Stablecoins are a type of cryptocurrency designed to track the value of a particular fiat currency. For example, USDT and USDC are stablecoins intended to be worth 1 USD.

This differs from other types of cryptocurrency, like Bitcoin and Ether, that derive their value from supply and demand. These assets’ values vary dramatically when compared to fiat currencies. While this has tended to be beneficial in the long run for many crypto holders — Bitcoin’s value has grown significantly over the last few years — the shorter-term swings in price can make them less appealing to mainstream consumers.

Stablecoins have gained interest recently since they provide some of the benefits of both crypto and fiat currency. In most cases, they hold value in relation to the pegged fiat currency, and they can be traded on-chain, which offers increased convenience compared to fiat currencies.

For stablecoins, the main potential risk is depegging. A stablecoin’s primary purpose is to maintain a 1:1 “peg” to the value of a fiat currency. Without this peg, they’ve failed.

Depegging is when a stablecoin’s value differs from that of the tracked fiat asset. In most cases, this is a slight and temporary price deviation that is automatically addressed by the protocol.

However, sometimes the depegging event is more serious. In some cases, like TerraUSD, a stablecoin has failed completely if it completely loses investor confidence and its value relative to the pegged fiat asset.

These depegging events can have various causes. In some cases, market dynamics, such as a crypto crash, can cause depegging. In others, an attacker may be able to destabilize pegs via illicit transactions or speculative attacks.

Unlike other tokens, which are valued based on supply and demand, stablecoins try to track an off-chain source of value. They can accomplish this in a few different ways:

Fiat collateralization is akin to the “gold standard”. In the past, governments held gold reserves equal in value to the paper money that they produced. Paper money is more convenient to transport and use, and having a 1:1 gold reserve was a hedge against inflation since it prevented excess supply.

Stablecoins that use the fiat collateralization approach to maintaining a peg will have fiat holdings equal in value to the number of tokens issued. Tokens that use this approach, such as USDC and USDT, will periodically release audits of their reserves that prove their ability to exchange stablecoins for fiat currency at the pegged price.

These pegs tend to be fairly stable, though they can be destabilized if some reserves aren’t accessible. For example, the collapse of the Silicon Valley Bank in March 2023 caused USDC to depeg to $0.87 since $3.3 billion of its reserves were held there.

Using fiat currencies as collateral can introduce additional complexity and risk for a stablecoin due to the need to prove the ability to access sufficient reserves to maintain the peg. For this reason, some stablecoins, such as DAI, use crypto as collateral rather than fiat assets.

This approach to maintaining the value of a stablecoin can be challenging due to the volatility of crypto assets, whose value can vary significantly when compared to fiat assets. One way that this type of stablecoin addresses this issue is by intentional over-collateralization with crypto assets.

For example, when acquiring DAI, users will deposit collateral equal to 150% of the stablecoin’s value. This helps to absorb any variations from the peg caused by volatility in the crypto collateral. The system will automatically liquidate collateral if the value falls below a particular threshold, maintaining the peg to the fiat asset. However, market crashes have the potential to cause mass liquidations of collateral.

Algorithmic stablecoins don’t maintain their peg by directly holding collateral, either crypto or fiat. Instead, different algorithms are used to help maintain the peg. 

Two common examples are:

• Rebase Model: This type of algorithmic stablecoin has a supply that expands or contracts to help maintain the peg. This change applies to all wallets and is proportional to the price increase/decrease.

• Coupon Model: Other algorithmic stablecoins allow users to trade stablecoins for bonds/coupons when the value of the stablecoin is below the peg. These coupons are redeemable for a premium at a later date. When the value of the stablecoin is too high, additional coins are created to help lower the price of the stablecoin.

Since algorithmic stablecoins don’t hold collateral, they are more vulnerable to failure due to loss of confidence and bank runs. For example, TerraUSD collapsed in 2022 for these reasons.

While these are the three main pegging models used by stablecoins, others are in use as well. For example, a stablecoin may use a mixture of fiat and crypto for its reserves or another commodity, such as gold or Treasury notes.

Stablecoins have gained increased interest in recent months due to their price stability and their utility for international payments and other use cases. This makes them attractive to both retail investors and larger financial institutions wanting to take advantage of the various capabilities of on-chain tokens.

However, the value of stablecoins arises from the fact that they’re able to maintain a value peg. This may be accomplished either by holding collateral or by using algorithms to maintain asset values despite volatility. Often, this functionality is implemented using smart contracts, which enforce the protocol’s rules and mint or burn tokens as needed.

Protecting these smart contracts against potential attacks and manipulation is essential to maintain the value of a stablecoin. An attacker who can exploit access control vulnerabilities or perform a flashloan attack may be able to mint tokens without authorization or drain value from the protocol.

Protecting against these threats requires a combination of secure design and smart contract audits. For help in securing your protocol against design and implementation flaws, reach out to Halborn.