What Stablecoins Are And Why They Matterby@toluajet
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What Stablecoins Are And Why They Matter

by Tolu AjetunmobiSeptember 12th, 2022
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Stablecoins act like a link to the traditional banking system. They are like a safe haven for investors/crypto users who want stability while still staying within the crypto ecosystem.  This piece explains everything you need to know about stablecoins, including types of stablecoins, the stablecoin Trilemma, and their regulation.

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The stablecoin market has grown tremendously, with a market cap of over $160 billion in March. Currently, the market cap is at $150.9 billion representing around 15% of the total crypto market.

That is huge!

So, what exactly are stablecoins, and why do they matter in crypto space?

What are Stablecoins?

A stablecoin is a digital currency pegged (tied) to another currency or financial instrument to achieve price stability. They are usually tied or pegged to stable currencies/commodities like “gold” or the USD (the U.S. Dollars).

Stablecoins do this through algorithm formulas and maintaining reserves to control the circulation. For example, stablecoins like BUSD, USD are pegged to the U.S. dollar at a 1:1 ratio. This means that 1 unit of these stablecoins is approximately 1 dollar.

Stablecoins act like a link to the traditional banking system. They are like a safe haven for investors/crypto users who want stability while still staying within the crypto ecosystem.

Think of them as blockchain-based fiat currencies. They are designed to reduce volatility and become better alternatives to popular cryptocurrencies as a medium of exchange.

Why Do We Need Stablecoins?

Stablecoins act as the bridge between the crypto world and everyday currencies. Sometimes, you need a way to store your assets without dealing with the volatility of other cryptocurrencies. You just want to save money and not deal with price fluctuations.

Problem: You need a stable currency to store your assets without dealing with market volatility.

Stablecoins are an excellent solution to this problem. Because they are designed to maintain a stable value or peg, their prices don't fluctuate.

For example, the USDT is pegged to the U.S. dollars at a 1:1 peg; You need $1 to buy 1 USDT. Next year, that peg remains 1:1; $1 equals 1 USDT. So, if you buy 10,000 USDT with $10,000, you’ll get back $10,000 when you need it.

Other types of cryptocurrencies like Bitcoin (BTC) don’t work this way; their prices are affected by market fluctuation.

For example, 1 BTC was over $45,000 in January this year; at the time of writing, 1 BTC is around $19,000. So, if you bought $45,000 worth of BTC earlier this year, you currently have less than $20,000.

This works both ways though, if the price of BTC increases over time, your money also increases.

However, unless you’re a seasoned trader, you have no way of telling what the market will do. Besides, if you need your money during a down period, you have to take this loss.

Another critical use case of stablecoin is a medium of exchange. Cryptocurrencies like BTC and ETH can be an insufficient means of trade because of their volatility. They are just not fair.

For example, you pay more if you send some money during a market low. So, you’re at the losing end. If you send some money when the price increases, you pay less, and the receiver is at the losing end.

Problem: You need a stable means of digital transfer without dealing with banks or third parties.

Due to their stability, stablecoins make peer-to-peer transfer possible without any problem. You don’t need an intermediary or multiple bank accounts.

For example, you’re a business owner who wants to pay your contractors in another country. Ideally, you need another bank account in that country to exchange your currency before payment. The other option is to go through a complicated banking process that can take days or weeks.

Stablecoins solve that problem for you. Like other cryptocurrencies, they are decentralized and accessible to anyone. All you need is a crypto wallet.

Furthermore, they are not susceptible to volatility, so you can send any time without worrying about fairness. Besides, you can send money anywhere in the world and fast.

How do Stablecoins work?

That usually depends on the type of stablecoin. But there are three broad ways that stablecoins work:

  • Collateralized by fiat currencies

  • Collateralized by crypto

  • Non-collateralized stablecoins

For example, fiat-collateralized stablecoins use a reserve of a fiat currency as collateral to maintain its value. I’ll cover the types of stablecoins and how they work later in the next section.

Types of Stablecoins

Stablecoins can be classified into six groups

  1. Fiat-based
  2. Commodity-backed
  3. Crypto-backed
  4. Hybrids
  5. Algorithm Stablecoins
  6. Non-collateralized Stablecoins

Fiat-Based Stablecoins

Fiat-based stablecoins are stabilized by pegging them 1:1 to fiat currencies. The most popular stablecoins are pegged to the U.S. dollar USD. But some are pegged to the British Pounds (GBP), Euro, the Japanese Yen, and the Chinese RMB.

