What Are Digital Stablecoins and How Do They Work?

What Are Digital Stablecoins?

Digital stablecoins are digital currencies designed to maintain a value anchored to an external reference asset. In most cases, this benchmark asset is a fiat currency, such as the dollar, although some stablecoins may be pegged to commodities such as coffee. Unlike cryptocurrencies like Bitcoin or Ethereum, which can experience significant fluctuations on a daily basis, fiat stablecoins solve the problem of volatility in the crypto world.

The birth of stablecoins came in 2014 with the launch of BitUSD, followed by Tether (USDT), which has reached a market capitalization of over $160 billion. Currently, stablecoins are critical in various applications, from international remittances to decentralized commerce, while major regulatory developments such as the GENIUS Act in the U.S. have provided the necessary clarity for the industry.

How Stablecoins Work

There are three main stablecoin models that explain how they work:

1. Backed by Fiat

These stablecoins are backed 1:1 by real assets that are held securely in bank accounts or managed by custodians and top-of-the-line brokers. Tether, for example, holds mostly U.S. Treasuries and cash, while Circle holds about 80% of its reserve assets in Treasuries and 20% in bank deposits.

• PEG adjustment mechanisms are simple, arbitrage-based.
• Monthly audits verify that the value of reserves matches the value of tokens in circulation.

2. Backed by Cryptocurrencies

Unlike centralized stablecoins, MakerDAO’s DAI is a decentralized stablecoin that uses cryptocurrencies as a backing. Users can deposit $150 worth of ETH to receive $100 worth of DAI, maintaining a collateral ratio of 150% to absorb potential price fluctuations.

• If the value of ETH falls, an automatic liquidation is triggered to secure the loan.
• This model replaces traditional banking institutions with smart contracts.

3. Algorithmic

Algorithmic stablecoins operate using software that automatically adjusts the supply of tokens based on demand. For example, if demand increases, new tokens are created; if it decreases, the existing ones are eliminated. However, this model has proven to be risky, as evidenced by the TerraUSD crash in May 2022, which caused a huge loss of confidence.

• Dependence on user trust in the system.
• Experimental models that have not yet been tested on a large scale.

Importance of Stablecoins in Today’s Economy

Stablecoins have significant value in today’s economy, offering several advantages:

• Banking Alternative: They provide access to savings and dollar payments to 1.4 billion unbanked adults.
• Instant Global Payments: They allow you to send money anywhere in the world quickly and at a low cost.
• DeFi Infrastructure: Used as base assets in 65% of lending protocols.
• Inflation Protection: They provide access to more stable currencies in countries with high inflation.
• Programmable Functions: They allow for automatic transactions and scheduled payments using smart contracts.

Risks and Challenges of Stablecoins

Despite their benefits, stablecoins also pose risks:

• Centralization Risk: Issuers may freeze accounts or face regulatory pressures.
• Stress in the Market: Crypto-backed stablecoins are vulnerable to market downturns.
• Technical Failures: Algorithmic models can destroy their value during crises of confidence.
• Due Diligence: It is crucial to check recent reserve reports and redemption processes before trading.

With proper oversight, transparent reserves, and robust infrastructure, stablecoins are already serving millions of users securely. Therefore, its responsible implementation could transform the current financial landscape.

Source: TON