What is a stablecoin? Why does it maintain value stability?

As a unique category of cryptocurrencies, stablecoins have become a \"safe haven\" in the digital currency market due to their pegging mechanism to legal tender. Unlike traditional highly volatile cryptocurrencies, stablecoins maintain their relative stability in value by pegging them to fiat currencies such as the US dollar and the euro at a 1:1 ratio, or adjusting supply through algorithms. This article will detail the concept, working principle and why stablecoins can effectively maintain value stability, helping investors understand this important cryptocurrency tool and its application scenarios in the digital finance world.

What is a stablecoin? Where is \"stability\"?

Liu Ying: stablecoins are a special cryptocurrency. The so-called special is actually the asset it anchors, which may be legal currency or gold. Of course, the legal currencies may be currencies such as the US dollar, RMB, and Hong Kong dollar. There are also several types of stablecoins with anchored algorithms. The core design goal of stablecoins is to maintain currency stability by anchoring specific assets and adopting specific mechanisms, and to serve as a value measure and transaction medium in the crypto market where prices fluctuate violently.

stablecoins solve the problem of violent fluctuations in cryptocurrency prices, which is its origin. Because the price of Bitcoin, a cryptocurrency, often rises and falls, it is sometimes controversial. Stable coins developed against this background. We also understand stablecoins as a bridge or link connecting the centralized real world and the decentralized encrypted world.

Where is the stablecoin stable? It is mainly reflected in three aspects:

First, stability lies in value. It uses a 1:1 fiat tender, such as the USDC issued by Circle, which is 1:1. To issue 200,000 stablecoins,(issuers) must first deposit US$200,000 as reserve assets. Because it is anchored to the dollar or U.S. debt, its price is relatively stable. Of course, stability refers to the corresponding fiat currency or some related assets, and the fluctuations in the price of the fiat currency itself or the fluctuations in the price of bonds itself, including the price of gold itself. The fluctuations in the prices of these corresponding assets are actually beyond the control of the stablecin itself.

The second is stability in technology. Because stablecoins run on the public chain, the transactions implemented by stablecoins on the blockchain are unbreakable and settled in real time. Therefore, it has the characteristics of traceability, query, and unmodifiable stability.

The third is to stabilize supervision. Whether it is Europe, the United States, Japan, South Korea, or China Hong Kong, there are regulatory laws and regulations, which are either introduced or are in the process of being introduced. With 100% cash or bonds or asset reserves, and regular audits to maintain transparency, these can maintain the stability and reliability of stablecoins and protect the interests of investors. So it is stable in these aspects.

In short, the stability of stablecoins essentially achieves price anchoring through the mortgage of legal assets, excess encrypted asset guarantees or algorithm regulation, and realizes redemption credit under the regulatory framework. Its core value lies in providing a safe haven or efficient payment tool for the cryptoeconomy.

In reality, we must be vigilant, such as whether the assets reserved are sufficient, whether they are transparent enough, and whether there are differences in supervision. Investors should of course pay attention to the qualifications of the issuer and the reserve of audit reports.

Three Models to Support Stability Disclosure

The methods for stablecoins to maintain value stability can be divided into three categories: fiat mortgage, crypto mortgage and algorithm. Fiat currency collateralized stablecoins realize that one currency corresponds to one unit of fiat currency by holding fiat currency reserves equivalent to the issued currency in banks or custodians. Holders can convert stablecoins back to their equivalent legal currency according to rules. For example, USDC and USDT maintain a pegged relationship in this way, and their prices are usually maintained around one dollar.

Crypto-collateralized stablecoins are guaranteed by crypto assets and usually adopt an over-collateralization mechanism to cope with price fluctuations. For example, MakerDAO\'s DAI maintains the peg between the DAI and the US dollar by using users to lock in ETH or other crypto assets as collateral and automatically liquidate the collateral according to smart contracts when the market fluctuates.

Algorithm stablecoins have no real reserves, but rely on algorithms and smart contracts to adjust the issuance and destruction of coins based on market supply and demand dynamics. For example, additional coins are issued when the currency price is higher than one dollar, and coins are destroyed when the currency price is lower than one dollar, so as to control the currency price close to the target price. Although such mechanisms increase the degree of decentralization, they may fail when the market fluctuates violently. There have been cases of TerraUSD collapse, and the sharp decline in the currency value led to the system collapse.

There are also commodity-backed stablecoins that use commodities such as gold or oil as collateral, but such models currently account for a relatively small proportion of the market size.

How does the pegging mechanism maintain the currency value? The operating logic behind economy and technology

Regardless of the pegging mechanism, the stability of stablecoins relies on market participants to take actions based on price deviations, forming an arbitrage mechanism. When the price of a stablecoin is higher than the pegged target, arbitrageurs tend to issue a profit to drive down the price; if the price is lower than the target, they purchase the currency through a redemption or curve mechanism to push up the price.

Fiat currency stablecoins form price suppression through a holder redemption mechanism. If a USDC can be exchanged for one dollar, the holder will not be willing to buy for more than one dollar; if the price is less than one dollar, someone will be willing to redeem it. This supply and demand mechanism and exchange mechanism form a natural balance.

The crypto-mortgage type is managed by smart contracts. When the market value of the collateral falls below a set proportion, the system automatically liquidates the mortgage, thereby maintaining the currency value. The algorithmic type relies entirely on code, issuing additional shares when demand increases and destroying them when demand falls to adjust prices. However, if confidence collapses or the market fluctuates extremely, the system may not be able to respond, resulting in a loss of linkage.

The institutional supervision report pointed out that algorithmic stablecoins may fall into a \"death spiral\" when trust is lost: the decline in the currency price triggers destruction, but market participants continue to sell, causing the currency to decline further and eventually collapse.

Summary

To sum up, stablecoins are a type of crypto asset that aims to keep their currency pegged to reference assets. They maintain value stability through the use of fiat or crypto asset reserves or algorithmic mechanisms, which are significantly different from fiat currencies in terms of issuers, circulation channels and scope of application. They support lock-in value, on-chain transactions and cross-border payment applications, which are more attractive to DeFi users and international transaction scenarios.