Stablecoins Explained: What They Are and How to Use Them

Stablecoins are considered one of crypto’s ‘killer apps’ because they facilitate a variety of real-world use cases, such as cheaper cross-border transactions. The sector’s market capitalisation reflects this potential, having grown to more than $200 billion as of December 2024.

This article explains how stablecoins work before exploring their use cases in both the traditional and crypto finance systems and examining the risks that holders face.

Definition

Stablecoins are cryptocurrencies that aim to maintain a stable value relative to a specified asset, or a pool or basket of assets. The primary mechanisms to maintain this peg are collateralisation, where the tokens are backed by a reserve, or algorithms that adjust a token’s supply when it deviates from the target value.

Although stablecoins are cryptos, they vary in their degree of centralisation. As of December 2024, the two biggest tokens by market capitalisation, USDT ($134 billion) and USDC ($39 billion) are issued by central authorities (Tether and Circle respectively). Both tokens track the US dollar at a ratio of one to one, and they’re backed by reserves. For instance, USDC’s reserve, audited by accounting firm Deloitte, consisted of US government bonds, repurchase agreements (short-term government securities) and cash at the end of October 2024.  

Central bank digital currencies (CBDCs) are another form of centralised stablecoin. However, they’re legal tender as they’re issued by central banks rather than private companies. Only Nigeria and Zimbabwe have launched CBDCs to date, while others including Russia, China, India, Saudi Arabia and various EU members are running pilots (as of December 2024).

DAI, the stablecoin with the third biggest market cap ($5.3 billion as of December 2024), is decentralised. The reserve is stored in smart contracts called Vaults operating on the Sky protocol (formerly MakerDAO). It’s also overcollateralised, meaning the collateral deposited by holders must be worth more than the tokens they receive. The protocol issues the stablecoin as a debt and relies on several mechanisms to maintain the ratio of one DAI to one US dollar, mainly arbitrage (participants buy DAI when it falls below $1 and sell for the opposite effect).  

Their Weight in the Crypto Market

With a market cap of $200 billion, stablecoins account for a sizeable share of the overall crypto market. In addition to the tokens discussed above, FDUSD ($1.9 billion as of December 2024), issued by First Digital Labs, and Tron’s USDC ($751 million), which are both decentralised, round out the top five.

99% of stablecoins are pegged to the US dollar, according to a recently published report, Stablecoins: The Emerging Market Story. Gold (0.62%) and the euro (0.38%) make up the majority of the outstanding balance. The authors suggest that some of the reasons for the dollar’s dominance include the liquidity of the stablecoins with the highest market caps and the dollar’s strength versus most other fiat currencies. 

The Current Utilities of Stablecoins

Stablecoins serve a number of uses, both in the traditional and crypto finance systems. 

Remittance- the World Bank estimates that expatriate workers sent home more than $650 billion in 2023 at an average cost of 6.65%. While cryptos offer a cheaper alternative, stablecoins don’t experience the same level of volatility.

Cross-border payments- in a similar fashion, stablecoins facilitate the movement of money across borders for commercial transactions. Developing countries particularly benefit because companies and workers can receive funds for performing tasks remotely.

Dollar accessibility- stablecoins allow people in developing countries to access US dollars, a lifeline when inflation soars and devalues the domestic currency. Research shows they were the fastest-growing crypto in Argentina in the second half of 2023, where inflation peaked at over 25% by the end of the year.

Hedging- the volatility of crypto markets can be hard to stomach. By converting holdings to stablecoins during crashes, investors can protect their portfolios without exiting the ecosystem.  

Decentralized finance (DeFi)- yield farming is an investment strategy that involves depositing crypto with DeFi applications to provide liquidity in return for rewards, typically in the form of the app’s native token. Stablecoins are popular for yield farming due to their lack of volatility compared to other cryptos.  

Crypto forecasts- Analytics firm CryptoQuant believes the rising market cap of stablecoins could be providing liquidity that’s helping to drive bitcoin’s latest rally. A recent blog post claimed ‘there was a high correlation between bitcoin’s price and stablecoin's exchange net flows’ in September 2024.

Risks of Stablecoins

The main risk associated with stablecoins is they depeg from the value of the underlying asset, which can happen for various reasons, such as a change in market conditions affecting the reserve or the failure of the peg mechanism. For instance, UST, an algorithmic stablecoin issued by Terra with a market cap of $18 billion at its peak, collapsed in May 2022. Large withdrawals of UST from a savings protocol led to a ‘death spiral’, which caused the values of both UST and Luna, the crypto used to maintain its peg to the US dollar, to plummet.  

Regulatory risks have fallen in the EU since the introduction of the Markets In Crypto Assets framework. MiCA bans algorithmic stablecoins and requires tokens pegged to fiat currencies to be backed by a reserve with a one-to-one ratio. The reserve must be ringfenced from an issuer’s other assets and held with a custodian. Circle, the USDC issuer, was the first to receive approval under the framework. The US doesn’t have an equivalent yet, although senators proposed a bill in April 2024 that would introduce stablecoin regulation.    

Finally, the threat of CBDCs seems to have receded in the US since Donald Trump won the presidential election in November. Trump was highly critical of CBDCs on the campaign trail in an interview with Fox News, labelling the digital dollar as ‘dangerous’ because it would allow the government to remove money from people’s accounts. He pledged to block the Federal Reserve from issuing a CBDC if elected.     

Conclusion

Stablecoins are cryptocurrencies that aim to maintain a stable value relative to a specified asset, or a pool or basket of assets. They maintain the peg through collateralisation or an algorithm, and the degree of centralisation depends on each token’s design.

Stablecoins serve a variety of purposes. In traditional finance, they provide a cheaper way to transfer money across borders and vital access to US dollars, while they allow crypto investors to hedge against volatility and earn a return through yield farming.

The biggest risk associated with stablecoins is the loss of the peg to the underlying asset. In terms of regulation, the landscape is clearer in the EU than the US, although the threat of CBDCs has faded in the US following Donald Trump’s victory in the presidential election.