This type of stablecoins maintains their value with a reserve of the fiat currency they are pegged to. Examples of Fiat-based stablecoin include BUSD, USDP, and USDC, which are pegged to the USD on a 1:1 ratio.

Commodity Based Stablecoins

Instead of fiat currencies, commodity-based stablecoins are pegged to the value of commodities like Gold, real estate, and oil. So, their value rises and falls with the value of these commodities. This type of stablecoin maintains its collateral by storing a reserve of the commodity it is pegged to.

Commodity-backed stablecoins are popular because they allow investors to invest in the underlying commodity without buying and storing it.

An example of a commodity-backed stablecoin is XAUT – a stablecoin pegged 1:1 to Gold, so 1 XAUT equals 1 Ounce of Gold.

Hybrid Stablecoins

Hybrid stablecoins are backed by fiat currency, physical commodities, and cryptocurrency. So, the stablecoin maintains a reserve of several non-fiat and fiat assets as collateral

An example of a hybrid stablecoin is USDT. According to its 2021 report, USDT is collateralized by 83% of cash equivalent and fiat with 17% of other collateral like corporate bonds, precious metals, and digital tokens.

Crypto-backed stablecoin

Crypto-backed stablecoins are usually collateralized by a large holding of other cryptocurrencies (more established and stable coins like BTC and ETH).

To avoid losing their peg, crypto-backed stablecoins are usually over-collateralized. That is, the reserve value usually exceeds the value of the coins issued. For example, a stablecoin may hold $5 million worth of the backing cryptocurrency in reserve to issue $2 million worth of the stablecoin.

An example of a crypto-backed stablecoin is the MarkerDAO’s DAI. It is pegged to the U.S dollar but backed by ETH and other coins worth around 164% of the total DAI in circulation.

Algorithmic Stablecoin

Algorithmic stablecoins rely on smart contracts containing a set of rules to maintain stability. It doesn’t matter if the stablecoin is collateralized or not.

The algorithm maintains its supply and value of coins based on the market demand and a minting/burning mechanism. It burns some coins during lower market demand to control the supply and it mints more coins during high market demand.

However, the algorithm can’t mint new coins from thin air; the stablecoin is either collateralized or controlled by a smart contract. How an algorithmic stablecoin works is close to how central banks work; algorithmic stablecoin relies on rules that use changes in the token supply to maintain the coin value.

The difference is that Central banks usually set monetary policy with economic parameters that are widely understood. They also backed that policy with an unlimited supply of fiat currency.

Non-collateralized Stablecoins

Non-collateralized algorithmic stablecoins, also seigniorage stablecoin, are purely algorithmic and use smart contracts to increase/decrease their supply and maintain stability automatically. An example is TerraUSD (UST), backed by its sister currency – LUNA.

While algorithmic stablecoins are an innovative way of creating a stable currency, technology is still largely underdeveloped.

The recent Terra crash exemplifies how bad the technology can tank. UST, the algorithmic stablecoin, lost its peg to the USD and fell 60% after its sister currency, LUNA, crashed overnight.

What Can You do with Stablecoins

  • Avoid Volatility

Stablecoins are excellent ways for crypto users to avoid volatility. Experienced traders usually leverage stablecoins to avoid market depression.

For example, you can convert volatile cryptocurrencies like ETH and BTC into stablecoin to lock in their assets’ value before a market crash. When the market is down, buy back more coins with the converted amount. In short, Sell high, Buy low.

  • Save Assets

You can save your assets with stablecoins without any intermediary. You don’t need a bank account, just your wallet. They are easy to manage and transfer.

  • Transfer Money fast and Cheaply

You can use stablecoins for payment within a few minutes without any complicated processing documents. The best part is that it is cheaper than most payment methods. For example, you need just 1 USDT ($1) to transfer USDT from one wallet to another on the TRC20 network.

  • Earn Interest (Passive Income)

By lending or staking your stablecoins, you can earn interest on your assets. It is a less risky way of earning money with your cryptocurrencies.

How Stable are Stablecoins?

The LUNA UST crash raised serious concerns and doubts about the stability of stablecoins. But before we get into discussing the stability of stablecoins, you should know that the UST situation is an exception rather than the norm. In Joe Downie’s words:

“UST was never really a stablecoin from the start.” It was an attempt to make something that appeared stable, that tried to be pegged to the dollar as much as possible, but by being backed by their own currency instead of U.S. dollars, it was a recipe for disaster essentially.”

