Cryptocurrency: What are Stablecoin Mechanisms?

A stablecoin is a cryptocurrency that attempts to maintain a fixed or ‘pegged’ price in terms of another asset. For example, the cryptocurrency may peg its value to USD, say at a one-to-one (1:1) ratio, so that each unit of the stablecoin is worth 1 USD. As such, a stablecoin system is very similar to a fixed exchange rate regime in foreign exchange markets.

Moreover, fixed exchange regimes can take different forms; the gold standard, for example, was a different method for fixing exchange rates compared to what countries employ today. Similarly, there exist a variety of different ways in which stablecoins can operate.

The pegged price characterizes the price the stablecoin attempts to attain. In reality, agents can trade with each other at any price they choose, which represents the market price. The market price is determined by forces of demand and supply. At any point in time, the market price may be different than the pegged price. So, there must exist some alignment mechanism that ensures that the market price remains close to the pegged price.

Stablecoins vary on the basis of the asset to which the stablecoin is pegged for determining its price. The most common peg is to the USD; examples include Tether (USDT), USD Coin (USDC), Binance USD (BUSD), TrueUSD (TUSD), Dai (DAI), Paxos (PAX), Ampleforth (AMPL), Synthetix (SNX), and so on. All of these are pegged to the USD 1:1, even though they may vary considerably in terms of their structure and how they function.

While a large proportion of stablecoins use USD as the asset they are pegged to, other alternatives exist. As an example, Terra (LUNA) proposes to be a ‘family of cryptocurrencies’, with each member pegged to a major currency – USD, EUR, CNY and so on. The peg need not be to a currency; Digix (DGX), for example, is pegged to gold, with each DGX representing one gram of gold. You can keep track of various stablecoins here.

The asset that backs the value of the stablecoin is the reserve or collateral for the issuance of the stablecoin. The reserve asset may be, and often is, the same as the asset that the stablecoin is pegged to. There are, however, instances where the reserve asset is different from the asset to which the stablecoin maintains a peg. There have also been attempts to issue stablecoins without a reserve asset.

Reserves are important because they provide something of value backing the exchange of a stablecoin. So, when an agent deposits some reserves (say USD) with a stablecoin treasury, they are entitled to an amount of the stablecoin determined by the pegged price. Similarly, agents may wish to exit their positions in the stablecoin and redeem the reserve asset. There have to be enough reserves to support the stablecoin in circulation at the pegged price, which lends credibility to the value of the stablecoin.

Depending on the nature of the reserve asset, or its absence, stablecoins can be classified into primarily three categories:

1. Fiat-collateralized (or fiat-backed) stablecoins: These are stablecoins that use a national currency as an off-chain reserve asset. USDT, for example, is backed by USD reserves that are held by third parties (like banks). A central entity (Tether Limited) acts as the custodian of the process by ensuring that USDT is minted (or destroyed) when agents deposit (or redeem) USD with the Tether treasury. As such, there may be a significant degree of centralization involved with fiat-collaterized stablecoins. In the case of Tether, this has led to questions over its auditing process and transparency. TrueUSD (TUSD) attempts to resolve this problem through a real-time auditing process. The main advantage of a fiat-collaterized mechanism is the simplicity of its operation. Other examples of fiat-collaterized stablecoins include USDC and BUSD.
2. Crypto-collaterized (or crypto-backed) stablecoins: These stablecoins are backed by other cryptocurrencies as the reserve asset. One of the main advantages of this is that the reserves are held on-chain, which takes away the need for third parties such as banks to hold the reserve asset, and consequently increases transparency. An example of a crypto-collaterized stablecoin is DAI, which is pegged 1:1 with USD, but reserves are held in cryptocurrencies such as ETH, wrapped BTC and so on. The main problem with a structure such as DAI’s is that the volatility of ETH in terms of USD requires excess reserves or ‘over-collaterization’ to stabilize the system.
3. Non-collaterized stablecoins: Non-collaterized stablecoins do not hold reserves; rather, they rely on algorithms to keep the market price stable. This presents a decentralized model for a stablecoin, without a need to ensure that enough reserves exist in the system at all times to support the stablecoin in circulation. The main problem with the absence of any asset of value backing the stablecoin, however, is the risk of collapse if users lose confidence in the effectiveness of the algorithms maintaining the price. Examples of non-collaterized stablecoins include AMPL and Empty Set Dollar (ESD).

Apart from these three main categories, a fourth category which is far less common at this stage is a commodity-collaterized (or asset-collaterized) stablecoin. This relies on reserves of a commodity such as gold, or some other asset. DGX is an example of this.

Depending on the structure of the stablecoin in terms of the pegged and reserve assets, different stablecoins use different mechanisms to align the market price with the pegged price.

The simplest mechanism is arbitrage, where agents take advantage of any discrepancy between the pegged price and the market price in order to make profits. USDT, for example, relies on arbitrage to maintain the peg. Suppose 1 USDT is trading for 0.9 USD in the market. An arbitrageur can purchase 1 USDT in the market (for USD 0.9) and then sell it to the Tether treasury for the fixed price of USD 1 (that the Tether treasury always stands ready to honor), thereby making a profit of 0.1 USD. As arbitrageurs buy USDT in the market to make such profits, the demand for USDT rises, and increases its price upwards from 0.9 USD. This process of arbitrage stops only when the market price equals the pegged price, at which point arbitrageurs can no longer make profits. It is straightforward to construct a similar argument in the reverse direction when the market price for USDT equals, say, 1.1 USD, and show that the process of arbitrage will set in motion changes that bring the market price back towards the pegged price.

Other systems like DAI (crypto-collaterized) or AMPL (non-collaterized), can rely on arbitrage, but also include more complicated and elaborate mechanisms to align the market price with the pegged price. For instance, these systems may change certain parameters, such as interest rates on borrowing and lending, in order to achieve the alignment.