What Are Stablecoins?

Updated April 18, 2022.

Stablecoins are a type of cryptocurrency that attempt to peg their market value to another asset, such as a fiat currency.

While cryptocurrencies are often known for their volatility, stablecoins bring relative stability to cryptocurrency markets by allowing fiat currencies like the U.S. dollar to be represented on the blockchain as digital tokens. These stablecoins allow anyone around the world to hold a token that’s purposely designed to hold its value in relation to the fiat currency it claims to represent (e.g. 1 USD stablecoin tries to maintain a value of 1 U.S. dollar). The desire for stable assets on blockchains has resulted in the wide adoption of stablecoins within the blockchain industry and decentralized finance (DeFi).


The explosive growth of total stablecoin supply. (Source)

In this article, we’ll walk through the fundamental questions around stablecoins—what they are, how they work, and how Chainlink oracles power a variety of stablecoin designs.

What Is a Stablecoin?

At their core, stablecoins are cryptocurrencies that try to maintain a “peg”—the same market value as the external asset they represent. There are a few approaches stablecoins can take to match the price of the currency they’re pegged to consistently, such as collateralization with external assets or algorithmic mechanisms such as dynamically adjusting supply in relation to demand.

There are two main types of stablecoins: centralized and decentralized. Centralized stablecoins are traditionally backed by fiat currency in an off-chain bank account that functions as the reserve backing the on-chain tokens. Alternatively, they may aim to follow another asset such as a commodity, index, or others. These stablecoin designs typically require trust in the custodian, although Chainlink Proof of Reserve can provide strong transparency guarantees through automated audits.

Decentralized stablecoins are commonly overcollateralized by on-chain cryptocurrencies and require price data to maintain full collateralization (e.g. a user’s collateral is worth greater than a certain percentage of their loan’s total value). Decentralized stablecoins are designed to be more resilient and transparent because they are not controlled by a single party and the collateralization of the protocol can be audited by anyone on-chain.
Algorithmic stablecoins typically don’t hold reserves but instead use smart contracts to codify a mechanism—similar to that of a central bank—to retain their peg with the target index through dynamic supply adjustments or other methods.

Another type of digital asset similar to stablecoins are Central Bank Digital Currencies (CBDCs). CBDCs are similar to centralized stablecoins, but they are issued by central banks and thus don’t necessarily have to be backed by fiat money in an off-chain bank account. CBDCs are considered legal tender by the government that issues them and are used for streamlining payments between both individuals and institutions.

How Do Stablecoins Work?

There are various economic mechanisms that stablecoins utilize to maintain relative stability by holding their peg. The most common examples of these include the ability to redeem the tokens for fiat money, collateralized debt positions, arbitrage, elastic supply, and more.

Types of Stablecoins

USDC is a centralized stablecoin issued by Circle. Each USDC is backed by one dollar or an asset with equivalent fair value, held in off-chain accounts with regulated financial institutions. Customers with a U.S. dollar bank account can redeem 1 USDC for 1 USD, ensuring that the tokens maintain their 1:1 peg with the U.S. dollar. Other similar centralized stablecoins include USDT, BUSD, TUSD, USDP, and others. Some centralized stablecoins enable the issuer to freeze tokens belonging to a certain address, effectively making the frozen tokens unusable. This method can be used by stablecoin issuers to freeze large amounts of stablecoins obtained through protocol hacks or exploits.

MakerDAO, a decentralized stablecoin protocol, maintains its peg by having users lock up collateral into a smart contract. The smart contract then mints the stablecoin DAI as overcollateralized debt with an adjustable interest rate. In order to maintain the 1:1 peg of 1 USD = 1 DAI, MakerDAO’s smart contracts adjust the interest rates set by MKR token holders through on-chain governance to encourage borrowers to pay back their debt or take out more stablecoin loans. By encouraging increases or decreases in the total supply via interest rate changes, the price of DAI will change, either rising in value when the supply and interest rate are low or decreasing in value when the supply and interest rate are high.

Another design for decentralized stablecoins involves using arbitrage within a stablecoin index, where the stablecoin is backed by multiple different stablecoins in order to achieve the stability of the peg. For example, if the price of one of the reserve stablecoins exceeds 1 USD while the index price as a whole is below 1 USD, then the smart contract will market sell the stablecoin exceeding 1 USD for the index stablecoin’s token to drive the index price back up to 1 USD. Chainlink oracles can provide reliable and high-quality price feeds that the stablecoin index smart contracts can reference when calculating how to rebalance the index.

Ampleforth (AMPL) is a decentralized, algorithmic stablecoin that uses an elastic supply mechanism to maintain its peg to the current Consumer Price Index (CPI) rate—an index from the Bureau of Economic Analysis on the current value of the inflation-adjusted 2019 U.S. dollar. This effectively means that the price target of AMPL is set to the purchasing power of one 2019 U.S. dollar as represented by the CPI. When the price of AMPL is higher than the index, the protocol increases wallet balances, and when the price of AMPL is lower than the index, the protocol decreases wallet balances. This automated change in supply, referred to as rebasing, impacts market prices by adjusting the outstanding supply of tokens. The total supply of AMPL is rebased on a daily basis to track the CPI rate—both the volume-weighted average price (VWAP) of AMPL and the CPI index are provided to the Ampleforth protocol by Chainlink oracles.

What Are Stablecoins Used For?

Stablecoins are an integral part of the cryptocurrency and Web3 ecosystem and account for a significant portion of its trading volume and underlying economic activity. 

