What are stablecoins

Volatility has always been a topic of discussion in crypto. Many cryptocurrencies are known for their sporadic price movements. What if you found out that not all coins have this trait? Some coins are in fact “stable”. This article will reveal to you the ins and outs of stablecoins.

What is a stablecoin?

Stablecoins are referred to as cryptocurrencies that are pegged to another currency. Such currencies could be fiat, a cryptocurrency, or other commodities. Stablecoins eliminate one of the main problems in crypto: volatility. Volatility is a concept that entails the random rise and fall in assets. This trait is very peculiar to crypto assets. It is a great tool for trading and earning profit but not so much enabling a good store of value. Stablecoins can enable you to keep your coins for a long time without having to worry about their price movements.

How do stablecoins work?

Stablecoins act as a link between real-world assets and crypto assets. This is because stablecoins have similar attributes to both commodities. Stablecoins are similar to fiat money in the sense that their value is pegged to it. What do we mean by pegged? In this context, pegged cryptocurrencies have a link to a particular commodity. Suppose a token is pegged to the United States Dollar (USD). The value of the USD will be the same as the value of the token since they are already linked. Hence, the value of one token would equate to $1. 

Bear in mind that stablecoins are also cryptocurrencies. They can be bought, sold, and exist on the Blockchain. The main difference between conventional cryptocurrencies and stablecoins is price stability. 

What is a stablecoin used for? 

Stablecoins have graced the crypto scene with many uses. One of which is its use as an intermediary between two cryptocurrencies. Instead of going through the hassle of paying high transaction fees when buying a crypto asset, you can easily swap one asset for a stablecoin and buy another asset with lower gas fees. Let’s take an example.

Assume you have Ethereum and you want to buy Bitcoin. Direct transactions of both will require exorbitant fees. What you can do here is swap your Ethereum for a stablecoin. With the acquired stablecoin, you can then purchase Bitcoin with lower fees. 

Stablecoins offer fixed prices that can be used as a store of value. They also bolster mass adoption through seamless and easy transactions for the everyday Joe.

Stablecoins have undoubtedly shown their benefits and usefulness. But this has struck some concerns among investors if the pegged digital currency is all rosy. Just like other crypto assets, stablecoins may bear some risks. But how is this possible? After all, volatility is eliminated. 

The centralization of stablecoins accounts for its risks. In a sense, the security of such coins might be threatened due to the organizations running them. Generally, centralized systems might pose threats to manipulation. These systems are not held accountable by the public and can manipulate supply or other mechanisms. Some stablecoins might crash for this cause leading to lots of money going down the drain.

A good example of this is the crash of TerraUSD and Luna that occurred at the beginning of the second quarter of 2022. Let’s visit the story of Terra and his close sister- Luna. Some might wonder: What is the relationship between Terra and Luna? Well, Terra and Luna work hand in hand. Terra is an algorithmic stablecoin that uses Luna to regulate its price. Don’t worry, we’ll discuss more about what algorithmic stablecoins are soon. For now, let’s get back to the story. 

Instead of fiat currencies, Terra is pegged to Luna. As the value of Terra equates to $1, the value of Luna may vary. In essence, Terra is burnt to create Luna while Luna is burnt to create Terra. The duo acts as counterweights used to balance each other. Traders succeeded in making a profit from this duo. But how? Suppose the value of Terra falls slightly. People will then trade Terra for Luna to make a profit. In this process, they will have to burn Terra to acquire Luna. This was a leading cause of the crash of both tokens. 

Many people continuously burnt Terra for Luna, thereby increasing Luna’s supply. Terra, on the other hand, had a decrease in supply with a plummeting price. The previously high potential stablecoin crumbled drastically. The balance of the duo was destroyed, and Luna also faced the tune of the unfortunate crash. 

Now, this is a warning call to tread carefully with any crypto asset, including stablecoins. Portfolio diversification is also encouraged to reduce risks.

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Types of Stablecoins

It is important to note that stablecoins are not just one-dimensional. There are different types of stablecoins with their individual mechanisms. Here are the main types of stablecoins:

  • Fiat-Collateralized Stablecoins: These stablecoins are pegged to a fiat currency, usually the United States Dollars (USD) or Pounds. The given fiat currency is used as collateral to maintain the value of the stablecoin. Gold and other precious metals could also serve as collateral. Some examples of fiat-centralized stablecoins include Tether (USDT), USD Coin (USDC), and TrueUSD (TUSD).
  • Crypto-Collateralized Stablecoins: These stablecoins are backed by other cryptocurrencies. However, they are riskier than other types of stablecoins due to price volatility. The cryptocurrencies contained in the reserves usually exceed the stablecoin. This is the case because there has to be some form of protection from the volatility of the coin for the value of the stablecoin to be maintained. We refer to this case as over-collateralized stablecoins. Here, a large amount of cryptocurrency is issued for a relatively lower amount of stablecoins. 
  • Algorithmic Stablecoins: These stablecoins are similar to crypto-collateralized stablecoins, although not entirely. In this case, a stablecoin and another cryptocurrency is involved but an algorithm in form of a smart contract is used to back them up. Think of this smart contract as a binding agreement between the two assets used to regulate the stablecoin’s supply. The smart contract is basically run by codes that execute commands when certain executions are fulfilled. For example, if there is high demand for an asset with low supply, the value of the asset will increase to stabilize the price and to ensure that it does not deviate far from $1. Examples of algorithmic stablecoins include TerraUSD (UST), Magic Internet Money (MIM), and Neutrino USD (USDN). 

Some of the most popular types of stablecoins

Stablecoins, as the name implies, are known to be stable irrespective of how the market flows. Their values are usually backed by real-world assets like country currencies or gold; however, some are also backed by other cryptocurrencies.

They were created as an alternative to curb the volatility of regular cryptocurrencies such as Bitcoin, which are limited by their utility capabilities because of their volatility.

This begs the question: What ensures these stablecoins? 

Using these three stable coins— USDT, USDC, and BUSD— as a yardstick, here’s how these stablecoins maintain their stability.

  • USDT: A recent report shows that USDT is backed by enough assets to cover the $78 billion worth of stablecoins in circulation. According to crypto briefing, assets backing up USDT involve deposits amounting to billions of dollars. Such deposits include cash and bank deposits, commercial paper and certificates of deposit, treasury bills, and other funds. All these assets that back up USDT make it a very stable and low-risk investment.
  • USDC: Most of the $22.2 billion of USDC in circulation is backed by cash and cash equivalents or money market funds (about 61%). The other assets include 13% Yankee Certificate of Deposits— the CD issued by non-American banks, 12% of U.S Treasuries, 9% of commercial paper, and the rest are backed by corporate and municipal funds. Like USDT, USDC has also been classified as very stable and able to handle its financial obligations.
  • BUSD: It has been verified that BUSD is one of the few stablecoins backed by 100% cash and cash equivalents.

Stablecoin Regulation

Due to the rapid growth of stablecoins and the potential to affect the financial system, they have come under high scrutiny by regulators. Some proposed regulations for stablecoins include the International Organization of Security Commissions (IOSCO) policy, which proposed the regulation of stablecoins as financial market infrastructure with payment solutions. This means they are deemed important yet a threat that can disrupt traditional payment systems.

Besides this, major politicians have also called for the regulation of stablecoins. For example, Senator Cynthia Lummins (R-Wyoming) proposed that stablecoin issuers regularly be audited. Some other politicians have also proposed the regulation of stablecoins using bank-like regulation policies.

Updated on: October 18, 2022