Thursday, April 28, 2022

What Are Stablecoins and How Do They Work?

What Are Stablecoins and How Do They Work?

In this article, you will learn the 101 of this crypto token class, how they work, how to buy them, and their pros and cons.

Stablecoins are cryptocurrencies whose value is pegged to a fiat currency like the US dollar, other cryptocurrencies, or a commodity like oil or gold, resulting in a relatively stable price.

Key takeaways:

  • Designed to maintain price stability, stablecoins bridge the gap between fiat currencies and cryptocurrencies
  • They are pegged to traditional assets such as fiat currencies or gold, making them a less volatile alternative than typical cryptocurrencies 
  • Promising faster transactions and lower costs, stablecoins are an attractive alternative to traditional banking
  • They allow traders to keep their money in the crypto ecosystem while storing them in a stable asset between trades or during volatile periods

Stablecoins are cryptocurrencies that have their price pegged to a specific asset – which is most often, but not always, the United States dollar. 

But what makes this type of cryptocurrency so special compared to classic crypto tokens?

You are probably aware of the drastic ups and downs of valuation of some traditional cryptocurrencies within a short period of time. Recalling the historical price of Bitcoin in February of 2021, it nearly doubled in price from around USD 32,000 to USD 58,000, but then dropped dramatically in May back to around USD 34,000. 

Such fluctuations, or so-called ‘short-term volatility’, make these cryptocurrencies unfavourable for everyday use by the public. 

Serving the purpose of maintaining the value and purchasing power, pegging with assets can make stablecoins more resilient from market fluctuations in cryptocurrency space. For instance, one of the most popular stablecoins – Tether (USDT) – is equal to USD 1 at nearly all times. Other popular stablecoins include USD Coin (USDC) and TerraUSD (UST).

Unlike other cryptocurrencies, not only does a stablecoin have significantly lower volatility due to its asset-backed nature, it also plays a bridging role in the world of cryptocurrencies and fiat currencies to facilitate daily commercial transactions and exchange. 

Benefits of stablecoins include:

  • Lower volatility 
  • Lower-cost transactions
  • Safe option to keep assets in the crypto ecosystem
  • Real-time payments

These benefits make stablecoins more competitive than other crypto tokens as they touch on consumer and business painpoints of Bitcoin and other tokens that offer neither stability nor scalability to real-time transactions.

Today, the total market capitalisation of all the stablecoins in the world has reached more than USD 150 billion. They command more than half of the global crypto trade volume, making them an important asset in the DeFi ecosystem.

There are four types of stablecoins:

  • Fiat collateralised stablecoins (the most popular)
  • Crypto-backed stablecoins
  • Commodity-backed stablecoins
  • Non-collateralised stablecoins

The primary use for a stablecoin is facilitating trades on crypto exchanges. Instead of buying Bitcoin directly with fiat currency, like the US dollar, traders often exchange fiat for a stablecoin – and then execute a trade with the stablecoin for another cryptocurrency like bitcoin or ether. 

Stablecoins can also act as payment alternatives. By utilising stablecoins, businesses can accept payments at a very low cost and governments could run conditional cash transfer programs easier than before. Due to its fast as thunder transaction, stablecoins can also be used to distribute monetary aid to beneficiaries worldwide. 

Another use for stablecoins is to send funds across international borders. Sol Digital, a stablecoin that’s pegged to the sol, Peru’s national currency, launched on the Stellar blockchain in September. It can be exchanged between individuals in different countries without third-party fees for cross-border money transfers.

The pegging of stablecoins is near-perfectly one-to-one through various methods including:

Reserving of pegged assets (e.g. USDC, USDT)

It refers to a fully collateralised system backed by the pegged asset, where arbitrageurs are incentivised by helping to stabilise the price. When the price of the stablecoin is lower than the pegged asset, the arbitrageurs can buy cheaper stablecoin, which can then be redeemed for USD 1 each. Similarly, when the price is higher than the pegged asset, they can sell the coins to gain profits.

Dual coins

Two coins exist in these kinds of systems, where one is the pegged coin while a secondary coin is used to absorb the volatility of the pegged coin.

Algorithmic coins

Instead of using any reserve or being backed by assets, these kinds of stablecoins use a fully algorithmic approach to adjust the supply of the stablecoin in response to price fluctuations. However, a stable algorithmic coin only exists in theory. None currently exist in the market.

Leveraged loans (e.g. DAI)

This kind of stablecoin is backed by an over-collateralised system. The most successful example is DAI, in which the stablecoin is backed by PETH, and its value is correlated to Ethereum. Since the collaterals are more volatile in terms of price, users need to have more than USD $1.5 worth of PETH to borrow USD $1 of DAI. If the collateral price falls sharply, the debt position will be liquidated, and the remaining amount of collateral will be returned to the user.

A common concern over stablecoins is whether they are less secure than US regulated bank accounts or money market funds. Investors can mitigate this in two ways: the first is the classic crypto advice of DYOR – do your own research – before investing. Check the issuing entity, their history and past projects, in detail before trusting them with your funds. Further, investors can easily move into other stablecoins or even other cryptocurrencies if investors lose confidence in a coin as volatility is not an issue. However, based on its nature and mechanism, the risk of failure or volatility is near zero for established stable coins if they are sufficiently pegged by the issuers.

Currently, stablecoins regulations are still up to discussion in most jurisdictions. For example in the US, the President’s Working Group on Financial Markets, composed of the heads of the US Treasury Department, Federal Reserve, SEC, and CFTC, has released a report in Nov 2021. It raises the risks related to lack of transparency, market integrity, and investor protection. Legislation to regulate stablecoin issuers is proposed but yet to be enacted.

With the growing acceptance of cryptocurrencies and the steadiness that stablecoins bring to the DeFi, their integral role in the ecosystem, providing ease of trading crypto, staking, and lending is cemented. While legislation of some countries may place additional restrictions and requirements on stablecoins issuers, it is also anticipated that financial regulatory agencies and related stakeholders will continue to work closely on ways to foster financial innovation while minimising associated risks.