How Do Top Stablecoins Work?

In the world of modern cryptocurrency trading, stablecoins hold a very crucial role. It doesn’t simply serve as the hedge against cryptocurrency volatility but also with other attractive use cases. For example, many people lock their stablecoins to DeFi protocols such as Curve Finance in order to “farm” DeFi tokens like CRV. They then can sell these DeFi tokens for more profits apart from the interests that they get by lending their stablecoins.

People who trade stablecoins can also easily send payments to remote freelancers all over the world. Unlike Bitcoin, Ethereum, and others that have become very volatile recently, paying with stablecoins reduces the headache and fear of price volatility. Many altcoin projects also often pay their own team members with stablecoins. Outside the usual crypto transactions, stablecoins can also serve as a wire transfer replacement.

I’ll give you an example. You can redeem USDC tokens to Circle (USDC issuer) and get real US dollars wired into your bank account. This use case is pretty big as you can live somewhere else and still get the money wired to your bank account (and then, you can use your bank’s debit card to cash out fiat from an ATM machine in another country).

But, have you ever wondered what the underlying technology is behind these stablecoins? Yes, we all know they have great use cases, and these use cases keep on expanding. But, is it truly stable and safe?

The Summary

There are four most popular cryptocurrencies. USDT, PAX, BUSD, and USDC. They work with the bank account method. Basically, these stablecoin issuers have real bank accounts where they store the US Dollars. So, for every stablecoin token that they issue on the blockchain, they have the real dollar to back it up in the real bank account. 

The idea is that everybody should be able to redeem their tokens easily. For example, if Ben wants to exchange $10,000 USDC to Circle (USDC issuer), Ben will receive real $10,000 USD wired to his bank account. It’s the same with the opposite scenario. If Ben sends $10,000 USD wired to Circle, Circle will then issue $10,000 USDC to Ben’s crypto wallet.

Because of this bank account method, USDT, USDC, PAX, and others are able to maintain their peg 1-to-1 to the US Dollar. However, this method has been widely criticized by crypto maximalists for having a single point of failure (which is the issuer’s bank account).

An alternative to this bank account method is having a stablecoin that’s algorithmically designed to have a stable price 1-to-1 to the USD. The most popular stablecoin born from this concept is DAI. DAI uses ETH and USDC as collaterals. And because the value of ETH that’s locked into its protocol is overcollateralized, they can make the price stable as long as the liquidity is there. Many crypto maximalists prefer DAI to USDT or USDC due to its more decentralized nature (it works without a bank account).

What Are The Risks?

However, these stablecoins do not work without risks. While it sounds very appealing to have a dollar on the blockchain that you can move anywhere and anytime you want, there are still risks associated with them. And everybody should know them.

For example, what happens if many crypto traders and exchanges try to redeem their stablecoins at the same time to the stablecoin issuers? In this case, the stablecoin issuers might try to block the withdrawal attempt due to lack of real USD liquidity. Sure, some of these issuers are regularly audited by top auditing companies, but the banks that partner with them might try to question the withdrawal attempts if they consider it as “bank run” moments. 

We all know that traditional banks use the fractional reserve banking strategy for quite some time. With the amount of stablecoins kept getting bigger, it’s very possible the banking partners might not have enough cash to pay everybody.

Unfortunately, this issue is not solved by a more decentralized stablecoin like DAI, either. The thing is that DAI itself has added USDC (a centralized stablecoin) as part of its collaterals in 2020 after it got very popular in the DeFi industry. 

Whether we will ever have a day like this where crypto traders attempt to do bank runs from stablecoin issuers, we don’t know yet. It might happen one day, it might not. It’s still important to understand how stablecoins work and what are the associated risks with them.