What are stablecoins and how do they work?

A stablecoin represents an IOU in the form of a token on a blockchain. If you’re the owner of a $1 token, it means it should be possible for you to exchange this token for $1 in USD fiat. It is this trust in your ability to redeem the token into the underlying asset that ensures its value. As we get into elsewhere, there are a few different mechanisms out there to ensure this holds true, some more risky than others.

Most of these mechanisms are comparable to how for example a money market fund would operate, by holding short term low risk highly liquid assets. The key difference is that stablecoins are issued on-chain, and this brings with them a host of useful features. Programmable money is one of these features.

How does a stablecoin operation work in practice? The simplest operational model is simply to accept money from someone who wants to obtain new stablecoin tokens. You put that money into a bank account and in return you create new stablecoins (minting process) through a smart contract, and transfer those to the entity or person that gave you the money initially. At that point they are free to trade and transfer these tokens with others (assuming the smart contract allows them to), and everyone’s happy that the tokens are sufficiently backed. You might collect the interest on the bank account, or it could be passed on.

Because such stablecoins don’t operate fully decentralized, as there’s money in a bank account somewhere, there’s an element of trust required. This is why it is important that centralized stablecoins like these are following and making available proper audits. This becomes even more important if the assets backing the tokens are more complex than just money in an account.

The above describes the minting process, i.e., the method used to collect the initial collateral and then issue tokens on a blockchain. That’s not even half the story however, because, even if you don’t participate directly in the minting process by providing collateral, you can still use these stablecoins by buying them on the secondary markets. There are many reasons for doing, including:

  • Traders wanting to sell a more volatile asset, but still keep all assets on the blockchain
  • Stablecoins might be used in other smart contracts, for example as collateral to enable borrowing and lending of other on-chain assets
  • Instead of using the existing correspondent banking system for money transfer, especially cross-border, a cheaper, faster or more deterministic option could be via stablecoins

One important thing to realize when stablecoins are traded on the secondary market, is that the individuals or smart contracts involved in this exchange do not typically have a direct relationship with the issuer. That means that they couldn’t usually redeem their stablecoins for the underlying asset without first going through the process of registering with the issuer. This also means that most users of stablecoins, instead of redeeming them, actually sell them for fiat on a centralized exchange if they wanted to take the money out of the blockchain system. Assuming there’s enough liquidity, this is likely easier than redeeming the underlying, as that would require a KYC process + additional redemption fees from the issuer.

The above describes the minting, trading/usage and redemption process of stablecoins. While the examples have been against USD fiat, it’s important to understand that stablecoins can have any asset as its underlying, including for example other cryptocurrencies or commodities. Gold can be used to mint tokens that then follow the price of gold. Same can be done for agricultural, livestock, energy, metals, or any other tradable asset and commodity. This then enables these assets to participate in the decentralized blockchain ecosystem, to be used in smart contracts, and to benefit from easy transfer of ownership, etc.