What are Stablecoins? The Complete Investor’s Guide

What are stablecoins?

Stablecoins are a type of cryptocurrency intended to maintain price stability through a variety of mechanisms — including pegging it to other assets such as currencies, commodities or crypto, or through algorithmically based supply controls.

On a fundamental level, stablecoins are a solution to a monetary problem in two ecosystems: crypto assets and fiat currencies.

Crypto users and investors need a safe, stable asset to more efficiently operate within that system, and people using the global fiat system need a currency that protects their wealth from inflation and financial exclusion.

Because these are monetary problems, the best way to frame the stablecoin endeavor is to evaluate them through the monetary policy they are attempting to implement.

In our previous article we outline what monetary policy is and how to evaluate it. We recommend reading it to understand how we got here. It will provide the context needed to and better measure the safety of each stablecoin issuer’s monetary policy.

Stabilize Money, Stabilize the World

Part 1: What’s broken
Why unstable money isn’t safe for the world and how to understand monetary policy
Part 2: What are people doing today about it?
A dive deep into the types of monetary policy alternatives that stablecoins offer
Part 3: What is the right way forward?
A guide to the various inflation hedging tactics and how they can be used in stablecoins
Part 4: What will the future look like?
A look at how tokenization will change the stablecoin ecosystem
About our sponsor: Reserve
A video explaining the Reserve Protocol

How to compare stablecoins and their importance

Stablecoin monetary policy is set apart by its explicit directive to enforce price stability. Stablecoins use different mechanisms to peg its value to assets including fiat currencies and commodities or an index like the CPI. Its safety is measured by the collateral backing and redemption and the degree of “can’t be evil” governance. For the purpose of this guide, we have grouped the stablecoins by types of collateral. But in each section, we will compare different governance structures and how this influences the safety of their monetary policy.

The different types of stablecoins

Fiat-backed

Fiat-backed stablecoins such as USD Coin (USDC), Tether (USDT), and Binance Dollar (BUSD) are tokens issued by central entities that peg the value of their coins through holding a one-to-one reserve of cash or cash equivalents and, in the case of USDT, also backed by loans, bonds and investments.

How it works

Like a traditional currency peg, the issuer uses their reserves and the help of arbitrageurs to maintain equal buy and sell pressure across exchanges. And they all use a burn mechanism that removes tokens from circulation when fiat from their reserve is exchanged for the token.

These reserves are held by central entities and are typically audited on a monthly basis. CENTRE, the issuer of USD Coin, is a joint venture of Coinbase and Circle. Their reserve is audited by US accounting firm Grant Thornton LLP.

Monetary policy

The monetary policy of fiat-backed stablecoins is guided by two variables. First, it imports the policy decisions of the fiat currency it chooses to peg its value to. So when the Federal Reserve decides to increase quantitative easing or tightening, the holders of USD stablecoins feel the effects of that decision. The second variable is how they enforce the price peg. Fiat-backed stables generally do this by holding reserves and the use of a redemption system. This policy enables several benefits to users.

First, it makes it possible for people in countries experiencing hyperinflation to easily access the monetary policy of a country with a more inflation-resistant currency. Secondly, because the monetary policy is embedded in digital money with fewer intermediaries, the fees for sending and receiving are much lower than traditional fintech. Lastly, it provides a safe haven for a frictionless user experience in crypto asset trading.

Governance

These stablecoins are centrally controlled by business entities whose primary objective is revenue generation. For issuers like CENTRE, the entity generates revenue through the yield generated from the assets in reserve and transaction fees; however, the companies backing the entity have multiple business products with their own liabilities. If the issuer becomes too burdened by debt, there is a risk that they may pause or break their promise to honor redemptions — just like the federal government did for its gold reserves. The risk varies between different issuers as Circle uses trust accounts to protect users funds from being used to cover other liabilities.

