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Let's dive deep into the stablecoin forest and find out what makes stablecoins such an incredible powerhouse for the crypto market
The nascent world of cryptocurrencies is evolving much faster than most markets today given that Bitcoin has only existed for a decade. Currently, the total market capitalization is well over $1 trillion with BTC taking the larger share at 60.7%. This space is now attracting stakeholders ranging from regulators all the way to fortune 500 companies and institutional investors across the globe.
Despite such growth, the crypto market is still notorious for its high volatility when it comes to price action. An issue that the industry is now trying to address through stablecoins like the USDT, USDC, PAX and DAI. This emerging class of crypto coins started gaining popularity back in 2015 when USDT was listed by a few exchanges that were active at the time.
By definition, stablecoins are crypto assets that are backed by a relatively stable asset to minimize the price volatility associated with crypto markets. This class of crypto coins rose to fame as an alternative for accommodating less volatility while trading crypto assets. Today, they are among the leading crypto trading pairs with most market makers opting to take profits through stablecoins.
As expected, the idea of stablecoins has sparked different reactions from innovators and regulators that are keen on the crypto industry. Some believe in their value proposition while others hold on to traditional economics, where only central banks have the mandate to supply money. Nonetheless, stablecoin supply increased by around 322% in 2020 to hit $24.8 billion from $5.9 billion.
Stablecoins have evolved over the years and now exist in 3 main types; fiat-backed, crypto-backed and non-collateralized (algorithmic stablecoins). Let’s take a look at the fundamentals of each type and how they work in the crypto ecosystem.
Like the name suggests, fiat-backed stablecoins are pegged to a particular currency and in most cases the U.S dollar. Ideally, the coins should be backed on a 1:1 basis such that the amount of circulating stablecoins balances with the reserves held by the issuing entity at any point.
Take for instance Tether (USDT), which is designed to be backed on a 1:1 basis by the U.S dollar. This means that Tether Foundation cash reserves should be equivalent to the amount of circulating coins at any time. However, this may not be the case according to the latest information, which reveals that the reserve backing is at $0.74 as opposed to $1 for each USDT.
Other stablecoins that are backed by the U.S dollar include Gemini Dollar (GUSD) and the USDC coin by Circle and Coinbase. These two came a bit later and are yet to challenge USDT’s market dominance in cumulative and daily traded volumes.
Given their centralized nature, fiat-backed stablecoins are mostly used within centralized exchanges where they are now part of the standard. Leading exchanges have listed fiat-backed stablecoin trading pairs for almost all the listed crypto assets on their platforms.
Crypto-backed stablecoins are collateralized by cryptocurrencies as opposed to fiat currencies. Well, you might be wondering how this provides stability or value retention?
Just like the U.S dollar which is known for its stability, some crypto assets like Bitcoin and Ether have gained a ‘stable’ status compared to the rest of the market. In fact, most crypto-collateralized stablecoins are backed by one of the two digital assets.
The most popular crypto-backed stablecoin is DAI; this innovation was launched by MakerDAO and leverages the Ethereum blockchain to run a decentralized reserve. Simply put, no one can control the DAI supply.
Of course, such fundamentals come at a cost; DAI’s collateral ratio is much higher due to the volatility in crypto prices. For example, minting (triggering supply) 1 DAI would require a deposit ratio of 1.5:1 (ETH to Debt) which basically counts as overcollateralization.
Liquidation is triggered in the event where collateral-to-debt ratio goes below the collateral liquidation ratio, where in the case of DAI it should always be over 150% (1.5:1). The liquidation is carried out by the underlying smart contracts which automatically execute based on the pre-coded conditions.
With Decentralized Finance (DeFi) gaining popularity, DAI stablecoins have become a favorite for Ethereum blockchain users. Most players mint DAI stablecoins to perform other profitable operations while placing their ETH as collateral. However, they have to pay a ‘stability fee’ for holding such positions.
Algorithmic stablecoins are largely theoretical as most of the innovations are still in early stages. This type of stablecoin borrows fundamentals from Seigniorage Shares, a concept that was first published by Robert Sams in 2014.
Basically, they are not backed by any asset and depend on smart contracts to ensure that their value remains stable at any time. To paint a picture, think of the smart contracts as a central bank which maintains stability through quantitative easing.
In this case, quantitative easing involves supply of new algorithmic stablecoins when the value goes above the pegged target and burning some of the coins in circulation when it goes below. This way, a stable value of the underlying crypto asset is maintained throughout.
Some of the project examples in this niche include Basis, Ampleforth, Celo and Terra. All these innovations enjoy the backing of heavyweight investors, although the idea of algorithmic stablecoins may take a while before stakeholders get a hang.
Stablecoins are gradually taking over the crypto market with more volumes being supplied to exchanges on a daily basis. Last year, the transactional volume for stablecoins grew by 316% to hit $248 billion according to data from Coin Metrics. Notably, the number of addresses that hold more than $100K in stablecoins also shot up by 201%.
Some of the developmental highlights in this space include Facebook’s proposed Libra stablecoin. This stablecoin was to be backed by a basket of stable currencies, although Libra later pivoted to the U.S dollar only. It has since been rebranded to Diem in an effort to make a second debut during the first quarter of 2021.
Unsurprisingly, the trend has caught up with regulators who are now looking at the possibilities and shortcomings presented by stablecoins. The Bank of International Settlements (BIS) published a detailed research back in 2019 to investigate the impact of global stablecoins.
Since then, authorities including the U.S government have narrowed down on this emerging class of crypto coins. The U.S Office of the Comptroller of Currency (OCC) recently issued an interpretive letter that allows banks to use stablecoins for settlements.
