Cryptocurrencies are notorious for their volatility. Quite often the prices of some cryptocurrencies fluctuate by more than 50% in a day owing to some specific event like getting listed on an exchange OR some bad news. But what if we told you that there was a specific type of cryptocurrency that is stable? Stable cryptocurrency. Sounds like an oxymoron, right? Well, pinch yourself because this isn’t a dream. Stablecoins are not only ‘stable’ by nature but also form a huge part of the total industry market capitalization.
But what are they? How do they work? Why would someone want to buy a cryptocurrency that never goes up? What types of stablecoins are there? Turns out, you are in luck. That is exactly what we are going to talk about today. Read on!
What are Stablecoins?
Simply put, a stablecoin is a type of cryptocurrency that is pegged to a ‘stable’ asset like USD, Gold, Euro etc. Pegging is essentially fixing or mimicking the price of the underlying asset. For eg. USDT, a stablecoin pegged to a dollar, will always mimic the actual price of a dollar in the real world.
Stablecoins act as a gateway from centralized finance to the decentralized world. Anyone can get exposure to cryptocurrencies, without worrying about volatility, just by holding stablecoins.
Stablecoins hit the sweet spot between the stability of a real-world asset and the flexibility of a digital currency. Imagine if you were to pay someone $1000 who lives in a remote country where dollars aren’t acceptable. Traditionally, you would go to a bank/money exchange agency. They would take their own sweet time to convert that money and share it with the intended recipient. All of this would cost you a percentage of the total money and also a lot of time. To top it all, if there is even a slight mismatch of details due to human error, the entire loop will start over.
Now compare that with sharing some USDT with the receiver. It would take less than 5 minutes to set up a wallet (in case they don’t have it already), and share the amount with them. Once received, they can sell it on a centralized exchange for the currency of their choice within minutes.
Therefore, the idea to convert real assets into their digital counterparts has a lot of potential. But is remittance the only use case of a stablecoin? Turns out there’s a lot more left to explore. Continue reading. But before that, let’s understand how stablecoins work!
How Do Stablecoins Work & What are the Examples of Stablecoins?
From a functional perspective, stablecoins are quite simple to wrap your head around. The sole purpose of a stablecoin is to mimic the price of the underlying asset. Depending upon the type of stable coin, there are multiple ways to achieve this feat.
For example, fiat collateralized stablecoins like Tether (USDT) often set up a reserve where the conversion between physical and digital assets takes place.
If you buy 1 USDT (which always must be equal to $1), tether (the issuing company), mints a new USDT and gives it to you. In turn, they take your $1 and store it.
Similarly, if you redeem 1USDT against a dollar, Tether would burn that token (or send it to an inaccessible address) and give you a dollar from its reserves.
In a different example, $DAI, issued by Maker maintains something called “Vault“. As a user, you can deposit your crypto (non-stablecoins) in the vault. Once the deposit is completed, you can use it as collateral to borrow $DAI, a stablecoin.
And then there are some stablecoins that aren’t backed at all. They rely on the basics of supply and demand to maintain the price of the crypto equal to the underlying asset.
For example, in the case of a stablecoin that mimics a dollar, the algorithm would burn crypto if the price goes below $1. This would create scarcity and hence bring the price back up to $1.
On the flip side, if the price exceeds $1 (say $1.1), the algorithm will issue more stablecoins to boost the supply and bring the price down.
While a lot of players are trying to achieve this, there has been little to no success. One failed cryptocurrency which tried achieving this is $LUNA from the Terra ecosystem.
What are the Types of Stablecoins?
Stablecoins can be divided into various subcategories based on the asset they are pegged to or the mechanism that is used to maintain the peg. Let us explore each one of them in detail:
A. Fiat-Collateralized Stablecoins (very popular):
A fiat-backed stablecoin will always maintain its price equal to a fiat currency. For the uninitiated, fiat is the currency issued by the government of a country. So, a fiat-backed stablecoin might be following USD, EURO, YUAN or INR.