And because these entities are centralized, they have the power to censor transactions and even freeze coins. For example, following the Office of Foreign Assets Control’s (OFAC) sanctioning of Tornado Cash, the USDC issuer froze all token transfers associated with the crypto mixer’s smart contracts. This commitment to unchecked and unilateral control eerily resembles similar measures in China already being used to enforce social credit scores, which can have a direct effect on users’ access to their assets and financial services. Monetary safety of fiat-backed stablecoins inherits the same degree of inflation of the underlying assets, and the potential for financial censorship and exclusion are native to the design.

Crypto-backed

Crypto-backed stablecoins are tokens that offer price stability through an overcollateralized backing of other cryptocurrencies — for example, holding at least $150 of ETH for every $100 of their stablecoin. The most popular crypto-backed stablecoin issuer is MakerDao. It uses a decentralized governance structure to set the parameters needed to collateralize its stablecoin, DAI, with USDC, ETH or approved ERC-20 digital assets.

The peg may be less consistent than fiat-backed stablecoins, because some of the reserves are non-stable assets locked in collateralized debt smart contracts. So because there is no centralized management of the reserves, it relies on free market forces to maintain buy and sell pressure.

Monetary policy

DAI collateralization requirements are denominated in USD in an attempt to peg the price to the US dollar. So even though the assets backing this stablecoin aren’t fiat, its holders still feel the effects of central bank policy makers. An important difference between crypto-backed and fiat-backed stablecoins is how policy decisions are determined and enforced.

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How it works

The stablecoin issuer collateralizes its currency through a series of lending smart contracts called the Maker protocol. It enables users to borrow DAI collateralized with ETH or other other ERC-20 tokens at a minimum of 150%. Borrowers who believe that the value of their collateralized assets will continue to grow benefit from holding DAI because it provides leverage and utility across the digital asset ecosystem.

However, this incentive for leverage only works if the borrower believes that the value of their collateral will rise. If it drops below the 150% threshold, it is automatically liquidated. So in bear markets, few users are incentivized to borrow DAI for the purpose of leverage. Instead, when digital assets are depreciating in value, the primary incentive for borrowing DAI is to use it to lockup illiquid assets for liquid ones.

Some argue that the demand to borrow DAI is not strong enough to issue enough DAI needed for it to scale. Their concerns are that there will always be greater demand to hold DAI as a safeguard against volatility than to borrow it.

Governance

DAI is governed by the Maker Foundation and its community of governance token holders. The Maker foundation is a centralized entity that plans to dissolve into independent and formally-elected risk teams and volunteer risk researchers. While there are elements of centralization in its governance, the ability for MRK token holders to vote on proposals makes the issuer far less centralized than fiat-backed stablecoins. Token holders are also able to stake and earn rewards from transaction fees. This helps incentivize governance but also introduces risk. If confidence in the governance token price drops, then key members may sell their tokens and stop participating.

Advocates of DAI argue that its decentralization makes it less exposed to insolvency risks and government censorship. The protocol is permissionless and no single entity can freeze tokens the way a centralized issuer can. However, the underlying USDC collateral does represent a blacklist risk. These safety protections are different from fiat-backed stablecoins; but it does introduce new smart contract and price oracle risks.

Algorithmic

Algorithmic stablecoins are tokens that attempt to achieve market stability through an automated mechanism that increases and decreases supply according to demand. This system is a fundamental departure from other types of stablecoins. It uses a collateral system that bakes wrong-way risk into the stablecoin.

They honor stablecoin redemptions through minting the equivalent dollar-denominated amount in its own self-referential token. Anytime a token is minted, the deposited token is burned.

Monetary policy

The monetary policy of algorithmic stablecoins is essentially another reflection of the fiat currency it is set to match and its on-chain mechanics for managing supply and collateral backing. The issuer of this type of stablecoin uses price oracles to monitor the exchange rate of their self-referential token to a fiat currency. That data is then used to determine how much of the self-referential token is needed to back one stablecoin to one fiat dollar.

How it works

This approach only works if there is enough market demand for both tokens. If the market has real use for them, whether through staking or a growing application ecosystem, then the demand for one helps increase the demand for the other. But if there is a sudden drop in utility of the stablecoin or referential asset, then the downward pressure of one token will hurt the value of the other — creating wrong-way risk.

