A beginner’s guide to stablecoins. | Credit: Shutterstock
Key Takeaways
- Stablecoins mitigate the extreme volatility of cryptocurrencies, allowing investors to navigate the crypto market more securely.
- They bridge the gap between traditional finance and the digital economy by maintaining a stable value relative to assets like fiat currencies or commodities.
- Stablecoins can be pegged to fiat currencies, backed by reserves, collateralized with cryptocurrencies, or algorithmically controlled.
- While stablecoins offer stability, a place of safe haven during market turbulence, and efficient transactions, they also come with risks like depegging, collateral volatility, and regulatory uncertainty.
Bitcoin’s meteoric rise from negligible value in 2009 to $69K in 2021 has presented investors with the challenge of navigating its extreme and unpredictable volatility. Introduced in 2014, stablecoins address crypto volatility by pegging their value to stable assets algorithmically to crypto or pegged to fiat currencies or gold.
This allows investors and traders to participate in the crypto market and take advantage of price fluctuations, while providing a safe haven during market turbulence, enabling a secure transition out of volatile cryptocurrencies into stablecoins.
What are Stablecoins
Stablecoins aim to bridge the gap between traditional finance and the digital economy. Stablecoins, in contrast to many other cryptocurrencies, are intended to retain a constant value in relation to a certain asset, such as the US dollar (USD). They offer a trading method that is less vulnerable to the notable price swings that are frequently observed in the cryptocurrency market.
By letting users keep the advantages of digital currencies while reducing the volatility frequently associated with cryptocurrencies, stablecoins provide an alternative to conventional fiat currencies.
Even though Bitcoin (BTC) and Ethereum (ETH) have delivered substantial returns, they also entail considerable risks. In contrast, stablecoins like Tether Gold (XAUT) are backed by tangible assets, such as gold. Others, like DAI (DAI) , the stablecoin based on the Ethereum blockchain is governed by the Ethereum protocol and pegged to the USD.
Each stablecoin has its advantages and disadvantages and their stable mechanism often sparks controversy due to their lack of transparency and inherent complexities and potential manipulation risks. Nevertheless, stablecoins are playing a vital role in the current phase of cryptocurrency development despite uncertainties about their long-term prospects and regulatory standing.
How Do Stablecoins Work?
As we expand on the differences between cryptocurrencies like BTC and ETH and stablecoins, one can identify that the latter are inherently designed to maintain a stable value. When understanding further on the mechanics of how they are able to do this we discover the following:
- Pegging: Stablecoins are pegged to fiat currencies like USD/EUR, maintaining a stable value, usually a 1:1 ratio with minor periods of slight volatility.
- Backing: Some stablecoins are backed by reserves of the asset they’re pegged to such as fiat currency or commodities like gold. If a stablecoin is pegged to the US dollar, there should be an equal amount of dollars held in reserve.
- Cryptocurrency collateral: Stablecoins like DAI are over-collateralized with other cryptocurrencies to maintain their value. Over-collateralization in stablecoins means more than one unit’s worth of another cryptocurrency, such as Ether in this case, is held in reserve for each DAI issued. This safeguards DAI’s value against the volatility of ETH, ensuring DAI maintains its peg to the USD.
- Algorithmic backing: Some stablecoins don’t have reserves but use algorithms to regulate supply and demand, keeping the price stable.
In essence, stablecoins can serve their role to facilitate everyday transactions, and serve as a safe haven during market turbulence.
Types Of Stablecoins
In the world of cryptocurrencies, stablecoins come in a variety of forms. Here are four typical categories:
Fiat-collateralized Stablecoins
Fiat-collateralized stablecoins are stablecoins that have reserves of fiat money, such as the US dollar or the euro. An equivalent amount of fiat money kept in a bank account or custodial service supports each stablecoin currently in use.
Stablecoins with fiat collateral include Paxos Standard (PAX) , USD Coin (USDC) , and Tether (USDT).
