How Stablecoins Work

Published by Mario Oettler on

Here, we learn three types of stable coins:

  • Fiat-backed stablecoins,
  • Cryptocurrency-backed stablecoins,
  • Algorithmic stablecoins.

The stablecoin itself can be a token on a blockchain following a token standard like ERC20.

Fiat Backed Stablecoins

Fiat-backed stablecoins buy fiat currencies and lock them away in their bank account. They promise everyone holding one unit of their stablecoin to change this to one unit of the underlying fiat currency (e. g. Euro). You can imagine this as an I owe U (IOU).

As a result, we have

1 unit of stablecoin = 1 unit of fiat currency

The more stablecoins exist, the more fiat currency has to be locked away to guarantee the right of exchange.

You can see that they are pretty centralized and you need to trust that the fiat currency reserve is really there. Stablecoins try to create this trust by audits.

Popular fiat-backed stablecoins are Tether and USDC.

Cryptocurrency Backed Stablecoins

Cryptocurrency-backed stablecoins also try to maintain a constant price in fiat currencies. In contrast to fiat-backed stablecoins, however, they don’t use Euro or Dollar as a reserve. Instead, they try to compensate price fluctuations through a cryptocurrency reserve and arbitrage traders’ help.

This works as follows:

A user buys Stable-Tokens (ST) from the stablecoin contract with ETH. This creates a new ST. There are two reasons why a user would use the stablecoin contract instead of a normal exchange to obtain ST.

  1. The user beliefs that the price of ETH will go up. He could lock up its ETH and receive ST. Then he uses the ST to buy more ETH on an exchange, and with that ETH he buys more ST.
  2. The demand for ST has driven the price above 1 Euro. The user could create ST for 1 Euro per unit and sell them immediately on an exchange at the higher price. This is free money. And it helps to bring down the price of ST to 1 Euro because more ST are created and offered on the market. The increased supply reduces the price.

Let’s further assume the user took 500 ST. To receive its ETH back, it has to return the 500 ST. If the price of 1 ST drops to 0,95 Euro, it can buy 500 ST for 475 Euro. He could use the cheaper ST to send them to the stablecoin contract and receive its ETH back. This increases the demand of ST, which helps to lift the price.

But crypto-backed stablecoins also have to deal with sharp declines of values. This is done by over-collateralization.

Let’s say ETH is worth 100 Euro. You would expect to get 100 ST for 1 ETH. But the problem here is that ETH fluctuates in price. That’s why the collateral (ETH) has to be higher than the actual value to compensate for price fluctuations.

If the collateralization ratio is 150%, the user will receive 66 ST for one ETH. Or in other terms, 100 ST are backed by 1.5 ETH collateral.

If you want your ETH back, you have to return the 66 ST. The ST will then be destroyed. 

If the value of ETH goes down, this can cause problems because suddenly the amount of ETH is less worth than the promised value of the ST.

Before this happens, the stablecoin contract liquidates the ETH by auctioning them. Buyers have to pay in ST. This increases the demand for ST and thus the price.

This is only a rough and incomplete explanation of how cryptocurrency-backed stable coins work. Some projects provide measures in case the auction was not successful, or the price oracle doesn’t respond. There are also rules on how to adjust the liquidation threshold through the community of ST holders.  

Algorithmic Stablecoins

Algorithmic stablecoins are an interesting but still experimental approach. There is no popular project that gained a lot of attention at the moment. But we want to explain the idea nonetheless since it shows how versatile the DeFi field is.

Algorithmic Stablecoins have no collateral. In order to maintain a stable value, they change the outstanding amount. If the price rises above a certain threshold, the number of tokens increases. This makes each token less valuable and causes a reduction in price.

If the market price declines, the number of tokens is reduced. This makes each token more valuable.

It is important to notice that each holder of the token is affected equally. If you hold 5% of all tokens, you will also hold 5% after a reduction or an increase of the number of tokens. This ensures that no position is diluted.

Algorithmic stablecoins rely on price oracles that inform the token smart contract about the market price.

 A project dealing with algorithmic stable coins is Ampleforth.