A fiat-backed stablecoin can be further divided into two categories:
A.1. Centralized Fiat Backed stablecoin:
A centralized stablecoin is controlled by a single authority. For example, Tether holds the right to issue or burn the USDT in the market. Similarly, in the case of USDC, ‘Circle’ operates it single-handedly. Most of the centralized fiat-backed stablecoins work through the model of maintaining a reserve.
These reserves are often audited by reputed firms and hence people place their trust in these companies.
A.2. Decentralized Fiat Backed Stablecoin:
A decentralized fiat-backed stablecoin is not a function of any centralized authority. Instead, smart contracts govern their issuance and burning. For example, the amount of $DAI that can be issued completely depends on the collateral locked by the borrower.
The smart contracts decide the number of coins that will be issued to the user. To top it all, the key decisions regarding the protocol are taken by consensus. $DAI is issued by the protocol named Maker DAO. And the holders of the $MAKER token vote on all the key decisions around the policy of issuing $DAI.
B. Commodity-Backed Stablecoins:
As the name suggests, a commodity-backed stablecoin tries to maintain its peg to a commodity like gold instead of fiat. These stablecoins work on a very similar model wherein reserves of the underlying commodity are held by a centralized authority which is obligated to get its reserves audited regularly.
These stablecoins are relatively riskier than their fiat counterparts. Why? Because commodity itself is more volatile as compared to fiat currency. Secondly, it is easier to maintain reserves for money as compared to something physical and bulky as a precious metal.
Some examples of commodity-backed stablecoins are Pax Gold ($PAXG) and Tether Gold ($XAUT).
C. Crypto-Backed Stablecoins:
One may argue that what is the point of cryptocurrency if they are going to be pegged against a centralized inflationary asset like USD? After all, USD has lost 92% of its purchasing power since 1933 (source).
Well, to counter this problem, crypto-backed stablecoins maintain their price equivalent to USD with a subtle twist. Instead of holding USD reserves, they maintain crypto reserves.
But cryptos are extremely volatile, how do they make sure that the value of their reserves always exceeds (or stays equal, at least) to the stablecoin floating in the market?
To answer that, we’ll quickly explain over-collateralization. If you wish to borrow $DAI (a crypto-backed stablecoin) worth $100, you need to deposit $ETH worth $200 or more. This gives $DAI a cushion from a crash to the tune of 50% in the price of Ethereum. Therefore, whenever you borrow in a decentralized protocol, more often than not, your loans are over-collateralized.
This means for every new $DAI minted or issued, there’s a 200% collateral in a blue-chip cryptocurrency reserved with Maker.
D. Decentralized Algorithmic Stablecoins:
Now maintaining the reserves may sound like an easy job, but in reality, it is a big responsibility. Also, the cost of auditing is often very high. Despite that, some users do not trust a non-government centralized authority with their funds.
So how about we do away with the reserves completely? Well, that is pretty much the idea behind an algorithmic stablecoin. Instead of relying on the reserves, it uses an algorithm to burn or issue the tokens to maintain the price equivalent to a dollar.
While the working of an algorithm-based stablecoin is fairly complex, there has been little success in making them mainstream. Given the last experiment of Terra-Luna led to a wealth destruction of $50B, the future looks bleak for them.
Other examples of algorithmic-stablecoins is FRAX, Magic Internet Money (MIM) (That doesn’t raise a sus at all?)
What are some Benefits and Drawbacks of Stablecoins?
We have already established that stablecoins are an essential gateway to the crypto realm. But is it all they have to offer? Turns out they could solve multiple problems at once. With that being said, there are some problems as well that need to be addressed before we see the light of the day. Let us discuss each of these aspects.
A. Blockchain Store of Value:
Do you want to park some funds in a completely decentralized and secure fashion? You already know that crypto could do it but quite often you cannot stomach the volatility. Well, stablecoins are a perfect blend. They offer you to hold relatively safer assets on a Blockchain-based platform. Some of the protocols also offer interest to deposit your stablecoins with them.
