Stablecoins 101

There are three broad functions of money: store of value, medium of exchange and unit of account.

Most cryptocurrencies were meant to serve as a medium of exchange, however due to the relatively small market cap, most cryptocurrencies tend to experience wide fluctuations in price. The smaller a market cap an asset has, the more volatile its price (throwing a rock into a small pond vs same rock into the ocean), the more it’s affected by everyday buy/sell orders.

This presents a problem. You can’t enjoy the benefits of decentralisation without the volatility - using BTC in everyday transactions means one day something costs x, and the next half that.

Stablecoins are an attempt to create a cryptocurrency that isn’t volatile - where its value is pegged to a real world currency, ideally redeemable 1:1.

Stablecoins are broadly split into a few groups:

Fiat-backed: digital representations of traditional fiat currencies e.g. GBP. Backed 1:1 by real cash or short-term government bonds, these stablecoins represent over 90% of the market (usdt, usdc, gbpt) and focus on institutional scale and compliance. The core of the smart contract logic here, is the minting of new stablecoins in exchange for a deposit of fiat, conversely to redeem the deposit is released and the burn function is called, taking the digital representation out of circulation.

Yield-bearing: instead of holding static cash in reserves, some stablecoins try to earn a return and pass it onto the holder - e.g. USDe, uses strategies to capture market premiums. These stablecoins focus on capital efficiency and passive returns.

Crypto-backed: unlike fiat backed, these are backed by other cryptocurrencies such as ETH. Because that collateral is more volatile than fiat, they tend to be overcollateralised so the token can still target a $1 peg. This means the value of the collateral needs to be constantly monitored, but on the other hand, they don’t rely on a single party to issue and burn tokens, or another party to audit the reserves. They therefore remain fully transparent and decentralised, but also have low capital efficiency.

Algorithmic: these stablecoins aren’t backed by any other asset. Instead the issuing company acts as a central bank (as with monetary policy) and writes a set of rules into smart contracts, and the algorithm increases or decreases the amount of tokens in circulation depending on price. When demand collapses, the rules can fail - Terra/UST has become a cautionary case.

Every type of stablecoin has to balance three main goals: price stability, capital efficiency and decentralisation. This is known as the stablecoin trilemma. Pick two and the third usually weakens. Fiat-backed buys stability and scale by leaning on issuers and audits; crypto-backed buys decentralisation by locking more capital; algorithmic designs chase all three and often break under stress.

So where are we today?

The ‘wild west’ era is over, with regulators stepping in to audit reserves, mandate reserve custody frameworks and token issuance caps: MiCA in Europe, the GENIUS act in the US, Digital Assets Regime in the UK and Stablecoins Ordinance in Hong Kong.

The stablecoin landscape has matured from primarily being used by traders on exchanges to lower their risk into a critical piece of global payment infrastructure, with monthly on-chain transfer volumes cited around $7.5 trillion - more than Visa’s payment volume, and far faster than US ACH (primary electronic network used in the US for domestic money transfers, taking 1-3 business days to settle) or BACS (traditional UK batch network used for processing direct debits and payroll, taking 3 business days to settle).

The primary way this works is the inherent lack of intermediaries on blockchain networks. Instead of payments bouncing through correspondent banks, each adding fees, FX markup, and delay - value moves wallet-to-wallet on a shared ledger, with settlement in seconds rather than days.

Where is this volume coming from?

A case from the inception of stablecoins was hyperinflation. If you live in a country with hyperinflation, or unstable local banking systems you can convert your rapidly deflating local currency to a digital dollar. Then, the world of remittances. Instead of paying Western Union about 10% and waiting days, you can move digital dollars across borders cheaply on-chain — though converting in and out of local cash is still where most of the real cost lives.

However, the bulk of the volume comes from SMEs and multinational corporations wanting to bypass the SWIFT network for international trade. Say a distributor in Ghana needs to pay a manufacturer in Taiwan. A traditional international wire transfer involves multiple intermediary banks, charges on FX and can settle in days. Stablecoins instead, allow for the settling multi-million-dollar invoices in seconds.

Just as information was freed with the rise of the internet, stablecoins are doing the same for capital - with the trilemma still deciding how much stability, efficiency, and decentralisation you actually get.