Crypto-collateralized Stablecoins
Crypto-collateralized stablecoins are stablecoins with cryptocurrencies kept as collateral. Users receive stablecoins in exchange for making a specified, generally over-collateralized, cryptocurrency deposit.
The stablecoin’s stability is preserved by the value of the collateral. Dai (DAI), which is backed by Ethereum (ETH), and sUSD (Synthetix USD) , which is backed by Synthetix Network Tokens (SNX), are two examples of crypto-collateralized stablecoins.
Algorithmic Stablecoins
Stablecoins that use algorithms to guarantee stability instead of collateral backing are known as algorithmic stablecoins. These stablecoins use algorithmic formulas and smart contracts to control their supply and demand in reaction to market conditions.
Algorithmic stablecoins include Frax (FRAX) and Ampleforth (AMPL) .
Commodity-collateralized stablecoins
Commodity-collateralized stablecoins are stablecoins that have physical goods as collateral, such as gold or other precious metals. The value of the underlying commodity determines the value of the stablecoin.
Tether Gold (XAUT), which is backed by gold reserves, is an example of commodity-collateralized stablecoins.
Every stablecoin kind has unique traits, benefits, and potential downsides. Individuals and companies can choose the stablecoin type that best meets their needs and preferences in terms of stability, transparency, and underlying collateral by being aware of the distinctions between them.
Advantages and Disadvantages of Stablecoins
The crypto space is still in its infancy and has seen many booms and busts. Stablecoins come with pros and cons which will be stress tested over time. Some advantages and disadvantages respectively include:
Advantages Of Stablecoins
- Stability: Stablecoins like Tether (USDT) and USD coin (USDC) are designed to maintain a 1:1 value with a fiat currency benefiting speculators and investors by mitigating against extreme price volatility throughout the crypto boom and bust cycles.
- Safe haven: In turbulent market conditions, investors can shift their assets into stablecoins without having to leave the cryptocurrency space. This prevents leakage of capital out of the crypto market and makes it more enticing for investors to enter the space.
- Efficient transactions: Stablecoins enable quick and efficient transactions and cross-border transfers especially beneficial in countries with unstable local currencies. It is a quick way to send value from one country to another.
Disadvantages Of Stablecoins
- Depegging risk: The risk that the stablecoin could lose its 1:1 peg with its underlying asset. Both USDT and USDC have experienced temporary depegging incidents due to market conditions and credibility quickly gets shaken when this occurs. Holding a stablecoin might lead to the catastrophic event of a collapse leaving its holder with a worthless token.
- Collateral volatility: Stablecoins backed by other cryptocurrencies, like DAI, face the risk of the collateral asset’s volatility. For instance if ETH’s value drastically decreases, the stablecoin’s stability can be undermined.
- Regulatory uncertainty: As stablecoins bridge digital assets and traditional financial systems, they might face regulatory challenges that could affect their stability and future usability.
One case study on a stablecoin is Luna (LUNC) and TerraUSD (UST) which were two native tokens of the Terra network with the latter algorithmically backed by the LUNC token enabling it to keep a 1:1 peg to the USD.
This blockchain-based project developed by Terra Labs in South Korea maintained its peg to the US dollar by algorithmically designing its supply in response to market demand, but ultimately failed to consistently uphold its peg amid sharp market fluctuations in 2022.
Its companion token, LUNA, which was meant to stabilize UST’s price, fell from $80 to a few cents by May 12 as a result, its feedback mechanism proved inadequate.
Luna’s fate was sealed when its value deviated significantly from its intended peg, causing users to lose confidence in its stability which led to its collapse. This failure underscored the challenges associated with designing stablecoins by highlighting the need for more robust and reliable mechanisms in the world of stablecoins.
Use Cases Of Stablecoins
Stablecoins are useful in online payments, trading, remittances, and numerous DeFi applications because they offer accessibility and efficiency.
- Online payments: Stablecoins offer an efficient and reliable medium of exchange for online transactions. Stablecoins can be used as payment medium by businesses, lowering the volatility concerns related to conventional cryptocurrencies.