Say market conditions are getting worse and you want to sell your holdings. At the same time, you don’t want to be taxed yet as you plan to get back in once the storm settles. Stablecoins enable just that for you. Instead of cashing all your crypto into fiat and paying exchange fees and taxes in the process, you can simply convert your crypto into a stablecoin, wait and then decide to switch back whenever required.
C. Entry to Exchanges:
Cryptocurrencies are always amidst legal uncertainty. Due to this, a lot of banks often, intermittently, disable the payments to fund your crypto wallet. In such a case, some exchanges resort to P2P or peer-to-peer exchange.
Idea is to connect two individuals, a buyer of crypto and a seller of crypto. These two individuals transact outside exchange to deposit money into the seller’s account. In return, the seller deposits a stablecoin in the exchange wallet of the buyer.
While this can be done for other cryptocurrencies as well, stablecoins often offer a simpler transaction that is unlikely to fluctuate while you are completing the process. Secondly, it offers a greater flexibility to buy other cryptos as most trading pairs are available with stablecoins.
Because we are a prudent set of investors, it is time to explore the other side of the coin. Some of the disadvantages of stablecoins include:
While the ethos of crypto revolves around trustlessness, most of the stablecoins are based on trusting a central authority like Tether or Circle. What if the audit reports are manipulated and they do not have enough reserves to cater to the redemptions? In fact, Tether has had a couple of close encounters with de-pegging (or losing its value from $1) in the past. There are also reports of Tether being involved in all sorts of shady activities with their funds.
B. Store of Value without Store of Value:
This is specific to fiat-backed stablecoins. What is the point of holding value in a devaluing currency like fiat? So if you are not deploying your stablecoin to earn some yield, there is no point. It is similar to keeping your cash in the bank to rot and lose its value over a period.
Lack of regulation also scares a lot of individuals who are on the fence about jumping into crypto. As we write this, the top two stablecoins USDT and USDC have a combined marketcap of $120B. This is more than the GDP of Bangalore (source).
Stablecoins badly need a consumer protection clause implemented by a government agency to make sure that interests of the retail investors are protected.
Are Stablecoins Really Safe?
Safety is a very subjective term. Are fixed deposits with banks safe? Are mutual funds safe? In the past, a lot of banks have defaulted on user deposits. There have been bank runs on some of the most famous fund houses like Franklin Templeton (source).
With that being said, stablecoins are relatively safer as compared to the rest of the crypto market. In principle, they are as safe as the fiat currency itself.
However, this needs to be taken with a pinch of salt. Stablecoins are unregulated and while governments can rescue banks and force the mutual fund houses to pay back the customers, stablecoins don’t really come under that purview.
To sum it up, Stablecoins offer stability against the ups and downs of the crypto market, often at the cost of compromising with decentralization. But comparing it with the rest of the crypto market, they are considered much safer as their price does not depend on the supply and demand.
With that being said, stablecoins issued by Circle (USDC) are least likely to default as they are a publicly listed entity ($COIN). Since SEC watches over their holdings, it is considered as the safest coin within the stablecoin realm.
The meteoric rise of stablecoins has successfully drawn the government’s attention. The collapse of LUNA has acted as a catalyst for this process. Over the next 2-3 years, a lot of regulations are expected in this space. Given the technological advancement it offers, it isn’t leaving anytime soon.
Well, just like stablecoins, there is a coin that is indispensable to this ecosystem. EPNS.
EPNS is a decentralized communication protocol for Web3! Using which any dApps, smart contracts, backends or protocols can send comm (starting with on-chain / off-chain / gasless notifs) tied to user wallet in an open, gasless, multichain and platform-agnostic fashion. The open comm layer allows any crypto wallet/frontend to tap into the network and get the comm across.
This post is sponsored by EPNS.