Mechanics and Stability of Stablecoins: An In-depth Analysis

Key Points:

• Stablecoins have become important in the crypto industry, accounting for over 70% of centralized exchange trades.
• The value of asset-backed tokens is in their stability and resistance to destabilizing factors.
• They are kept stable through various mechanisms, such as algorithmic control and reserves.

Stablecoins, also known as pegged cryptocurrencies or asset-backed tokens, are exciting and innovative solutions to the challenge of volatility in the crypto market. When preserving financial value or making low-cost transactions, crypto traders often prefer holding, buying, and selling asset-backed tokens over other coins in the market. The introduction of asset-backed tokens has also opened up many opportunities in the industry.

What Are Stablecoins?

Stablecoins are a type of cryptocurrency pegged to the value of fiat currencies such as the USD, GBP, and EURO, or some other commodity such as gold and silver. They are pegged because an equivalent amount of the fiat currency or commodity is usually deposited in an audited reserve as collateral for stablecoins. The trading rate of an asset-backed token is kept pegged to the value of the fiat currency to maintain its status and value in the crypto market. They are privately issued, stored, and transferred on distributed ledger technology (blockchain).

Like other coins widely used for crypto trading, they are subject to the typical crypto and blockchain properties, features, and challenges. But they offer more in preserving value; this ability is maintained by keeping them fixed. There are several important and commonly used tokens like USDT, USDC, BUSD, UST, and USDP. The key questions to ask are: how stable are stablecoins? By what mechanisms are they kept fixed?

The Stability of Stablecoins

Their stability is a two-part affair that accounts for the price of the fiat peg and the volatility of the crypto market. If, for instance, the USD exchange rate increases against other currencies, the trading price of a USD-pegged stablecoin such as USDT may not increase, but the intrinsic value increases because the value of the USD increases.

The stability of asset-backed tokens depends on several factors, such as supply (liquidity) and demand, the integrity of the issuer, regulations, and the quality of the collateral. They are generally kept non-volatile by increasing or decreasing the amount in circulation or the collateral asset deposited in reserves. Issuers achieve these through the following ways.

Algorithmic Control

Algorithmic controls stabilize pegged cryptocurrencies by adjusting their relative supply to control price. These assets are called algorithmic stablecoins. The issuers deploy programs to monitor the supply and add or remove them from the supply to keep the price pegged to the fiat currency or commodity. But they may also not be linked to any asset; the computer program adjusts the supply to control price but has no reference reserve asset to monitor.

In most cases, algorithmic stablecoins have a high level of stability, but they can break their peg; as USDC showed, this method has flaws and could cause massive drops in value and an eventual de-pegging of the asset.

Fiat Collateral

Fiat-collateralized stablecoins are pegged to fiat currencies or commodities, with physical reserves of the pegged assets. Such reserves are usually held in third-party custody and are regularly audited to maintain integrity. They are primarily kept non-volatile by increasing or decreasing the volume of reserve assets, as they are usually pegged at parity. USDT and USDP are good examples of this. For each USDT minted, an equivalent amount is deposited in reserves. If the price of USDT falls or hikes due to the demand level, the issuers can mint more USDT and add more USD to the reserves.

Crypto Collateral

Some are collateralized with other cryptocurrencies instead of fiat or commodities. They are backed by deposits or holdings of those other tokens, which may be volatile. To overcome the volatility challenge, the issuers typically use assets worth far more than the stablecoins. This creates a price buffer that keeps prices consistent. For example, $5 million worth of coin A may be used as collateral for $2 million worth of asset B. Crypto-collateralized tokens are non-volatile but may be at risk if sudden market events cause the backing assets to fall below a critical price level.

Correction of Price Drop In Stablecoins

When it comes to the stability of stablecoins, price correction is noticeable by observing hourly and daily reports. If you check the price of any five assets pegged to the USD in parity, you’ll find at least one that trades at $0.99.

The stability of pegged cryptocurrencies does not mean their prices don’t fall short of the pegged currency. Still, they are usually quickly corrected to keep the market consistent, as extended price fluctuations may cause ripple effects. Price correction ensures the market can maintain its integrity and help crypto traders protect their financial value from volatility.

As a crypto trader, pegged cryptocurrencies are excellent for withdrawing your profits or saving for long-term targets. Regulatory concerns, privacy, and stability are vital issues that affect them; this is seen with the delisting of several cryptocurrencies in previous years and announcements of delisting plans for others. You should keep abreast of developments that impact them and how traders can use them. You can keep up with the latest stablecoins news to know the regulatory status as they unfold.

DISCLAIMER: The information on this website is provided as general market commentary and does not constitute investment advice. We encourage you to do your own research before investing.