At Donut, our goal is to provide a simple and secure earning experience in DeFi and Web3. We convert user funds to stablecoins to generate high yield returns in digital lending markets and wanted to bring you up to speed on all things stablecoins.

What is a stablecoin?

A stablecoin is a digital dollar that makes participating in the global digital economy, easy. Purists would call a stablecoin a cryptocurrency token denominated in and equal in value to a single unit of another asset. These reference assets are typically the dollar or euro, but can be commodities such as gold and oil, or even Arizona Tea. The term that defines this 1:1 value relationship is a peg. For a stablecoin pegged to the US dollar, one stablecoin is worth and always redeemable for $1.

The goal of a stablecoin is to stay pegged to its reference asset. To maintain its peg, stablecoins are backed by reserves equal in value to the dollar value of stablecoins outstanding. If the circulating supply of a stablecoin is 1 billion, its reserve is equal to at least $1B. The stronger the reserve, the stronger the peg, the more adoption a stablecoin will have.

The process of producing stablecoins for the first time is known as "minting". This is how stablecoins enter circulation. If you have $100 and send that to a stablecoin issuer, you will mint 100 stablecoins, each worth $1. If you ever want to exchange your stablecoins for dollars, you’ll be able to do so at a 1:1 value. Most consumers don't mint though, opting instead to acquire stablecoins on exchanges.

Stablecoins in the wild

Stablecoins facilitate participation in the crypto economy. Some exchanges don’t even accept fiat currencies, therefore holding stablecoins better prepares a person for buying and trading opportunities.

The most obvious benefit of stablecoins is their stability. If both parties in a transaction can trust that 1 Stablecoin = $1, they can transact just like they would with cash or card. As permissionless currencies, these two actors can exchange stablecoins without needing any additional parties or approvals. Removing intermediaries not only increases settlement times, but nearly eliminates fees and empowers individuals.

As borderless instruments, these benefits extends to improve peer-to-peer payments too. To split a dinner bill abroad or transact internationally, Venmo and Zelle has no role and using credit cards invites additional fees to buyers and merchants. Enter stablecoins.

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As a medium of exchange stablecoins protect vendors from volatility risk of the asset they are paid in. This can be seen live across El Salvador where merchants who accept Bitcoin have seen the price of the asset drop 41% in the past year. Stablecoins too have lower transaction fees compared to larger cryptocurrencies and instant settlements provide vendors with immediate liquidity.

Globally, the convenience, accessibility, and liquidity of US dollar-denominated stablecoins provide a more efficient opportunity to save in a stable currency. A recent example of this is in Argentina, where consumers use US dollar-denominated stablecoins to hedge against the devaluation of the Argentine peso amid significant inflation. With the ability to execute this exchange themselves, consumers absorb less fees and avoid conversion rates.

The digital nature of stablecoins also better power remittances. By removing the need for a third party, settlement times and transaction costs are reduced, making more of the sent amount available to the recipient, faster.

Stablecoins also optimize traditional financial actions of saving, lending, and borrowing.

Stablecoins and yield

Stablecoins generate yield through lending. Digital lending markets offer yields of 5% or more, an improvement 250x greater than the .02% interest offered by legacy banks. This can be done directly on decentralized protocols or in safe and secure environments like Donut (humble brag).

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Stablecoins generate interest when lent into digital markets for above-average yields. Borrowers are attracted to this lending environment because they can deploy borrowed funds into arbitrage and market-neutral strategies that take advantage of volatility to earn high returns. These borrowers use cryptocurrency as collateral, allowing them to access their holding’s liquidity without a taxable event. For example, a person holding $1M in Bitcoin is able to take out a stablecoin loan against their Bitcoin, accessing its liquidity without the expense of capital gains.

The preference to generate yield by lending stablecoins over other cryptocurrencies is that stablecoins are not subject to price volatility.

In cryptocurrency interest accounts, lenders earn high reward rates on the cryptocurrency they’ve deposited into their account. The risk with these accounts is that the price of their cryptocurrency asset will drop in value. When this happens, although the quantity of the cryptocurrency in the account has increased from interest, the dollar value of that cryptocurrency is less than what it was when deposited.

