Stablecoins Unpacked Pt 3: How Stablecoins Actually Work (Without the Jargon)
?? "Stablecoins are just crypto dollars, right?"
?? "They're always worth $1… until they aren't."
?? "If they’re so great, why aren’t banks using them?"
Stablecoins power trillions of dollars in payments. But are they really as stable as they claim? Or is there a hidden catch?
Let’s break it down. ??
Why Do Stablecoins Stay Stable?
We all know Bitcoin and Ethereum can swing 10%+ in a single day. Stablecoins avoid this volatility by being designed to maintain a steady value, typically $1 per coin.
?? But how do they do this?
Stablecoins use different methods, and these fall into three main categories:
1 - Fiat-Backed Stablecoins (Simple & Trusted)
Imagine stablecoins as casino chips - you deposit $100, get $100 in chips, and later cash them out for real dollars.
How It Works:
1?? Every stablecoin is backed 1:1 by real U.S. dollars (or safe assets like Treasury bonds).
2?? When you want to "cash out," the issuer will redeem your stablecoin for real dollars.
3?? The issuer then burns (removes) the stablecoins from circulation to keep the supply balanced.?
?? Examples of fiat currency backed Stablecoins: USDC (Circle), USDT (Tether), BUSD (Binance), PYUSD (PayPal)
Use cases:
?? Risks:
?? Where does security come in?
Companies like Fireblocks & Dfns provide secure custody & infrastructure to help institutions safely store and manage stablecoin reserves.
How Are Stablecoins Minted & Redeemed? (Where Do They Come From?)
Stablecoins don’t just appear out of thin air, they are minted (created) when someone deposits real dollars with the issuer.
Minting Process (How New Stablecoins Are Created):
1?? A user (business, trader, or exchange) deposits cash with a stablecoin issuer like Circle or Tether.
2?? The issuer mints (creates) 100,000 new stablecoins (each backed 1:1 by real dollars).
3?? The stablecoins are sent to the user’s crypto wallet.
4?? The user can now spend, trade, or send their stablecoins like digital dollars.
?? Example:
Redeeming Process (How to "Cash Out" to Real Money):
1?? A user sends their USDC or USDT back to the issuer.
2?? The issuer burns (deletes) those stablecoins from circulation.
3?? The issuer wires real dollars back to the user’s bank account.
?? Example:
?? Companies like Zero Hash & Mesh make this process easier by providing on/off-ramp solutions, enabling businesses to convert stablecoins into real-world payments.
2- Crypto-Backed Stablecoins (Decentralized & Overcollateralized)
?? What if you don’t want to trust a company like Circle or Tether?
Crypto-backed stablecoins are an alternative to fiat-backed stablecoins, but instead of dollars, they are backed by cryptocurrency.
How It Works:
1?? Instead of holding cash, these stablecoins are backed by crypto collateral (like Ethereum). 2?? To issue $100 worth of stablecoins, you might need to deposit $150+ worth of ETH as collateral (extra buffer against volatility).
3?? If the price of ETH drops too much, the system automatically sells some of your collateral to ensure stability.
?? Think of it like borrowing money from a bank, you put up your house as collateral, but the bank requires you to have more than the loan amount in case house prices drop.
?? Examples of crypto backed Stablecoins: DAI (backed by Etherium & other assets), LUSD (backed by ETH).
Use cases:
?? Risks:
3 - Algorithmic Stablecoins (The Experiment That Failed)
?? What if a stablecoin could stay at $1 without needing reserves?
That was the idea behind algorithmic stablecoins, but most have failed.
How It Worked:
?? Example: TerraUSD (UST) (Collapsed in 2022)
?? Takeaway: Algorithmic stablecoins haven’t really worked in the real world so far. It’s best to stick with fiat-based or crypto backed stablecoins.
Final Thoughts: Why This Matters
Stablecoins bridge the gap between crypto and real-world finance. Whether it’s paying employees, avoiding inflation, or moving money globally, they’re already transforming finance.
Whether you’re a freelancer getting paid internationally, a business settling transactions instantly, or someone protecting their savings from inflation, stablecoins offer a faster, cheaper, and more accessible alternative to traditional finance.
?? But not all stablecoins are created equal:
? Fiat-backed stablecoins → Most reliable, but require trust in issuers.
? Crypto-backed stablecoins → Decentralized and transparent, but require extra collateral.
? Algorithmic stablecoins → A risky experiment, with past failures like TerraUSD proving their instability.
?? The big question: As governments step in and stablecoins continue growing, will they replace banks - or will banks adopt them?
Want to go deeper? Check out these great reads:
This is part 3 of my 12-part "Stablecoins Unpacked" series, where I break down everything you need to know about this growing area of finance. Check out the other parts below.
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