Joe Downie is the chief marketing officer at NiceHash. Now, let’s get into the nitty-gritty of the stability concerns of stablecoins. The first thing to know is that:

“The Stablecoin Trilemma controls the stability of stablecoins.”

Stablecoin Trilemma

Developers have to make several tradeoffs between several factors like decentralization when developing a stablecoin. The Stablecoin Trilemma results from these different decisions they have to make.

The Stablecoin Trilemma states that a stablecoin design can avoid at most two of the following risks at a time:

  1. Downward price instability of the coin’s peg from $1 due to moral hazards of the system
  2. Downward price instability when the coin is exposed to external market risk or has a poor financial performance
  3. Upward instability of the stablecoin from $1 when there is a limited supply

In simpler terms, the Trilemma implies that a stablecoin has to make tradeoffs between:

  • Decentralization;
  • Price stability (control over the peg), and
  • Capital efficiency (scalability)

To properly understand the Trilemma, you must understand that there is a need to control the demand and supply to maintain stability. To do this, the stablecoin can either maintain a high reserve value or limit the coin in circulation.

This is where the Trilemma starts – to keep a high reserve value or limit the coin in circulation. Should the stablecoin decide to hold a high reserve value, the type of risk they can’t avoid depends on which kind of reserve they hold.

In the case of fiat assets (fiat-collateralized assets), the stablecoin faces downward price instability due to the moral hazards of the system. That is, it is always at risk of instability because transactions and policies of the reserve can’t always be transparent.

In non-fiat reserve (blockchain-based assets) cases, the stablecoin avoids the system’s moral risk. But the stablecoin now faces downward price instability due to the volatility of its reserve.

Should the reserve fall below a certain point, the stablecoin has less than enough to back its issued coin. That brings up the risk of downward instability due to external market risk or poor financial performance.

If the stablecoin decides to control the market by limiting coin supply, the design risks upward stability due to limited supply.

All these scenarios prove that no single stablecoin design can have everything – decentralization, capital efficiency, and control over the peg. Existing stablecoins vary in their design, some with better stability pegs than others. So, it is hard to conclude on a single superior stablecoin design.

But according to research;

“Most people perceive that a coin with limited coin supply is more stable than the other two tradeoffs. Furthermore, the choice of the stablecoin model varies at country level, suggesting that a stablecoin design can be customized.”

The Bottomline is this:

“No stablecoin can avoid the Trilemma to achieve a stable of perfect stability, but that doesn’t mean they will lose their peg or become unstable. Instead, each stablecoin manages the risk in their own way.”

Stablecoin Regulation

Currently, stablecoins are regulated lightly with no regulatory body. Although, several governments – the U.S., the U.K., and the E.U – are actively looking into this, especially since the Terra crash. There are already several proposed regulations for regulating the space.

Some regulations propose controlling stablecoin issuers under the same financial rule as financial providers. Specifically, the regulators want more say on the reserves stablecoin is backed with. According to Sarah Kocianski, an independent Fintech consultant:

“The riskiness of a stablecoin fundamentally relies on what reserves it’s backed by — in short, the greater the reserve, the lower the risk; being able to accurately assess the riskiness of a stablecoin enables regulators to create appropriate rules, meaning companies’ transparency around their reserves is vital.”

Before You Buy a Stablecoin

If it is your first time buying a stable, you should know that:

  • Stablecoins are backed with different types of collaterals
  • Holding your assets as stablecoins still carries some risk. For example, you’ll lose your assets if your wallet is compromised. If you’re using a custodial wallet on an exchange, you risk a single point of failure.

So, before you buy a stablecoin, ensure the coin is truly stable and secure. Here is how to do that:

  • Look for a stablecoin that is audited and transparent.
  • Research to understand how the stablecoin is designed.

Ask yourself the following questions to be sure you understand the stablecoin design well:

  • Do you know how the stablecoin works?
  • How secure is the design?
  • How large is the reserve? What type of reserves do they hold?
  • Is the stablecoin audited?
  • How transparent are the stablecoin issuers?

Go for stablecoin with a large volume and type of different reserves. That is, it is backed up by different types of fiat and digital tokens. It is easier for stablecoins with varying types of coins to maintain their peg. Furthermore, be sure that independent financial firms regularly audit the stablecoin to confirm its assets. The stablecoin issuer should also be transparent with their reserves and transactions.

However, although stablecoins are less volatile than other crypto, risks are still involved. Like other cryptocurrencies, stablecoins are still at risk of hacking and a single point of failure.

Besides, with the regulation policies process, the government might decide to clamp down on the stablecoin market causing less decentralization and significantly changing the scene.