This article aims to provide an overview of stablecoins. It references cryptocurrencies and blockchain technology. If you are unfamiliar with crypto, consider reading our introductory articles on crypto and blockchain, and our insights article on the evolution of stablecoins here.
What Are Stablecoins?
Stablecoins bridge the gap between fiat currency and digital currencies. Unlike other cryptocurrencies, most stablecoins are pegged to the value of a reserve asset, such as gold or government monies. Amid the COVID-19 pandemic, many investors were drawn to stablecoins for their price stability, leading to the explosion of the stablecoin market. Currently, the total market capitalization of stablecoins exceeds US$160 billion, according to CoinGecko. If you are wondering why there are so many stablecoins, read our article here!
How Do Different Stablecoins Work?
Users can mint stablecoins on a blockchain like any other cryptocurrency. However, the underlying mechanisms of different stablecoins vary. To find out more about the advantages and disadvantages of each stablecoin, consider reading our article on the evolution of stablecoins.
The most popular stablecoins are backed by fiat currency reserves at a 1:1 ratio, which implies that one stablecoin is represented by one fiat currency unit, such as one USD or Euro. These reserves remain in financial institutions and entities which act as central issuers.
Taking Tether USD (USDT) as an example, when a user mints 5 USDT, Tether takes out a corresponding amount of US$5 from its reserves. When users sell their USDT back for USD, Tether burns the 5 USDT to remove it from the supply in circulation. Other popular stablecoins include USD Coin (USDC) issued by Circle and Coinbase, and Binance USD (BUSD) issued by Binance and Paxos.
Collateralized Debt Position (CDP)
CDP is the position created by locking collateral in a smart contract rather than relying on a central issuer. This system was first introduced to decentralized finance (DeFi) by MakerDAO, and its stablecoin DAI is created this way.
When a user buys this type of stablecoin, their collateral is locked into a smart contract to obtain tokens of an equivalent value. DAI adopts an overcollateralized model where the collateral deposited must exceed at least 150% of the value of DAI that the user mints. For example, to buy $100 worth of DAI, users must provide at least $150 worth of collateral. The intention behind DAI’s overcollateralization is to defend the stablecoin against price fluctuations of the collateral asset. If the market price of the collateral falls, the excess collateral maintains DAI’s price stability. If users want to sell their stablecoins, they must deposit their tokens into the same smart contract to withdraw their original collateral.
Algorithmic (Algo) Stablecoins
Algo stablecoins are not backed by any reserves and are typically undercollateralized. They utilize smart contracts with algorithms that adjust the number of tokens in circulation by matching the level of demand in the market.
Taking the Frax Protocol (FRAX) as an example, its fractional-algorithmic stablecoin is partly collateralized and partly algorithmically stabilized. The protocol utilizes a two-token design, including its stablecoin, FRAX, and a governance token, FXS. To mint FRAX, FXS must be burned alongside collateral, such as USDC. The amount of collateral needed is determined by the collateralization ratio. For example, assuming the collateralization ratio is 70%, this indicates that 70% of $1 worth of FRAX is backed by collateral, and 30% is backed by the FXS supply. FRAX maintains its peg through deep liquidity pools, such as FRAX3CRV on Curve. FRAX3CRV facilitates the trade and swap of FRAX for other stablecoins with low slippage. Other algo stablecoins include the Fei Protocol (FEI) and TerraUSD (UST). Read more about the recent UST depeg here.
What Can You Do With Stablecoins?
Similar to other cryptocurrencies, a user can invest in stablecoins via crypto staking and yield farming.
Staking makes use of the Proof-of-Stake (PoS) consensus mechanism where users lock up their assets in smart contracts in exchange for rewards. Similar to keeping money in a savings account, users can earn interest by staking their stablecoins.
Yield farming refers to generating passive income from interest off crypto assets by locking them in a liquidity pool. The funds locked in the pool provide liquidity for the protocol, while the platform distributes the transaction fees proportionally to investors in exchange for providing liquidity.
Medium for International Exchange
Furthermore, the fast processing rate and low transaction fees make stablecoins a good medium for international exchange. Businesses and individuals gain better access to established national currencies and can transfer money across borders cheaply.
Risks of Stablecoins
As some stablecoins are centralized currencies, investors must trust central issuers like Tether to act in good faith. However, this may not always be the case as fiat in centralized entities could be fractionally reserved instead of fully backed. For example, Tether was fined multiple times in 2021 for lying about the constituents of their fiat reserve. Before investing in a stablecoin, it is good practice to check if routine attestations are released from trustworthy auditors. For example, Binance and Paxos liaise with Withum, which conducts monthly audits of the BUSD reserves.
A “bank run” effect can occur if there are insufficient buyers during a massive sell-off. When stablecoins lose their peg for an extended time, investors may lose confidence in their ability to repeg. Algo stablecoins are especially vulnerable to liquidity risks, as seen in the recent UST collapse in May 2022. Issuers of centralized coins can absorb the downward pressure using their hard assets. However, uncollateralized coins (i.e. algo stablecoins) purely rely on investors’ self-interest.
Given that decentralized stablecoins operate using smart contracts in protocols, there is always a risk that a hacker could exploit a vulnerability in the algorithm. Actions executed by fraudulent contracts cannot be annulled due to the blockchain’s immutable nature.
While still relatively nascent, regulatory frameworks for stablecoins are well underway. Following TerraUSD (UST)’s crash, Senator Elizabeth Warren and Treasury Secretary Janet Yellen called for tighter regulations on the stablecoin industry. Massachusetts Representative Jake Auchincloss told TIME that a legislation draft to mandate that stablecoins be federally audited is in the works. His draft also includes stablecoin issuers proving that they have 90 days’ worth of liquid reserves and providing insurance for investors. Other parts of the world are considering stricter laws, such as the European Commission’s possible strict cap on the stablecoin market, effectively outlawing large-scale stablecoins.
The Future of Stablecoins
Stablecoins provide a semblance of stability that is lacking in most cryptocurrencies. The interdependence of fiat and cryptocurrencies in stablecoins could further mainstream the adoption of crypto assets. Crypto beginners can also try their hand at investing with stablecoins first before diving into more volatile coins.
However, stablecoins are not immune to crashes and price fluctuations despite their name. The recent TerraUSD (UST) crash proves this true, as virtually $45 billion dollars were wiped out over the course of a week. Every stablecoin comes with its own set of risks, and investors should always do their own research (DYOR) before entering the market.
Stablecoins have a huge potential to integrate into traditional financial markets. Revolutionary stablecoins and alternative mechanisms or models are constantly being developed and launched. Even existing stablecoins, such as Tether, are venturing into untapped crypto markets. Tether recently announced its entry into Latin America with its Mexican peso-pegged stablecoin, MXNT. For a greater understanding of current innovations in the stablecoin space, read our Insights piece, “The Evolution of Stablecoins: A Vital Cog in DeFi” here.
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