It’s no secret that volatility and cryptocurrency go hand in hand. But there is one type of crypto specifically designed to offer a fixed price: stablecoins.
A stablecoin is a cryptocurrency whose value is tied to the price of another asset, hence the term “stable.” For example, if a stablecoin is functioning properly pegged to the US dollar, it should always be valued at $1.
Recent events have taught us that not all stablecoins are created equal. In May, the TerraUSD meltdown showed that not every stablecoin can guarantee price stability.
Here is a general guide to understanding the various stablecoins currently available on the market.
What are stablecoins?
Stablecoins are a type of cryptocurrency designed to maintain a stable price over time, tied to the value of an underlying asset, such as the US dollar. They aim to offer all the benefits of crypto while trying to avoid rampant volatility.
The total market capitalization of Crypto can rise and fall by the billions of dollars per day. Even the main cryptocurrency – Bitcoin (BTC) – is subject to significant fluctuations in value. Over the past month, investors have seen about a 4% daily change in the value of BTC.
Fiat currencies, such as the US dollar or British pound, do not experience this level of price volatility. So another way to think about stablecoins is as a tokenized version of a fiat currency. In theory, a US dollar-based stablecoin is a token that resides on a blockchain and always trades for one dollar.
Types of Stablecoins
Stablecoins are usually pegged to a currency or a commodity such as gold, and they use different mechanisms to maintain their price peg. The two most common methods are holding a pool of reserve assets as collateral or using an algorithmic formula to control the delivery of a coin.
Collateralised stablecoins maintain a pool of collateral to support the value of the coin. Whenever a stablecoin holder wants to cash out their tokens, an equal amount of the collateral assets is drawn from the reserves.
USD Coin (USDC) is a good example of a collateralized stablecoin. The chart below shows USDC’s collateral reserves as of August 2022 – at $54 billion, the coin’s reserves slightly exceed its liabilities of $53.8 billion.
USDC’s reserves are held in safe assets that should hold their value, such as cash and US Treasuries.
USDC is an outlier of stablecoin in releasing precise data on its assets and liabilities. There has long been controversy over the reliability of collateral reserves related to certain stablecoins (i.e., stablecoin liabilities exceeding reserves).
The most prominent and oldest stablecoin is Tether (USDT). With a market cap of $66.9 billion, USDT is currently the third largest cryptocurrency, behind Bitcoin and Ethereum (ETH). However, it has been besieged for years by doubts about the reliability of its reserves.
Stablecoins and cryptocurrencies are now under increased scrutiny by federal regulators.
In October 2021, the Commodity Futures Trading Commission (CFTC) issued a statement ordering Tether to pay a $41 million civil fine for making “untrue and misleading statements” and for “disclosing to customers and the market misrepresented that Tether has sufficient U.S. dollar reserves to support each USDT in circulation with the ‘equivalent amount of corresponding fiat currency.’”
Tether still claims it has enough reserves to support the $66.9 billion worth of Tether tokens in circulation. In addition, the company has not yet defaulted on any redemption request.
“Our journey to greater transparency is not yet complete,” Paolo Ardoino, Tether’s chief technology officer, stated in April, promising to continue assuring the market that Tether is trustworthy.
Stablecoins can also be backed by other cryptocurrencies. The biggest example in this category is the DAI (DAI) algorithmic stablecoin, which is pegged to the US dollar but backed by Ethereum and other cryptocurrencies.
But because the underlying collateral is in cryptocurrency, it is prone to more volatility.
Experts say the DAI stablecoin is overcollateralized, meaning that the value of cryptocurrency assets held in reserves can exceed the number of DAI stablecoins issued.
Algorithmic Stable Coins
Algorithmic stablecoins maintain their price peg through algorithms that control the supply of the token.
TerraUSD (UST) was the largest algorithmic stablecoin, reaching a market cap of more than $18.7 billion at its peak on May 5 before starting to fall sharply after falling below its peg.
The price of TerraUSD was pegged at $1 via the minting (making) and burning (destroying) of a sister coin, Luna. There was no collateral, with the whole model running through this algorithmic beating and burning of Luna tokens every time a UST stablecoin was bought or sold.
This turned out to be a problematic model. TerraUSD suffered what has since been known as a “death spiral” when a wave of panic finally caused the crypto equivalent of a run-on-the-bank in May, with a tidal wave of sales “de-pegging” TerraUSD from its price of $1 and eventually sending the “stable” coin to near zero, alongside its sister coin, Luna.
At the time, fear in the markets caused Tether to drop below its 1:1 dollar peg to 94 cents on May 12.
While not to the same extent as TerraUSD, investors were concerned about the reliability of reserves and whether Tether was fully backed.
TerraUSD now trades under TerraClassicUSD (USTC) since the Terra blockchain was officially discontinued and unpegged from the US dollar on May 9. USTC is trading at barely 3 cents.
How are stablecoins used
Stablecoins allow investors to move in and out of various cryptocurrencies while staying within the cryptocurrency world.
“Stablecoins are being used to bridge the gap between fiat currencies and cryptocurrencies without the volatility,” said Richard Gardner, CEO of Modulus Global. “Stablecoins also allow people from high-inflation economies to store the value of their savings in assets pegged to a more stable currency, such as the US dollar.”
These coins offer the benefits of cryptocurrency, namely instant transfers and low fees, without the downside of volatility. That means investors can hold them without worrying about wild swings in the value of their portfolios.
International wire transfers are a good example of a use case. Normally this would require foreign exchange (FX) conversions with multiple banks and intermediaries. This route would then involve a series of steps and various costs and often take a few business days to complete, unlike a stablecoin transfer which would be instantaneous and involve low or no costs.
How Stablecoins Make Money
The first method stablecoin issuers use to make money is by simply charging redemption and issuance fees.
After that, it often varies depending on the type of stablecoin. For centralized issuers, this desire to make money leads to the controversy surrounding reserves transparency, discussed above. For many, this is the downside of the centralized model: the fact that investors who hold such stablecoins take on the counterparty risk.
Counterparty risk is the chance that the other party in the asset will default on part of the deal and default on the contractual obligation.
“(Centralized) stablecoins make money by investing their dollar reserves in higher-yielding asset classes, e.g. commercial paper or treasury bills,” said Ganesh Viswanath Natraj, assistant professor of finance at Warwick Business School in the UK. costs zero interest.”
On the other hand, decentralized stablecoins have monetization modes that vary from protocol to protocol.
Typical examples include selling governance tokens that allow buyers to vote control over the future of the stablecoin or locking money into smart contracts on the blockchain to earn interest.
But with these investments from stablecoin issuers come risks. The stablecoin issuer faces a trade-off.
“While investing their dollar reserves can increase profits, it also increases the risk of a (bank) run and not having enough liquid reserves to meet principal payments in response to investor panic,” says Natraj.