Here’s an example: If you had deposited 1 ETH ($2,610) in June 2021, into an account earning 10% APY, one year later in June 2022 you would have 1.1 ETH. Unfortunately, the dollar value of your 1.1 ETH would be worth 50% less, due to ETH’s price collapse. Had you held an equal amount of dollar denominated stablecoins in an account earning 10% APY, a year later you’d have $2,871, in value and stablecoin quantity, a $261 gain.

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As a technology, stablecoins are making participation in a new economy accessible, appealing, and inclusive to all. Each day as the crypto market expands, stablecoins become more and more accepted as a medium of exchange, a unit of account, and a lending instrument.

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The types of stablecoins

There are four primary types of stablecoins:

  1. Fiat-backed

  2. Crypto-backed

  3. Commodity-backed

  4. Algorithmic

Fiat-backed stablecoins

Fiat-backed stablecoins are dollar digital currencies backed by an equal value of fiat or cash equivalent collateral. If there are 1 billion fiat-backed stablecoins in circulation, we trust that there is $1B in cash or cash equivalents locked up in the issuer's reserve.

Fiat-backed stablecoins are minted when you send a fiat currency to the issuer. In return, you receive a quantity of stablecoins equal to the value of fiat sent. Similarly, at redemption the issuer sends fiat currency back to the buyer and burns the redeemed stablecoin, removing it from circulation. Fully collateralized fiat-backed stablecoins do not require new money to keep entering the system to stay afloat. With fully collateralized fiat-backed stablecoins stability is naturally achieved, passing the consumer test of if a user wants to redeem their stablecoins for fiat dollars, they can do so.

Criticisms of fiat-backed stablecoins include centralization, counterparty risk, and the lack of an on-chain ledger to monitor reserves. The public instead relies on reserve audits and attestations.

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Crypto-backed stablecoins

Crypto-backed stablecoins are denominated in dollars and backed by overcollateralized reserves of cryptocurrency assets secured by automated protocols called smart contracts. Ensuring an issuer holds an equivalent amount of crypto assets in reserves is easier to audit because you can look at the Smart Contract code.

Crypto-backed stablecoins are minted when users send an amount of crypto assets to the issuer's Smart Contract. Unique to crypto-backed stablecoins is a risk management system called overcollateralization. This accounts for price volatility. Most commonly, this ratio is set at 150%, meaning that to mint $100 worth of a crypto-backed stablecoin, you will need to post at least $150 worth of an accepted cryptocurrency as collateral. If the price of the collateralized cryptocurrency were to drop, so would the collateralization ratio, initiating a margin call or even liquidation.

While capital inefficient, overcollateralization protects lenders from borrower defaults and provides borrowers a buffer against price fluctuations in the collateral asset.

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Commodity-backed stablecoins

Commodity-backed stablecoins, often referred to as asset tokens, are backed by commodities such as precious metals, oil, and real estate, and pegged to an amount of the backing asset, denominated in dollars. This means 1 commodity-backed stablecoin equals the dollar value of the pegged asset, not $1.00. 

Commodity-backed stablecoins are subject to the backing asset's volatility. A stablecoin backed by one fine troy ounce of a 400 oz London Good Delivery gold bar is currently priced at $1,835 (June '21). Should the market price of this volume of gold change, so would the value of the stablecoin. This makes commodity-backed stablecoins unreliable units of account or mediums of exchange.

As digital representations of physical commodities, these stablecoins advertise price appreciation and facilitate investments into assets that may otherwise be out of reach.

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Algorithmic stablecoins

Algorithmic stablecoins are either undercollateralized or not backed by anything. Their price stability results from the use of algorithms and smart contracts that manage the supply of tokens in circulation. There are three forms of algorithmic stablecoins: rebase, seigniorage, and fractional algorithmic.

