Stablecoins are digital assets tied to the value of fiat currencies such as the US Dollar, Euro, and other currencies. There are four main types of stablecoins, differentiated by their backing structure: fiat-collateralized, crypto-collateralized, commodity-collateralized, and algorithmic.
Contents:
- How Stablecoins Work
- Traditional Collateral (Off-Chain)
- Crypto Collateral (On-Chain)
- Algorithmic Stablecoins
- Commodity-Collateralized Stablecoins
- Stablecoin as a Medium of Exchange and Store of Value
- Popular Stablecoins
- Risks of Stablecoins
- Conclusion
How Stablecoins Work
Like any new asset class, cryptocurrencies are subject to market forces. Consequently, many crypto projects actively explore ways to mitigate risk and expand participation in the broader crypto ecosystem. This led to the emergence of a new segment of the cryptocurrency market known as stablecoins. This type of cryptocurrency tracks the underlying asset's value, making its value stable over time, at least relative to the currency to which it is pegged. Essentially, it's as if the underlying asset became electronic, like a digital dollar.
Since their goal is to track the value of an asset, stablecoins are often backed by specific assets to which they are pegged. For example, an organization issuing a stablecoin typically creates a reserve at a financial institution where the underlying asset is stored. Thus, a stablecoin might hold $100 million in reserve and issue 100 million coins with a fixed value of $1 per coin. If a stablecoin holder wants to cash out the coin, the real money can ultimately be taken from the reserve.
This structure differs from most cryptocurrencies like Bitcoin and Ethereum, which are not backed by anything. Unlike stablecoins, other cryptocurrencies fluctuate significantly as speculators push their prices up and down, trading for profit.
While many stablecoins are backed by hard assets, others are not. Instead, they use technical means (such as burning a portion of the coins to create a deficit) to maintain the cryptocurrency's price at a fixed level. These are called algorithmic stablecoins and can be riskier than asset-backed stablecoins.
Traditional Backing (Off-Chain)
The most popular stablecoins are backed 1:1 by fiat currency. Since the underlying collateral is not another cryptocurrency, this type of stablecoin is considered an off-chain asset. The collateral remains in reserve with a central issuer or financial institution and must remain proportional to the number of stablecoin tokens in circulation.
Some of the largest stablecoins in this category by market value include Tether (USDT), USD Coin (USDC), True USD (TUSD), and Paxos Standard (PAX).
Cryptocurrency-Backed (On-Chain)
Stablecoins backed by cryptocurrency use another cryptocurrency as collateral. This process occurs within the network and uses smart contracts instead of relying on a central issuer. When creating such a stablecoin, you lock your cryptocurrency in a smart contract. Then you can put your stable back into the same smart contract to withdraw the original amount of collateral. DAI is the most famous stablecoin in this category using this mechanism.
Cryptocurrency-backed stablecoins also have over-collateralization to mitigate price fluctuations of the required cryptocurrency collateral. For example, to issue DAI stablecoins worth $1,000, you would need to deposit $2,000 worth of ETH – this corresponds to a 200% collateralization ratio.
Algorithmic Stablecoins
Such coins do not use fiat or cryptocurrency as collateral. Instead, their price stability results from the use of specialized algorithms and smart contracts that manage the supply of tokens in circulation. The algorithmic stablecoin system will reduce the number of tokens in circulation when the market price falls below the tracked fiat currency price and increases when the price rises. An example of a former stablecoin is UST in the TerraLuna network.
Commodity-Backed Stablecoins
Commodity-backed stablecoins are backed by physical assets such as precious metals, oil, and real estate. The most popular commodity for collateral is gold. The two most liquid gold-backed stablecoins:
- Tether Gold (XAUT).
- Paxos Gold (PAXG).
It's important to remember that these commodities can fluctuate in price, leading to a loss of value.
Commodity-backed stablecoins facilitate investment in assets that might otherwise be inaccessible at the local level. Commodity-backed stablecoins can also be useful for those who want to exchange tokens for cash or buy the underlying tokenized asset. Owners of Paxos Gold (PAXG) stablecoins can sell them for cash or buy the underlying asset - gold.
Similarly, Tether Gold owners can redeem XAUT tokens in exchange for physical gold if they complete the verification process with TG Commodities Limited and have at least 430 XAUT. This minimum reflects the standard gold bar of the London Bullion Market Association (LBMA) weighing 430 ounces. After redeeming XAUT, holders can take possession of their gold at any location of their choice.
Stablecoin as a Medium of Exchange and Savings
The most obvious advantage of stablecoin technology is its usefulness as a medium of exchange, effectively bridging the gap between fiat and cryptocurrency.
Stablecoins pave the way for the integration of traditional financial markets with the rapidly evolving decentralized finance (DeFi) industry. As a force of market stability, stablecoins represent a key tool for adopting cryptocurrency in credit markets, while inheriting much of the utility previously reserved only for fiat currency.
Popular Stablecoins
Stablecoins usually don't get as much hype as other cryptocurrencies, partly because they don't offer the same 'get rich quick' opportunity. But some of them are among the most popular cryptocurrencies by market capitalization.
Top 3 popular stablecoins by market capitalization as of August 2022:
Tether (USDT) $66.3 billion USD Coin (USDC) $54.4 billion Binance USD (BUSD) $17.9 billion
Of course, the capitalization of these coins is insignificant compared to the largest cryptocurrencies, such as Bitcoin with a market capitalization of almost $435 billion and Ethereum with more than $190 billion.
TerraUSD, an algorithmic stablecoin, was another popular option, but it lost its peg to the dollar in May 2022. This stablecoin used other cryptocurrencies and a complex system of arbitrage to maintain its value at 1:1. However, the downturn in the cryptocurrency markets and subsequent loss of confidence in the stablecoin led to its price collapse.
Risks of Stablecoins
At first glance, stablecoins may seem low-risk compared to popular cryptocurrencies that are not backed by anything. However, stablecoins present some typical crypto risks:
- Security
Like other cryptocurrencies, stablecoins need to be stored somewhere, whether it's your own digital wallet or an exchange. And this is associated with risk, as the trading platform may be insufficiently secure or have some vulnerabilities.
- Counterparty Risk
It may seem that cryptocurrency is highly decentralized, but in reality, you are dealing with several parties in the transaction, including the bank where the reserves are stored, and the organization issuing the stablecoins. They must do the right things (security, proper reserve management, etc.) to maintain the currency's value.
- Reserve Risk
A key element of the stablecoin ecosystem is the reserves backing the stablecoin. These reserves are the last support for the value of the stablecoin. Without them, the coin issuer cannot fully guarantee the value of the stablecoin.
- Lack of Certainty
If a stablecoin is insufficiently backed by solid assets, especially cash, it can suffer and lose its peg to its target currency. This is what happened with the algorithmic stablecoin TerraUSD in May 2022, as it was backed not by cash but by other cryptocurrencies. The price of the stablecoin decoupled and went down as traders lost confidence in its ability to maintain the peg.
Conclusion
Stablecoins provide some stability that most cryptocurrencies lack, making them suitable for use as real currency. But those who use stablecoins should be aware of the risks they take when owning them. Although it may seem that stablecoins have limited risks most of the time, stablecoins can become the riskiest during a crisis, when owning them should be the safest.