Stablecoins offer some distinct benefits over their traditional counterparts due to blockchains being the underlying mechanism facilitating the transfer of value instead of opaque, outdated, and manual processes. Centralized stablecoins effectively allow for value pegged to fiat currencies to move globally between wallets without the need for intermediaries to facilitate the transfer.

Stablecoins are also commonly used as a non-custodial savings account to store personal savings or as collateral in DeFi to generate returns and engage in yield farming strategies.

Stablecoin Risks

Different stablecoin designs have different risks associated with them. These may include:

  • Depegging risk—Failure of the underlying economic or algorithmic mechanisms through liquidity events, “bank run” scenarios, suboptimal reserves practices, and more present the risk of the stablecoin depegging from its target.
  • Regulatory risk—Stablecoins may be regulated in different ways by local financial institutions in particular geographic locations.
  • Centralization risk—Some centralized stablecoin issuers have the ability to freeze tokens at specific wallet addresses.
  • Key management risk—If stablecoins are held in a non-custodial wallet, the user must take full responsibility for securely storing their private keys.

Stablecoin Applications Using Chainlink

Despite the differences in stablecoin architecture and design, all stablecoins require accurate price data for their underlying pegging mechanism and when used in decentralized applications. Since exchange rates are constantly fluctuating, real-time price data needs to be fed to stablecoins in order for them to maintain their peg. Furthermore, since stablecoins are usually backed by other crypto assets or off-chain bank reserves, tamper-proof methods of acquiring the details of these reserves are needed to ensure the security and reliability of these systems.

Chainlink is a decentralized oracle network that provides smart contracts with access to a secure and reliable source of real-world data. Since stablecoins collectively hold substantial value in DeFi applications, they require the same assurances and security guarantees as the blockchains they operate on. Effectively, this means that the oracles providing data to stablecoins need to be robust, decentralized, and have multiple layers of security to help ensure that stablecoin pegs remain at a 1:1 ratio. This provides transparency and trust to the users of these stablecoins, as they can confirm that the stablecoin asset they are using is secure end-to-end and does not contain a single point of failure.

An example of this is TrueUSD (TUSD), which uses Chainlink to bring details of collateralization levels on-chain and give users a clear understanding of whether their assets are fully backed. With this newfound transparency, DeFi users can verify in real-time the true collateralization of all minted TUSD tokens and the protocol itself can automate the protection of users funds from any fractional reserve practices or potential black swan events.

A diagram showing how TrustToken uses Chainlink to provide smart contracts proof of its off-chain fiat reserves.
TrustToken uses Chainlink Proof of Reserve to provide smart contracts proof of the off-chain fiat reserves backing the TUSD stablecoin.

This mechanism for verifying the reserves of an asset leverages Chainlink Proof of Reserve (PoR). PoR reference feeds provide smart contracts with the data needed to calculate the true collateralization of any on-chain asset backed by off-chain reserves. These reference feeds are operated by a decentralized network of oracles on the Chainlink Network and allow for the autonomous auditing of collateral used within a protocol in real-time, helping ensure that user funds are protected from unforeseen fractional reserve practices and other fraudulent activity from off-chain custodians.

For stablecoin protocols that utilize off-chain reserves, recurring audits enabled by Chainlink PoR help enhance transparency and ensure the status of the reserves backing a stablecoin. Stablecoins that use PoR can offer a higher degree of transparency to their users as they can prove that their tokens are backed. PoR can also provide collateralization data regarding any type of pegged asset, including alternative fiat currencies or commodities like gold, increasing the transparency of any token protocol utilizing this mechanism.

Paxos, a financial market infrastructure and crypto brokerage platform, uses Chainlink to provide DeFi smart contracts with a highly available, tamper-proof, and accurate source of on-chain pricing data for the USD-backed stablecoin Pax Dolar (USDP) and the gold-backed token PAX Gold (PAXG). Additionally, Chainlink Proof of Reserve Data Feeds for Paxos tokens allow DeFi applications to quickly verify on-chain that tokens are fully backed 1:1 by U.S. dollars and gold bars held off-chain in Paxos’ custody.

A diagram showing how Paxos uses Chainlink to verify collateralization.
How Paxos uses Chainlink Proof of Reserve to verify the collateralization of off-chain assets.

Another example of a Chainlinked stablecoin system is Fei Protocol, which effectively functions as an algorithmic central bank that aims to maintain the peg of its stablecoin on the open market through a process called reweighting. Users can mint the stablecoin FEI with an equivalent deposit value of ETH, which gets added to the protocol’s reserves to be used as Protocol Controlled Value (PCV). PCV represents all assets that aren’t redeemable by users. If FEI is trading below the peg, PCV is used to buy FEI on the open market to push the price up, and if FEI is trading above the peg, more FEI is minted and sold on the open market to push the price down. Fei Protocol uses Chainlink Price Feeds to help ensure accurate data is referenced during all market or network conditions.

Central Bank Digital Currencies (CBDCs) will likely also be pegged to an external asset, meaning that they would need to be able to receive price data about that asset. Chainlink could support these government-issued stablecoins by providing the price data needed for them to maintain their pegs along with important information about the current collateralization of the system.

Conclusion

Despite their simplicity, stablecoins can be considered to be one of the cryptocurrency industry’s most significant innovations, allowing for the seamless transfer of stable value. While there are a number of different stablecoin designs, the common backbone of any stablecoin protocol is the data that it receives about the asset it is pegged to. Chainlink provides the battle-tested data infrastructure that helps ensure the reliability, security, and transparency of stablecoins and the stability of the larger DeFi ecosystem.

If you’re a developer and want to integrate Chainlink into your smart contract applications, check out the developer documentation or reach out to an expert.

Additional Resources