Rebase algorithmic stablecoins

Rebase algorithmic stablecoins control the supply of a coin to maintain its peg with fiat currencies. Instead of using reserves to maintain the peg, rebase algorithmic stablecoins automatically mint or burn new coins in line with the price movement of the stablecoin. If the price of the stablecoin slips below $1, coins are removed from circulation and vice-versa. Rebase algorithmic stablecoins are elastic and non-dilutive, as the supply changes, users retain the same proportion of the overall supply. This means if you hold a rebase algorithmic stablecoin in your wallet, the quantity you hold may change, but your ownership proportion of the overall supply stays the same. That’s the algorithm working, though some argue this volatility excludes rebase coins from being classified as stablecoins. 

Seigniorage algorithmic stablecoins

Seigniorage algorithmic stablecoins use a burn-mint multi-coin structure, where one coin is minted or burned to control the value of another. No collateral is used to mint these stablecoins as they are self-collateralized. If the value of the stablecoin is above its peg, the algorithm creates more stablecoins until demand is met. If the value of stablecoin lowers from $1.00, the algorithm buys the stablecoin and burns it, reducing supply, and bringing the price back to $1.00. If the price remains below $1.00 and there are not enough earnings to buy more of the coin's supply, seigniorage shares are issued. Seigniorage algorithmic stablecoin protocols offer incentives to market participants to buy/sell the paired cryptocurrencies to maintain the price of the stablecoin.

Fractional algorithmic stablecoins

Fractional algorithmic stablecoins are partly collateralized, meaning they are somewhat backed by a real-world asset in addition to their algorithm. These stablecoins avoid overcollateralization. The amount of collateral needed to mint 1 fractional algorithmic stablecoin is determined by a collateralization ratio. At an 80% collateral ratio, 1 fractional algorithmic stablecoin is backed by collateral like USDC, and 20% is backed by the algorithm that manages governance token supply. For both minting and redemption purposes, the protocol obeys the collateralization ratio.

A not so successful story

In theory, algorithmic stablecoins have promise. In reality, they pose a risk because they're not backed by any real-world assets, which means that the stability of their price isn't as much of a sure thing as one would like to think. In practice, algorithmic stablecoins have seen little success in any environment where U.S. dollars may be used, even as a unit of account.

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Stablecoins on Donut

At Donut, we evaluate opportunities at the intersection of safety, security, and high yield, and aim to provide the easiest and safest earning experience in DeFi and web3.

We convert your USD to digital dollars (USDC stablecoins) and put those dollars to work in lending markets seeking to provide you a protected base APY of 5% or more.

We use USDC, not only because it is preferred by our lending partners to ensure safety in our offering, but because we’re excited by USDC’s stability, track record, and transparency. Since its inception in 2018, USDC’s issuer Circle has conducted annual audits, published monthly attestations and weekly reserves breakdowns, and is fully regulated by the NY Department of Financial Services. Circle’s last two audits, for 2020 and 2021, have been published as part of Circle’s SEC filings as they prepare to become a listed public company on the New York Stock Exchange.

To power this lending service, we partner directly and indirectly with regulated US custodians Wyre, Genesis, and Abra. These prime brokers and institutions help protect against the risk of partner failure and introduce an added layer of safety through diversification. 

As a FinCEN registered organization we are committed to safeguarding the financial system from illicit use. To protect your principal and interest earned, all loans are collateralized by over 125%. If the value of the collateral falls, borrowers are margin called and required to top up or repay part of their loan. If not, they are liquidated.

We also protect funds through diversification and securely lend funds via our wallet partner, Fireblocks. At the account level, we use the highest security standards of AES-256 alongside 2FA and personal pins. 

We’re striving to make DeFi lending even more simple, accessible, and safe for you. To learn more about Donut, start here with our most secure plan yet, or reach out by e-mail or DM us in-app.

Getting started with Donut

Donut is available in the United States and can be downloaded from the App Store or Google Play Store.

Donuts with friends

Increase your APY +5% for 5 days every time a friend you refer makes their first deposit on Donut. Head to the Boosts section of your app to start introducing friends to the future of finance.


Real talk 🚨

Any saving and investment strategy puts your capital at risk.

The above information is intended for informational purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice.