Stablecoins: Neither Stable Nor Decentralized

Most cryptocurrencies have valuations set by the market. For example, Bitcoin's price is set by supply and demand, which contributes to its famous volatility. Other cryptocurrencies, like Ethereum, are less volatile but also experience variability.

Stablecoins are designed to address the volatility issue by pegging the value of a cryptocurrency to a fiat asset. However, their values aren't as stable as they seem, and they accomplish this goal by sacrificing the decentralization that is one of the founding concepts of Web3.

Stability and Decentralization are a Tradeoff

Stablecoins work by pegging the value of a cryptocurrency to a fiat asset, like the US Dollar (USD). Ideally, this ensures that the value of the cryptocoin maps 1:1 to the fiat asset, protecting its value.

Stablecoin issuers need to keep a reserve to maintain their pegs. There are a few different ways of accomplishing this:

• Fiat Collateral: The simplest and safest way to do so is to hold reserves of the fiat asset at a 1:1 (or greater) ratio to their issued coins. When someone deposits a USD, a new token is minted. When this token is burned, the user can withdraw the backing asset. This model is stable, but a single authority holds the reserves and issues the tokens. The stablecoin issuer can unilaterally freeze assets, as Circle (USDC) has demonstrated in the past.
• Crypto Collateral: Some stablecoins will keep a mix of digital and fiat assets in their reserves, hoping that the value of these reserves meets or exceeds that of issued tokens. This model is more decentralized, but market volatility poses a serious risk to the ability to honor withdrawal requests. If these requests aren't fulfilled, the stablecoin loses its peg and can spiral downward.
• Algorithmic Stablecoins: Algorithmic stablecoins aren't fully backed, instead minting or burning a companion token to maintain the peg based on market pressure. This model is the most decentralized but can fail badly, as in the case of Terra/UST going to zero in May 2022.

Balancing the Risks of Stablecoins

Stablecoins are marketed as offering the best of both worlds: the stability of fiat assets and the decentralization of cryptocurrency. In reality, tradeoffs are made, accepting centralization for greater stability or vice versa.

Stablecoins have significant benefits and are the reason why many institutions are entering the Web3 space. However, it's important to understand how they work and where a particular coin falls on the decentralization-stability continuum and the implications of this choice.

Educational content, not legal, financial, investment, or professional security advice. Terms