens and the demand is lower. The algorithm is programmed to reduce the number of coins in circulation until the demand matches the supply, thus restoring the token price to $1.

However, it is worth noting that currently, it is impossible to find any reliable algorithmic stablecoins in the cryptocurrency market.

For example, the case of UST and Terra Luna has shown that algorithmic stablecoins are not perfect, and if something happens to the automatic market maker, it can cause an instant deviation from the price of the underlying asset, which would instantly undermine the future of the coin.

Despite the obvious drawbacks and implementation issues, many crypto enthusiasts believe that stablecoins have a bright future. For instance, they can become a convenient tool for real estate or securities transactions. And as a supporting mechanism for decentralized finance, they are simply essential, as this sector would not be able to function without them.