Terra (UST) is the most famous example of an algorithmic stablecoin. It lost its peg after an extreme drop in UST demand in April of 2022 and never regained a one-to-one backing with the US dollar.

The stablecoin’s referential asset token was called LUNA. Terra (UST) maintained price stability through an automated system that promised to always mint $1 amount of LUNA for 1 UST. The demand for UST was largely propped up by a yield-generating lending platform called Anchor. At one point, it promised unprecedented lending yields of 20%. This promise was unsustainable, and as those yields began to drop to 2%-1%, there was a mass exodus of users selling their UST for better yield-bearing products. This created the equivalent of a bank run that flooded the market with LUNA. The rapid inflation of LUNA supply drove its price down, further increasing the mint needed to meet UST redemptions.

Governance

At Terra/Luna’s onset, the stablecoin issuer was claimed to be governed by an open community of Luna stakers. Anyone in that community could vote or submit proposals to make protocol upgrades and fund ecosystem projects. While this system was open and permissionless, the governance model was prone to centralization if too much staked luna is controlled by one entity. Terra/Luna’s collapse revealed that its governance put too much reliance on centralized actors, such as the Luna Foundation, to defend the peg.

Some argue that the lack of governance structure removed the necessary risk assessments needed to approve projects like Anchor. They argue that the community was too focused on immediate yields than long term growth. It is an example of how decentralized organizations don’t always capture the wisdom of the crowd. So while the stablecoin’s decentralized governance model protected users from censorship, it failed to keep them safe from monetary collapse.

Commodity-backed

Commodity backed stablecoins are tokens issued by central entities who promise to back the tokens in circulation with a commodity such as gold, oil or silver. Some promise a one-to-one backing, while others like Venezuela’s oil-backed stablecoin (Petro), do not disclose how much oil is held in reserves or how to redeem it.

The most popular commodity-backed stablecoin is Paxos Gold (PAXG). The issuer pegs its price to one fine troy ounce of gold in the London Good Delivery market.

Monetary policy

Unlike the previous categories, the monetary policy of commodity-backed stablecoins is a direct departure from the policy of fiat currencies. They represent a policy that is closer to the Bretton Woods gold standard.

How it works

The price-stabilizing process for commodity-backed stablecoins such as PAXG is very similar to fiat-backed stablecoins like USDC. They promise a one-to-one backing at all times and offer redemption without demanding a custodial fee. They only permit redemption for account holders and can only deliver their gold bars to vaults in the UK. To redeem PAXG for gold, the account holder needs at least 430 PAXG plus delivery fees.

The price of PAXG has consistently tracked the price of many gold ETFs. But since gold has greater volatility to reserve fiat currencies like USD and EUR, it hasn’t offered holders a currency they would want to use in day-to-day transactions. It, like bitcoin, is used more as a store of value and inflation hedge.

Governance

The governance of commodity-backed stablecoins can vary. Some, like Petro, are governed by sovereign governments, while others, like PAXG, are controlled by business entities incentivized by profit. The same counterparty and censorship risks of fiat-backed stablecoins apply.

Asset-backed, multi-collateral

Asset-backed, multi-collateral stable currencies can be collateralized with a basket of stablecoins such as DAI and USDC and crypto assets like stETH, wBTC, tokenized commodities, or even yield-bearing DeFi primitives like Curve and Uniswap liquidity provider tokens with exposure to stablecoins or crypto assets. In the future, it may even include tokenized loans, equities, bonds and real estate, to name a few.

Yield-bearing collateral baskets enable stakeholders of the currency to share in the revenue (e.g., a dollar with built-in APY), preserving purchasing power and potentially outperforming other financial indexes. The only platform enabling this approach with useful, fungible and decentralized stablecoins is the Reserve Protocol. The protocol enables any anon or doxxed entrepreneur, institution or government to permissionlessly design/deploy/govern a stablecoin for their specific “job to be done.”

