Stablecoins: Digital Money Between Crypto and Traditional Finance

Cryptocurrencies are known above all for their volatility. The price of Bitcoin, Ethereum, or other digital assets can rise or fall sharply within a short period of time. That is exactly why it may seem strange that one of the most important parts of the crypto world has become an asset class whose main goal is the exact opposite – keeping its value as stable as possible.

But why does the world of cryptocurrencies need an asset whose price is not supposed to change significantly?

If a blockchain is meant to serve not only speculation but also payments, value transfers, trading, or other financial services, it is useful to have something on it that works similarly to traditional money. That is precisely the role played by stablecoins.

What is a stablecoin

A stablecoin is a digital token whose value tries to mirror the value of another asset. Most often this is the US dollar, so one token is meant to be worth approximately one dollar.

If everything works correctly:

1 stablecoin ≈ 1 USD

This price link is called a peg. If the price starts to move significantly away from the value of one dollar, we talk about a depeg.

One thing is important to emphasize right at the start, though:

The word "stable" does not mean "safe."

A stablecoin merely uses a certain mechanism that tries to stabilize its price. How good this mechanism is, and what risks lie beneath it, depends on the specific stablecoin.

How a stablecoin holds its value

The simplest model works through reserves.

For example, an issuer receives 1,000 dollars and creates 1,000 digital tokens against them. If the tokens can subsequently be exchanged back for dollars under set conditions, there is a reason why their market price should stay close to one dollar.

Arbitrage also helps with this. If a stablecoin is trading at, say, 0.98 USD, but it can be redeemed for one dollar, traders have an incentive to buy the cheaper token. This increases demand, and the price can move back toward one dollar.

So a stablecoin is not stable just because its name says so. There must be an economic or technological mechanism behind it that genuinely supports its value.

Not all stablecoins work the same way

This is exactly where the biggest difference between individual stablecoins arises.

The best known are stablecoins backed by traditional assets, such as USDC or USDT. Behind them stands a specific issuer and reserves, which may include cash, bank deposits, or short-term government bonds.

This model is relatively simple, but it means the user must trust the issuer and its ability to actually hold and manage the reserves.

A different approach is taken by stablecoins collateralized by cryptocurrencies. With these, the reserves do not sit in a bank but, for example, in a smart contract. Because cryptocurrencies themselves fluctuate in value, overcollateralization is often used – for example, cryptocurrencies worth 150 dollars may back a stablecoin worth 100 dollars.

There are also algorithmic stablecoins, which try to hold their price mainly through economic incentives and a relationship with other tokens.

The most famous cautionary tale became TerraUSD (UST).

TerraUSD: when stability disappeared

TerraUSD was supposed to maintain a value of one dollar through its relationship with the cryptocurrency LUNA.

As long as the market believed the whole system worked, UST managed to hold around one dollar. In May 2022, however, it began to lose its stability.

People started selling off UST, the system minted more LUNA tokens, and their price fell sharply. The more LUNA was created, the less it was worth, and the less trust the market had in the whole mechanism.

This created a spiral that led to the collapse of the entire ecosystem within a few days.

The TerraUSD case revealed one important lesson:

It is not enough to know that something is a stablecoin. You need to know why it is supposed to be stable.

What stablecoins are used for

Stablecoins originally gained importance mainly in cryptocurrency trading.

An investor can, for example, sell Bitcoin for a stablecoin and stay within the crypto environment without having to immediately convert the money back to a bank account.

Today, stablecoins are also used for:

• – transfers between wallets and crypto platforms,
• – international payments,
• – decentralized finance, or DeFi,
• – lending and liquidity management,
• – settlement of certain payment transactions.

Their main advantage is the combination of relatively stable value with the ability to operate directly on the blockchain.

A stablecoin is not the same as money in a bank account

If we have 1,000 dollars in a bank account and also hold 1,000 USDC, both balances may have almost the same value.

But they are not the same asset.

Money in a bank account represents a client's claim against the bank and is subject to banking rules and protection mechanisms.

A stablecoin is a digital token. How it functions depends on the issuer, the reserves, the legal regime, and the technology.

Likewise, a stablecoin is not the same as a CBDC, a central bank digital currency. A stablecoin is usually issued by a private company or protocol, while a CBDC would be issued directly by a central bank.

Stablecoins and MiCA

In the European Union, stablecoins are also subject to MiCA regulation.

It distinguishes in particular between e-money tokens (EMT), which are pegged to a single official currency, and asset-referenced tokens (ART), which differ from EMTs and try to maintain a stable value by referencing another value, a right, or a combination of these.

For an ordinary user, the main significance is simple.

If a token claims to represent a stable value, it is important to know who issues it, what reserves it holds, how its redemption works, and who oversees compliance with the rules.

Regulation does not mean that a stablecoin cannot run into trouble or lose its value. It does help, however, to create a clearer environment in which the rules of operation are better defined.

Conclusion

Stablecoins were created to bring something to the crypto world that it had long lacked – a relatively stable value. Thanks to this, they are used today not only for trading but also for transfers, payments, and in decentralized finance.

At the same time, not all stablecoins are alike. Behind one may stand dollar reserves and a regulated issuer, behind another crypto collateral or a complex algorithm. The same price on the screen therefore does not necessarily mean the same risk.

Stablecoins are one of the best examples of how traditional finance and blockchain are gradually becoming interconnected. That is why, when evaluating them, the most important question is not just "How much is the stablecoin worth?" but above all "What holds its value up, and why should we believe it will hold tomorrow too?"

This text is for informational and educational purposes only and does not constitute investment advice. Crypto-assets are volatile and you may lose the entire amount invested.