How Stablecoins Maintain Their Peg

Stablecoins often get a lot of bad publicity—and to be fair, there have been many poor excuses for stablecoins that have become wrongly famous. That being said, the entire idea of a stablecoin is that its price remains stable—allowing it to be used with ease for cross-border payments, asset parking, and more.

Stablecoins maintain their peg using reserves and advanced technological processes that allow the stablecoin to move through the blockchain ecosystem without destroying or inflating its value. While this may sound simple, it is actually a complicated process that, unfortunately, many blockchains fail to maintain. Read on to learn more about how stablecoins maintain their peg.

1. Reserves

The main aspect of a stablecoin is the fact that it is pegged to another asset and doesn’t have any value on its own. While this asset doesn’t have to be fiat, it typically is, as it has to be an asset that remains relatively stable. However, there are many stablecoins that are based on items that are not fiat, such as gold and oil; these assets tend to be less stable than their more typical stablecoin counterparts.

We want to reiterate that for a token to be considered a stablecoin, it must be 100% backed by a relatively stable asset. Of course, fiat and gold often undergo value fluctuations (inflation); however, you always know exactly how much you own of your respective asset. For example, one USD coin will always equal $1, though the underlying value of the US dollar may change. Tokens are given to users when an equal value of the underlying asset is locked in a smart contract—only to be released when an equal number of tokens are returned.

Unfortunately, this is a line that has been blurred over the years, mainly by a specific token known as Tether. Tether is only 75% backed by assets, which, in our eyes, makes it speculative and excludes it from being a true stablecoin. That being said, it has many die-hard fans who continue to buy and use it every day, though we refuse to refer to it as a stablecoin—because it isn’t backed in a way that would actually make it stable in our eyes.

2. Blockchain Processes

Beyond reserves, the second aspect a blockchain must have in order to be considered a stablecoin is some sort of technical process for moving that token throughout the system without creating additional tokens or destroying the ones that are already present.

Many blockchains accomplish this by using complicated create and burn mechanisms, ensuring that the token you purchased with the smart contract remains visible throughout the entire process of the transaction, even as other things happen in the background. While this works in many cases—it doesn’t work in them all, something which many individuals have learned the hard way, like with the TerraLuna fiasco in 2022 or the Titan and Iron stablecoin disaster in 2021.

Unlike with reserves, which are required for a token to be considered a stablecoin, some stablecoins function without the backing of a fancy blockchain. They are more of a store of value—such as PaxosGold, where each token is pegged to the value of one ounce of gold. We do want to reiterate, however, that just because a certain stablecoin blockchain is easy to follow does not mean it’s safe. Always proceed with caution even when it comes to investing in stablecoins.

3. A Way to Maintain Its Peg

While reserves and blockchain processes are important, the most important aspect of a stablecoin is that it can maintain its value—continuing to match the asset it is pegged to. This particular requirement has led to the death of many stablecoins, as once a token deviates from its peg, it can be impossible for it to regain it, leading it to the death spiral of no return. Many stablecoins accomplish this through algorithms and advanced dapps.

The most famous stablecoin that lost its peg is TerraLuna, which never recovered. There are some, such as USDC, which were able to recover with the help of the governing authorities, but in general, if a token cannot maintain its peg, it is not a true stablecoin.

Are All Stablecoins Good?

Stablecoins have unfortunately gained a reputation for being a stable way to invest in cryptocurrency. While this is somewhat true, we want to make it clear that there are just as many scammers in the stablecoin space as there are honest stablecoins. Because these tokens rely on a reserve of value (one that you often don’t personally have access to), we urge you to only invest in projects you trust.

Let’s put it this way. You can buy a token that is backed by one ounce of gold, but how do you verify that if the bank used by the blockchain is in another country? Even if you lived there, you cannot walk into the bank and demand to see the gold stocks of a large business. Basically, investing in a stablecoin is still risky—just not as volatile as investing in a pure cryptocurrency like Bitcoin.

This is what gets people in trouble, as they believe that stable is equal to safe, but that has never been the case. Just ask those involved in the TerraLuna fiasco, which resulted in the loss of $46 million USD—most of it owned by hardworking citizens like yourself.

Should You Invest in Stablecoins?

We’ve said it once, and we will continue to say it: stablecoins are not an investment. While they are great for making cross-border payments or investing in an asset like gold without having to store the gold in your home, they aren’t built the same way as stocks or crypto investments. And as we mentioned, they can often be just as risky. For this reason, we only recommend stablecoins for those who have a use for them and know (and trust) the company they are trusting their money to. Regardless, you should never put your money into a stablecoin for the purpose of investing—you will only be disappointed and, what’s worse, you may even lose everything.