In the long term, there could be one or more global reserve stable currencies with multitrillion-dollar market valuations. In the short term, with expanding programmability, easing technical requirements, and balanced innovation/protection regulatory regimes, this could enable a long-tail of stable currencies with market valuations at $100 billion, $10 billion or just $1 billion.

Monetary policy

Monetary policy decisions for collateral baskets, revenue sharing and safety mechanisms are determined by decentralized consensus executed through on-chain voting. And unlike central banks, if there are any mistakes in basket allocation decisions, the governors are the first capital at risk to cover or partially cover any losses.

How it works

“RToken” is a generic reference to any stablecoin issued on the Reserve Protocol. RTokens are 100% asset-backed stablecoins with dynamic collateral baskets and proof of reserves on-chain, 24/7.

Any yield generated by the collateral for RTokens is shared with the community, and overcollateralized in a surprising way, allowing RSR governance token stakers to provide backstop default protection (skin-in-the-game curation) in case of any specific collateral failure. RTokens are decentralized, each with its own governance participation by RSR stakers and the collateral baskets are composable with any ERC-20s spanning 60+ assets and DeFi protocols.

Anyone can visit Register.app, the block explorer for the Reserve ecosystem, and start the process to deploy an RToken and deposit collateral. And because the collateral is on-chain, the reserves are 100% transparent.

Governance

RTokens are governed by the community of more than 50,000 Reserve Rights Token (RSR) holders. RSR stakers can vote on RToken governance proposals and provide s collateral-backstop to earn a portion of the revenue and provide a safety mechanism in the event of a collateral failure. Should RToken collateral depreciation fall below a specific threshold, the protocol shifts to an emergency collateral basket, and for any shortfall during a potential depeg, RSR stakers could be required to cover the deficit to return the collateral basket to 100% backing.

This mechanism is fundamentally different from the algorithmic system UST used which relied on its endogenous LUNA token as collateral. RTokens rely on exogenous collateral for 100% backing, with emergency backup collateral automated on-chain, backstopped by RSR stakers.

The safety of RTokens are fundamentally different from all other types of stablecoins. Its permissionless protocol and diversification of assets makes it censorship resistant and reduces the counterparty risk. Should a portion of RToken collateral default occur (for example, if USDT were 20% of the basket and depegged) the protocol would swap the USDT and the staked RSR backstop collateral for the emergency collateral basket. Briefly the RToken would be below peg, yet the 100% redemption (collateral-backstop) outcome would be verifiably predictable on-chain. In the case where RToken collateral defaults and the collateral-backstop pool is spent with net collateral at 95% of target price, RToken holders equally take the haircut rather than a privileged first-come-first-served exit — this eliminates the bad debt without a hyperinflation event.

Reserve’s end goal is to “facilitate the creation of an asset-backed currency that is independent of fiat monetary systems.” The team wants to encourage permissionless innovation and competition to produce useful alternatives.

Even though fiat-backed stablecoins offer convenient options to countries with rapidly depreciating currencies, they don’t solve the root problem of money. The world has seen the greatest increase of monetary expansion of all time — resulting in record-high inflation in many counties. Unless fiat currencies stop being issued, this problem will always remain.

And because commodity backed stablecoins still experience market volatility, people need a stable currency alternative they feel comfortable spending at all times. They need a backing with a consistent and stable inflation hedge. Because no single asset can provide that, Reserve created a way to launch stablecoins that represent a basket of assets. Eventually, there could arise a global reserve currency that retains its value indefinitely, is not too volatile, and is outside the fumbling of geo-political and Big Tech manipulation.

The Reserve team does not intend to issue any RTokens directly and expects the RSV stablecoin (discussed in Part 1) that predates the permissionless protocol to be replaced with a true RToken from the community in early 2023. Additionally, MobileCoin has already announced plans to launch the first RToken, eUSD, which promises sub-penny fees, fast settlement, and private end-to-end encryption, once bridged to their blockchain.