What are Stablecoins? - Understanding the Basics

Stablecoins are a promising development in the cryptocurrency ecosystem, and maybe even the broader economy, but how do they really work?
by Yoaquim Boom
March 14, 2023

Stablecoins have emerged as one of the most promising applications of blockchain technology.

They offer a stable value and combine the best of both worlds - the transparency, immutability, and security of blockchain, and the stability of fiat currencies. In this article, we will explore what stablecoins are, how they work, their purpose, risks, and recent examples of stablecoin collapses.

What are Stablecoins?

A stablecoin is a type of cryptocurrency that aims to maintain a stable value. Unlike traditional cryptocurrencies like Bitcoin or Ethereum, whose value can fluctuate wildly, stablecoins are designed to provide stability, making them useful for day-to-day transactions, trading, and as a store of value.

There are three main types of stablecoins: algorithmic, crypto-collateralized, and fiat-collateralized.

Algorithmic stablecoins: Algorithmic stablecoins use complex algorithms to maintain price stability.

For example, an algorithmic stablecoin might use a smart contract to automatically increase or decrease the supply of tokens based on the demand. Examples of algorithmic stablecoins include Basis Cash, Seigniorage Shares, and Frax.

Crypto-collateralized stablecoins: Crypto-collateralized stablecoins are backed by other cryptocurrencies.

This type of stablecoin maintains its value by holding a reserve of a more volatile cryptocurrency, which is used as collateral. The value of the stablecoin is directly linked to the value of the collateral cryptocurrency. Examples of crypto-collateralized stablecoins include Dai, Synthetix, and BitUSD.

Fiat-collateralized stablecoins: Fiat-collateralized stablecoins are backed by traditional currencies like the US dollar, the euro, or the yen.

These stablecoins are pegged to the value of the underlying fiat currency, and each unit of stablecoin represents one unit of the underlying currency. Examples of fiat-collateralized stablecoins include Tether (USDT), USD Coin (USDC), and TrueUSD (TUSD).

How do Stablecoins Work?

The working of stablecoins depends on the type of stablecoin. Let's take an example of Tether (USDT), which is a popular fiat-collateralized stablecoin.

Tether (USDT) is pegged to the US dollar, which means that each USDT is worth one US dollar.

To ensure that the value of USDT remains stable, Tether Limited, the company behind USDT, holds a reserve of US dollars in a bank account.

For every USDT that is issued, an equivalent amount of US dollars is held in reserve. If the demand for USDT increases, Tether Limited can issue more USDT, and if the demand for USDT decreases, Tether Limited can buy back USDT from the market and destroy them, thereby reducing the supply of USDT and maintaining its value.

The Purpose of Stablecoins and Why They Are Important to Crypto

Stablecoins offer several benefits to the crypto industry. Firstly, they provide stability to the crypto market, making it easier for traders to enter and exit positions without worrying about the volatility of other cryptocurrencies.

Secondly, they enable the use of blockchain technology in everyday transactions, such as buying groceries, paying rent, or booking flights.

Thirdly, they provide a hedge against inflation and economic uncertainty, making them a useful store of value. Finally, they enable cross-border transactions without the need for a third-party intermediary, making them faster, cheaper, and more transparent.

Risks of Stablecoins

Despite their benefits, stablecoins also come with risks. One of the biggest risks is the potential for stablecoin issuers to engage in fraudulent or unethical behavior.

For example, if a fiat-collateralized stablecoin issuer were to engage in fraudulent behavior, such as misrepresenting the amount of fiat currency held in reserve, the stablecoin could collapse in value.

There have been several instances of stablecoin collapses in the past. One notable example is the collapse of the stablecoin issuer Bitfinex in 2016.

Bitfinex, which issued the stablecoin Tether (USDT), was hacked, resulting in the loss of over $72 million worth of Bitcoin. In order to cover the losses, Bitfinex allegedly used funds from Tether's reserve to prop up the value of USDT, leading to concerns about the stability of the stablecoin.

Another potential risk associated with stablecoins is regulatory uncertainty.

Due to the relative novelty of stablecoins and their potential impact on the traditional financial system, regulators around the world are still grappling with how to classify and regulate them.

Some countries, such as the United States, have taken a relatively hands-off approach to regulating stablecoins, while others have banned their use altogether.

Additionally, stablecoins may be subject to cybersecurity risks. As with any digital asset, stablecoins can be vulnerable to hacking and other cyber attacks.

If a stablecoin platform is hacked or otherwise compromised, it could result in a loss of funds for users. While many stablecoin platforms have implemented robust security measures, such as multi-factor authentication and encryption, the risk of a breach is always present.

Finally, there is also the risk of market manipulation. Stablecoins are often traded on cryptocurrency exchanges, which can be subject to market manipulation.

If a single entity or group of entities were to gain control of a significant portion of the market for a particular stablecoin, they could potentially manipulate the price in their favor, leading to losses for other investors.

Stablecoin Collapses

While stablecoins have the potential to provide stability to the volatile cryptocurrency market, they are not immune to failure.

In fact, there have been several instances of stablecoin collapses in recent years.

One high-profile example is the collapse of Tether, a fiat-collateralized stablecoin that was once the most popular stablecoin in the market.

In 2018, concerns were raised about the backing of Tether's reserves, and the company later admitted that only 74% of its tokens were backed by cash and equivalents.

This led to a sharp drop in Tether's price and sparked a wider sell-off in the cryptocurrency market.

Another example is the collapse of Basis, an algorithmic stablecoin that raised over $133 million in funding.

Basis aimed to maintain stability by adjusting its supply in response to changes in demand, but the project was ultimately abandoned due to regulatory concerns. Investors in Basis ultimately lost their entire investment.


Stablecoins have emerged as an important tool in the cryptocurrency ecosystem, providing stability and predictability in a market that is otherwise known for its volatility.

Whether they are algorithmic, crypto-collateralized, or fiat-collateralized, stablecoins allow investors to hedge against cryptocurrency volatility and transact with greater confidence.

However, stablecoins are not without their risks. From regulatory uncertainty to cybersecurity threats to market manipulation, investors should be aware of the potential risks associated with stablecoins before investing.

Additionally, the collapse of Tether and Basis demonstrate that stablecoins are not immune to failure, and investors should conduct thorough due diligence before investing in any stablecoin project.

Overall, stablecoins are a promising development in the cryptocurrency ecosystem, but investors should approach them with caution and always do their own research before making any investment decisions.