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Stablecoins: Digital Dollars

9 min
beginner

The problem stablecoins solve

ETH can drop 20% in a week. Bitcoin has fallen 50% in a few months. If you are a freelancer getting paid in crypto, or a business accepting crypto payments, this volatility is a problem.

Stablecoins target a reference value, often one US dollar. Their market price can still move away from that target. Reserve assets, redemption access, collateral rules, and issuer permissions determine how the peg is supported.

Three ways to stay stable

There are three approaches to keeping a token worth $1. Each has trade-offs.

Fiat-Backed USDC, USDT $1 token = $1 in a bank Reserves: cash + Treasuries Audited monthly ✓ Simple and reliable ✓ Easy to understand ⚠ Centralized (company) ⚠ Can freeze accounts Crypto-Backed DAI $1 token = $1.50+ of crypto Over-collateralized in ETH Smart contract enforced ✓ Decentralized ✓ No company can freeze it ⚠ Complex mechanism ⚠ Liquidation risk if ETH crashes Algorithmic UST (failed), FRAX $1 token = supply/demand algo No physical backing Code adjusts supply ✓ Fully decentralized ✓ Capital efficient ⚠ Can collapse (UST lost $40B) ⚠ Unproven long-term

Fiat-backed: USDC and USDT

The simplest model. A company holds real dollars (and Treasury bonds) in a bank. For every USDC in circulation, there is $1 in reserves. When you want to redeem, the company burns the token and sends you dollars.

USDC is issued by Circle and backed by reserves. Consult Circle's current reserve disclosures and independent assurance reports; an attestation about reserves is not the same as an audit of the issuer's entire business.

USDT (issued by Tether): The largest stablecoin by market cap. Has faced scrutiny over its reserves transparency but remains the most traded crypto asset by volume.

Crypto-backed: DAI

DAI uses smart contracts instead of a company. To create DAI, you lock up ETH (or other crypto) worth more than the DAI you mint. If you want $100 of DAI, you lock up at least $150 of ETH as collateral.

If the value of your collateral drops too low, the smart contract automatically sells it to protect the system. This is called liquidation.

Algorithmic: the risky experiment

Algorithmic stablecoins use code to adjust supply. When the price rises above $1, the algorithm mints more tokens. When it drops below $1, it burns tokens.

In May 2022, the algorithmic stablecoin UST (Terra) lost its peg and collapsed from $18 billion to near zero in days. Its companion token LUNA went from $80 to $0.0001. This event shook the entire crypto market and led to tighter regulation.

Comparing stablecoins

Stablecoin What to examine
USDT Reserve disclosures, redemption terms, and issuer controls
USDC Reserve disclosures, redemption terms, and supported networks
DAI Collateral composition, governance, and liquidation rules
FDUSD Reserve disclosures and redemption eligibility

Circulating supply and transfer volumes change over time. Use a dated dataset when comparing adoption, and distinguish trading volume from on-chain transfers.

Key takeaways

  • Stablecoins are tokens designed to hold a steady $1 value, solving crypto's volatility problem.
  • Fiat-backed (USDC, USDT) are the simplest and most widely used - backed by real reserves.
  • Crypto-backed (DAI) are decentralized but complex, requiring over-collateralization.
  • Algorithmic stablecoins have a poor track record - UST's $40B collapse is a cautionary tale.
  • Stablecoins are critical infrastructure for DeFi, payments, and cross-border transfers.

Quiz: Stablecoins: Digital Dollars

1 / 5

Why do stablecoins exist?