Stablecoins like PayPal USD (PYUSD) emerged as a solution to the volatility and inefficiency often associated with traditional cryptocurrencies like Bitcoin.

They aim to combine the best of both worlds: the quick, inexpensive, and borderless transactions of cryptocurrencies and the purported stable value of traditional currencies.

What are stablecoins?

Stablecoins are a type of cryptocurrency designed to maintain a stable value over time, usually by introducing mechanisms pegging them to a more stable asset like the U.S. dollar, gold, or a basket of currencies. Unlike their more volatile crypto counterparts, stablecoins offer a steadier option for traders and a more dependable medium for everyday transactions.

They can be built on various smart contract blockchains including Ethereum, Solana, Avalanche, and Stellar, with issuers ranging from fintech startups to major financial institutions.

The underlying technology and operational mechanisms may also vary, but the goal remains consistent: stability in a typically turbulent market.

How do stablecoins work?

Stablecoins function through a balance of innovative technology and more practical financial strategies to maintain a stable value. Primarily, there are two types of stablecoins: collateralized and algorithmic.

Collateralized stablecoins

These are the most common type of stablecoins, backed by a reserve of assets. For instance, fiat-collateralized stablecoins maintain a reserve of a specific currency, like the US dollar, as collateral, ensuring that each coin issued has a direct, stable monetary equivalent. Tether (USDT) and USD Coin (USDC)—the world’s two largest stablecoins by market capitalization—are well-known examples, promising one-to-one pegs to the U.S. dollar.

Other collateral types can include precious metals, like gold or silver, or even other cryptocurrencies in crypto-collateralized stablecoins. The PayPal stablecoin, PYUSD, is an example of a collateralized stablecoin, being fully backed by U.S. dollar deposits, U.S. treasuries, and similar cash equivalents.

Algorithmic stablecoins

Unlike collateralized stablecoins, algorithmic stablecoins are not backed by any physical reserve. Instead, they use sophisticated algorithms to maintain their value, often mimicking the mechanisms deployed by central banks for  traditional currencies. This can involve automatically adjusting the supply of the stablecoin based on its current price: if the value dips below the pegged currency, the algorithm will reduce the supply to raise the price back to its intended level, and vice versa.

Following the collapse of the algorithmic stablecoin TerraUSD and the Terra ecosystem in 2022, the credibility of purely algorithmic stablecoins has been called into question. Some algorithmic stablecoins, such as MakerDAO’s DAI, operate an overcollateralized model; users are only able to borrow DAI worth a percentage of their collateral when they lock up their crypto.

What's so special about stablecoins?

Stablecoins are gaining traction due to their unique ability to provide stability in a fast-paced digital economy. They are increasingly used for remittances, lending, and payments, making financial services faster, cheaper, and accessible to a wider population, including those unbanked.

Many argue that stablecoins shine brightest in cross-border transactions, significantly slashing fees and waiting times. Big names like PayPal stepping into the stablecoin arena with PayPal USD is a sign that these types of digital assets are moving from niche to normal, hinting at a future where digital currencies might be as everyday and reliable as the cash in our wallets.

Stablecoins have also faced criticism from some corners of the crypto space. Critics argue that stablecoins could compromise on the foundational principles of decentralization and censorship resistance that are core to cryptocurrencies, while their reliance on traditional assets and regulatory compliance makes stablecoins susceptible to the same systemic risks and regulatory constraints as traditional financial systems. This could include interference from central authorities or the inherent instability of the assets by which the stablecoins are backed.

Critics have also questioned the transparency and solvency of some stablecoin operators, with calls for more rigorous audits and disclosures about their reserves. The complexity and potential fragility of algorithmic stablecoins have also been highlighted, especially after high-profile incidents of de-pegging and crashes in the market, casting doubt on their long-term viability and stability.

Addressing these critiques and ensuring robust, transparent, and decentralized operations will be crucial for the stablecoins to sustain their path towards mainstream adoption.

The entry into the space of well-established fintech companies like PayPal addresses many of these concerns; PayPal USD issuer Paxos is regulated as a stablecoin issuer by the New York Department of Financial Services (NYDFS), and is subject to stringent monitoring requirements.

With the backing of a well-established name in the fintech space like PayPal, a fully-backed, regulated stablecoin such as PayPal USD has the opportunity to bring the benefits of stablecoins to a wide audience, while mitigating the risks.