- Trading: Stablecoins are used as a trading pair on cryptocurrency exchanges, enabling traders to instantly enter and exit positions without having to convert their holdings to fiat money. Stablecoins can be used by traders as a hedge against market turbulence.
- Remittances: Stablecoins provide a quick and affordable way to send money across international borders. Without using conventional banking systems, users may transmit stablecoins internationally, which lowers fees and speeds up transactions.
- DeFi applications: Stablecoins are essential to decentralized finance applications. Within lending, borrowing, and yield farming procedures, they act as a solid unit of account, collateral, and liquidity. Users may use stablecoins to access decentralized financial services without being exposed to changes in the cryptocurrency market.
Regulation Of Stablecoins
In the US, stablecoin regulation is a fluid and changing landscape. Some stablecoins are considered securities by the Securities and Exchange Commission (SEC) and, as such, are governed by applicable securities laws.
Stablecoins that are considered commodities are within the purview of the Commodity Futures Trading Commission (CFTC), which focuses on derivatives and futures contracts. Additionally, stablecoin issuers and service providers must adhere to Financial Crimes Enforcement Network (FinCEN) laws for AML and KYC compliance.
In accordance with existing regulatory frameworks, the Office of the Comptroller of the Currency (OCC) enables national banks to retain stablecoin reserves. Additionally, many states may have their own rules, such as laws governing money transmission. In this changing regulatory climate, it’s critical for players to stay educated and obtain legal counsel to maintain compliance.
HM Treasury (HMT) intended to control stablecoins as an accepted payment method in the UK. By placing stablecoins under regulatory oversight, HMT hopes to promote innovation and confidence in the nation’s crypto industry by giving stability and validity to their use as a form of payment.
The Future Of Stablecoins In The Crypto Landscape
Stablecoins have a bright future, but they also face governmental scrutiny. These digital assets have already made a significant impact, offering stability and usefulness in the erratic cryptocurrency market. However, depegging of USDT and USDC raised concerns about their stability and regulators across the world are rigorously scrutinizing their activities to make sure they comply with financial legislation as the demand for stablecoins rises.
The outcome of this regulatory investigation will be crucial in determining the amount of investor protection, confidence, and transparency connected with stablecoins in the future. Stablecoin stability, security, and regulatory compliance are being improved through industry-wide initiatives to develop clear norms and frameworks. These improvements are essential for stablecoin acceptance and integration into the global financial system.
FAQs
What are stablecoins and how do they work?
Stablecoins are types of digital money created in 2014, designed to hold steady value with fiat currency, achieved by tying their worth to stable resources like traditional currencies or commodities like gold. Their stability comes from either matching the stablecoin’s value with a reserve of traditional currency or goods, or by holding more of another cryptocurrency as a safety measure.
What are the advantages and disadvantages of stablecoins?
Stablecoins act as a safe haven during market turbulence, offer stability, and help enable efficient transactions in and out of volatile crypto assets, especially in countries with unstable local currencies. Some disadvantages involve the risk of losing the 1:1 peg with the underlying asset like the USD, volatility of the collateral asset if backed by other cryptocurrencies, and stablecoins are surrounded by regulatory uncertainties.
What are the different types of stablecoins?
There are fiat-backed, cryptocurrency-backed, and commodity-backed stablecoins, as well as algorithmic and hybrid stablecoins. Each type has its own unique mechanisms for maintaining stability. It is not yet certain which type of stablecoin is the most robust and reliable.
What are the main use cases for stablecoins?
Stablecoins can be used for online payments, trading, remittances, and various decentralized finance (DeFi) applications. They provide an efficient, reliable medium for transactions and are an effective hedge against market volatility.
How are stablecoins regulated and what is their future in the crypto landscape?
Regulation varies by country; in the US, some stablecoins may be classified as securities or commodities and must comply with respective laws. The UK aims to regulate stablecoins as accepted payment methods. Future developments in regulation, investor protection, and transparency will be crucial for the integration of stablecoins into the global financial system.
