What is a stablecoin?
Stablecoins are a class of cryptocurrency that’s backed by “stable” reserve assets like gold and the U.S. dollar. Being pegged to reserve assets allows them to offer greater price stability than unpegged cryptocurrencies like Ethereum and Bitcoin.
- Stablecoins are tokens whose price is pegged to a fiat currency, or other stable reserve assets like gold;
- Stablecoins are critical to decentralized finance because they allow investors to leverage the benefits of DeFi without having to transact in highly volatile assets;
- There are many models for creating and governing stablecoins. Each comes with their own set of tradeoffs.
Cryptocurrencies were created to provide the public with an autonomous, safe, and decentralized medium of exchange. Despite all of its advantages, volatility has been a major obstacle to mainstream adoption of crypto.
Volatility is measured by how dramatically the price of an asset fluctuates over a period of time. When it comes to national currencies, often referred to as fiat, minimizing volatility allows the currency to function as a medium of exchange and store of value.
Our economy is built on the theory that you can accept an asset, which represents value, and then subsequently trade that asset for a product, service, or asset deemed as equal value.
Although volatility can be seen in our national currencies, it’s only a fraction of what occurs on a daily basis with cryptocurrencies. On any given day, the price of Bitcoin or Ethereum can rise or fall by several percentage points. While this may be a viable investment for some individuals, the daily price fluctuations of Bitcoin and Ethereum aren’t suitable for a stable medium of exchange in a global economy.
The blockchain community was tasked with creating a form of cryptocurrency that offered the benefits of decentralization, but also replicated fiat’s efficacy at storing value. The answer: stablecoins.
How Do Stablecoins Hold Value?
Stablecoins are tokens that peg their value to a fiat currency, or some basket of stable assets. Minimizing volatility is their core objective, allowing them to deliver a unique and critical value proposition to stakeholders across the blockchain ecosystem.
Four categories of stablecoins
1. Fiat-Backed Stablecoins
Fiat-backed stablecoins like USDC are collateralized by fiat currencies stored off-chain. Aiming to minimize price fluctuations of the token, these stablecoins are pegged against a specific fiat currency. For a typical fiat-backed US Dollar stablecoin, there’s a central institution, or multiple institutions, holding one USD in a bank account for every token available in the market.
Therefore, if a fiat-backed stablecoin has a supply of 1 million tokens, $1 million will equally be held in a central reserve. This is the case with USDC which has a circulating supply of about 31 billion tokens at the time of writing this article — meaning each token has a dollar equivalent. It should be noted that the institutions behind USDC, have changed their reserve policy to allow for approximately 40% of USD collateral to be invested in short term debt securities.
2. Crypto-Backed Stablecoins
A few stablecoins have substituted traditional backing-assets, such as the U.S. Dollar or gold, for collateralization using other cryptocurrencies. In this case, a stablecoin might be backed by the Ethereum blockchain in addition to some other token to achieve true stability.
When it comes to crypto-backed stablecoins, over-collateralization is the strategy leveraged to create a stable ecosystem. For instance, a $1 crypto-based stable coin may be equivalent to $2 in value of the backed asset. This strategy is commonly referred to as ‘security pledge.’ Should an underlying asset suffer a price drop, the stablecoin will retain its value as the protocol leverages a built-in cushion to regulate the price alteration, thus fulfilling its’ ‘pledge’.
For example, DAI is an Ethereum-based and Maker-managed stablecoin that’s collateralized with cryptocurrencies the token's investors deposit into smart contract vaults. Therefore, if DAI experiences a price crisis, the Maker protocol will begin a liquidation process to meet the token’s price demands and restore stability. Essentially, crypto-backed stablecoins utilize numerous financial strategies to constantly readjust a coin’s price to reflect true stability.
3. Commodity-Backed Stablecoins
Similar to how many fiat currencies maintained value for centuries, some stablecoins are collateralized to gold and other precious metals. Through this collateralization, the value of the stablecoin can be assessed in terms of gold’s valuation in the market. Two common stablecoins under this category include PAXG and AUXT.
