Stablecoins, a type of cryptocurrency, provide stability in volatile markets by maintaining a consistent value, typically pegged to fiat currencies such as the US dollar or commodities like gold. Purveyors of stablecoins may maintain their value by holding a reserve of assets that back the coin. For example, an issuer who created one million stablecoins tied to the US dollar might maintain one million actual US dollars in a secure bank reserve.

Reasons for stablecoins

Stablecoins offer stability in the volatile cryptocurrency landscape, appealing to users who desire a dependable store of value while still retaining key digital asset characteristics:

• Global accessibility: Like other other cryptocurrencies, stablecoins can be accessed globally by anyone with an internet connection, enabling seamless transactions across borders and around the clock.
• Efficient transactions: Transferring stablecoins is fast, cost-effective, and secure, thanks to their blockchain-based infrastructure. 
• Digital nativity and programmability: Stablecoins are inherently digital, allowing for programmable functionalities with smart contracts. This programmability makes stablecoins versatile tools for developing innovative financial products and services tailored to specific needs.

Mechanisms of stability

Stablecoins employ various mechanisms to maintain their stability. The most prevalent mechanisms include:

• Fiat-collateralized stablecoins: These stablecoins are backed by reserves of fiat currency often held in banks. For every stablecoin issued, there is an equivalent amount of fiat currency held in reserve. Examples include USDC, which claims to be backed one-to-one by US dollars.
• Crypto-collateralized stablecoins: Instead of fiat reserves, these stablecoins are backed by a reserve of other cryptocurrencies. Smart contracts govern these systems, ensuring that the value of the collateral consistently exceeds the value of the stablecoins issued. DAI, pegged to the US dollar and collateralized by Ethereum, is a prominent example.
• Algorithmic stablecoins: These stablecoins leverage algorithms and smart contracts to adjust the supply dynamically, maintaining a stable value. The most notable example of an algorithmic-stabilized stablecoin is FRAX, which at the time of writing is transitioning away from algorithm reliance.

Not all stablecoins fall into one bucket, as stablecoins can be backed by anything, including precious metals like gold. Certain stablecoins adopt hybrid approaches, utilizing multiple types of reserves. For instance, Ondo Finance offers stablecoin-like tokens that are backed by short-term US treasuries, money market funds, and bank deposits. Stablecoin alternatives, like Ondo Finance’s products, can offer exposure to yield-generating assets while remaining liquid and usable. The Sui ecosystem will soon see such products available for use.

Use cases of stablecoins

Stablecoins serve a variety of purposes across different sectors:

• Trading digital assets: Stablecoins are an essential element to the onchain trading environment. Traders often use stablecoins in trading pairs and also treat them as a hedge against the volatility of other cryptocurrencies.
• Decentralized finance (DeFi): Stablecoins play a fundamental role in the burgeoning DeFi ecosystem. They serve as a stable medium of exchange and store of value within decentralized lending platforms, liquidity pools, and decentralized exchanges.
• Merchant payments: Some merchants accept stablecoins as a form of payment, offering an alternative to traditional payment methods while avoiding the volatility risks associated with cryptocurrencies.
• Remittances and cross-border payments: With stablecoins, individuals and businesses can conduct cross-border transactions swiftly and inexpensively, bypassing the delays and fees associated with traditional banking systems.

Risks in stablecoins

When considering the risks associated with stablecoin usage, there are two obvious aspects that must be considered. First, when reserves are held with a bank or another third party without transparency, the concern of counterparty risk arises. This risk involves questioning whether the entity truly holds the collateral it claims. This matter has been widely debated concerning the credibility of certain stablecoin issuers' claims of maintaining a one-to-one backing.

Secondly, cryptocurrencies were designed to eliminate the need for intermediary companies that traditionally handle users' funds. Intermediaries inherently have control over these funds. For instance, they can usually halt or reverse transactions upon user request. While this aspect is often seen as advantageous for blockchain technology, users unfamiliar with this responsibility may be taken aback when attempting to stop or reverse a transaction.

From old to new

Stablecoins emerged as a vital component of the cryptocurrency ecosystem, appealing to users seeking a reliable store of value. They bridge the traditional finance world, with its generally trustworthy notions of value, and cryptocurrency, which offers technical security. 

Stablecoin versatility extends to remittances, trading, DeFi, and beyond, contributing to the growing adoption of blockchain technology. Yet, challenges remain inherent in any new technology. As the landscape continues to evolve, a deeper understanding of stablecoins and their mechanisms is essential for investors, regulators, and stakeholders alike.

Note: This content is for general educational and informational purposes only and should not be construed or relied upon as an endorsement or recommendation to buy, sell, or hold any asset, investment or financial product and does not constitute financial, legal, or tax advice.