As highlighted earlier, stablecoins are fundamentally designed to minimize the volatility associated with crypto markets. They are a critical part of this market’s infrastructure, especially in maintaining a stable portfolio value.
Going forward, this class of cryptocurrencies is likely to gain mainstream adoption as more stakeholders realize the underlying value. Here are some of the ways that stablecoins are used within the crypto ecosystem and financial markets in general.
Stablecoins can be used to hedge the crypto market volatility by acting as a store of value. Unlike Bitcoin and other crypto assets, stablecoins preserve the portfolio value even when the market is extremely volatile. They are used by crypto market stakeholders to hedge for long-term moves that might require to commit a specific fund amount.
Take for instance miners who are paid in BTC, but require to purchase the mining equipment in USD. It makes sense to hedge for this move by holding stablecoins as opposed to BTC which is exposed to the crypto market volatility. In doing so, the miners are protected from any price movements that might reduce the portfolio value of the committed funds.
Given their stable nature, stablecoins are used to take profits in the crypto market. They provide a simple way for market makers and investors to count their profits.
Ideally, stablecoins enable profit realization in the crypto market by preserving the value of such gains. Were it not for these digital assets, most profits made in trading cryptocurrencies would go unrealized or eventually be wiped out.
Medium of Exchange
Like fiat currencies, stablecoins serve as a medium of exchange in the active crypto market and day-to-day transactions. They can be used to buy other digital assets on exchanges or peer-to-peer markets that support this type of infrastructure.
Businesses and retail are also using them to make everyday transactions including the purchase of goods. In the crypto industry, stablecoins are gradually becoming the payment standard for services offered alongside other forms of trade.
Cutting Transaction Costs
Transaction costs can be overwhelming and could end up eating into most of the realized profits. Well, some stablecoins have been designed to tackle this shortcoming by providing cheaper transaction costs compared to other crypto assets.
Exchange coins like the Gemini Dollar (GUSD) and the Binance Dollar (BUSD) have way lower fees than the U.S dollar when it comes to trading crypto pairs. Such coins are some of the initiatives that crypto exchanges have debuted to increase adoption and convenience in cryptocurrency trading.
While they were originally designed for the digital ecosystem, stablecoins have started being used in the traditional finance marketplace. Remittances can now be sent in stablecoins, a process that takes a shorter time frame than the normal remittance channels. Furthermore, the stable nature of these digital assets ensures that transacting parties realize the optimum value.
When it comes to making money, everybody loves a lucrative yield (interest) on their capital. Stablecoins present multiple opportunities for crypto market participants to make decent yields than they would have through traditional finance instruments.
Here the yields could be as high as 400% in risky opportunities like yield farming, this is an emerging DeFi niche where participants are incentivized with high yield in order to provide liquidity. Less risky crypto market activities can yield between 20-30% and could go higher during the bull seasons. Stablecoins provide a perfect means to interact with this ecosystem. Let’s take a look at some of the ways they can be used to generate yields.
Stablecoins present an opportunity to trade in the crypto market where the upside potential could be quite rewarding. These digital assets can be used to buy crypto assets like Bitcoin or Ether, both have more than doubled in price within the past year.
Additionally, the stablecoins provide access to leverage while trading; one could get as much as 100X on some exchanges. This means that the profits will be a hundred times what you would have made by trading with only your initial capital.
Another burgeoning trading niche where stablecoins can be used to earn yield is crypto derivatives, which includes products such as perpetual contracts and futures. The crypto derivatives market has especially gained traction within the past year and is now a fundamental part of the whole market.
Lending and Borrowing
The crypto ecosystem is not any different from traditional finance, probably the reason that some have coined it ‘The Future of Finance’. Stablecoins can generate yield through activities like lending and borrowing within this nascent market.
Yes, it is possible to lend and borrow in crypto just like it’s done in traditional finance. In fact, this type of financial service has found a home in both Centralized Finance (CeFi) and Decentralized Finance (DeFi). The latter is especially famous for the high deposit rates offered on decentralized protocols. Some of the deposit rates are as high as 25%, quite a deal compared to what traditional finance offers.
So where do stablecoins come in? These digital assets can be used to lend in the crypto market by making a deposit on interest accounts run by exchanges or DeFi lending protocols like Aave, Maker and Compound. They can also be used as borrowing collateral to get another crypto asset with the interest charged being as low as 1% in some scenarios.
Last year saw the rise of DeFi as a hot trend in crypto, its momentum peaked in summer when liquidity mining was introduced. This basically involves the provision of liquidity to an Automated Market Maker (AMM), most of the active projects run on Ethereum blockchain.
In itself, liquidity mining is highly profitable but also carries along a high degree of risk. Back in summer 2020, AMM pools were offering liquidity providers thousands of percentages in returns for providing liquidity. While the craze appears to have died off, some pools are still offering as much as 400% APY.
Stablecoins are a means to access these DeFi protocols and could be used to provide liquidity as well. The composition of some AMM pools allows for users to deposit a stablecoin as one of the tokens to supply liquidity.
Despite being a young market, crypto is really giving traditional finance a good run for its money. Die-hard enthusiasts believe that the digital asset economy will eventually surpass the volumes done in today’s financial markets. This would mean that most financial activity will have shifted on-chain while stablecoins might have assumed a similar role to the U.S dollar in this ecosystem.
Like any sound market, the yield generation opportunities by stablecoins have some strengths and drawbacks. Here are some of them;
Lending & Borrowing
As per this breakdown, you can already see that there are multiple opportunities to generate yield through stablecoins. Interestingly, some innovators in the crypto space have leveled up the game by offering interest accounts on stablecoins. This is a more convenient and less stressful way to make money in the crypto market while preserving the value of your portfolio.
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