Launched in 2017, PAXG was launched by Paxos Standard (PAX) as a token that’s collateralized by an equal value of gold that’s securely kept in the world's safest vaults. Additionally, the token is regularly assessed to ensure that the backing gold is indeed verifiable.
Another gold-backed stablecoin is XAUt, which has each of its tokens pegged against a troy ounce of 99.5% pure gold. Holding this token comes with the benefit of retaining ownership without incurring storage costs associated with physically securing gold.
4. Algorithm or Smart Contract-Based Stablecoins
This type of stablecoin does not follow the collateralization principle; instead, smart contracts are leveraged to achieve the desired token stability. The framework is similar to a central bank printing new notes to regulate the value of fiat money. The only difference in this case is that the regulatory task is undertaken by smart contacts and a consensus mechanism, not human judgement, is used to determine when new tokens are required in the ecosystem.
A common stablecoin using this method is RSV from the Reserve Rights dual token platform. A similar token, RSR, is used to foster the stability of RSV against a constant price of $1.00.
Terra USD (UST) is another algorithmic stablecoin worthy of mention. The coin was created to address the scalability challenges faced by stablecoin such as DAI. UST has been able to garner traction in the DeFi market through its minting mechanism and its growing adoption by DApps for benchmarking pricing structures.
Risks of Stablecoins
Despite the many advantages that stablecoins provide to investors, there are risks associated with digital currencies that aim to deliver stability in the face of a challenging market and global economy:
Liquidity, specifically as it relates to sufficient assets held in reserves to maintain the necessary value for collateralization, can be a major challenge for some stablecoins. In particular, the liquidity of a stablecoins can be stretched to its limits if there is a sudden demand for large-scale withdrawals in the market. While unexpected surges in demand can be challenging for any stablecoin to maintain stable value and price, the challenge is compounded for those who are utilizing multiple asset classes and strategies.
For example Tether has stated that cash, government securities, fiduciary deposits, and reverse repo notes constitute 26.2% of its reserve while commercial paper — which the protocol leverages to boost the market value of the reserve — makes up 49.6%. Should there be a sudden demand for cash it'd be nearly impossible for the protocol to liquidate enough investments to satisfy demands immediately. Risks of this nature are the primary reason USDT has an all-time low price of $0.00001 (reached on 14 June 2021), which is significantly far from the expected $1 benchmark.
While regulation impacts the overall cryptocurrency market, the impact is arguably most pronounced with fiat-backed stablecoins. Fiat-backed stablecoins use a national currency, which is subsequently regulated by that country, as the collateral for their digital assets. Therefore, the stability of a fiat-backed stablecoin can be impacted by the policies, regulations, and transparency of the central bank.
For instance, the President of the Boston Federal Reserve — Eric Rosengren — has claimed stablecoins to be disrupters to credit markets. Additionally, regulatory officials have expressed general concerns on the rate at which users in the cryptocurrency space are adopting stable coins. These concerns indicate the possibility of regulations which may adversely affect the current use cases of stable coins.
While there is varying degrees of price fluctuation that stablecoins are able to minimize, it’s important to note that there are some stablecoins that outperform others in storing value. For example, crypto-backed stablecoins often face greater challenges than commodity-backed stablecoins given the underlying volatility of the cryptocurrencies that they’re using for collateral. It’s imperative to analyze which cryptocurrencies are held by the stablecoin, specifically how the digital assets are correlated with each other, when selecting crypto-backed stablecoins.
Stablecoins are an integral part of the cryptocurrency market. The coins provide a means to store tokens without compromising their market value, crucial in the cryptocurrency space where investors continually move funds from one token to another. Stablecoins allow you to do so seamlessly without having to worry about market fluctuations. Therefore, by addressing the stability gap in the cryptocurrency market, stablecoins have been able to establish a meaningful presence in the industry.