The massive popularity that digital assets and their underlying tech, the blockchain, are enjoying in many ways affected and developed stablecoins. As of now, you cannot have a conversation in crypto without mentioning stablecoins as well, making them a big deal in the industry. But, what are stablecoins, and why are they so relevant in the crypto space?
In this article, we look at what stablecoins are, their history, and the importance they carry for any cryptocurrency investor.
What is a Stablecoin?
A stablecoin is a type of cryptocurrency designed to maintain a stable value by pegging it to an external asset. This stability is achieved by fixing the value of the coins to different entities, which include;
- Traditional Real-World Assets: Stablecoins can be tied to a single fiat currency, like the US dollar.
- Currency Baskets: Some stablecoins combine multiple currencies to maintain stability.
- Valuable Commodities: Others are backed by real-life commodities.
The primary purpose of stablecoins is to counteract the speculative nature of most cryptocurrencies. Their low volatility appeals to significant players in the financial world. By emphasizing stability, stablecoins aim to create a reliable market environment where digital assets and blockchain technology can flourish.
Notably, many stablecoins are pegged to the unofficial global fiat currency, the US dollar, at a 1-to-1 ratio.
A Brief History of Stablecoins
Indeed, the crypto industry is still in its early stages, and the liquidity of digital assets remains relatively low. This lack of liquidity contributes to the high volatility observed in many cryptocurrencies.
The volatile price swings pose challenges for the widespread adoption of crypto assets. Frequent fluctuations make it difficult to use them practically for everyday transactions or as a reliable store of value.
In response to this issue, stablecoins emerged. These specialized cryptocurrencies leverage blockchain technology to maintain a stable value by anchoring themselves to external reference points, as we discussed earlier. By doing so, stablecoins offer a more predictable and less volatile alternative within the crypto ecosystem.
The very first stablecoins were issued back in 2014. BitUSD and NuBits were collateralized through other cryptos instead of fiat currencies. BitUSD lost its peg to the U.S. dollar in 2018 and never recovered.
How do Stablecoins Work?
Stablecoins, despite their name, are not traditional coins. Instead, they are tokens that exist on established blockchain networks like Ethereum or Rootstock. Their primary purpose is to maintain a stable value, hence the name.
Here’s how they work:
When the demand for a stablecoin increases, the issuer can create more units of that stablecoin and sell them to buyers. This action expands the supply, preventing the price from fluctuating significantly.
Conversely, if demand decreases, the issuer buys back units of the stablecoin, reducing the supply and maintaining stability.
In essence, stablecoins act as a bridge between the volatile world of cryptocurrencies and the stability we associate with traditional fiat currencies. They provide a reliable means of exchange and store of value within the crypto ecosystem.
Types of Stablecoins
Currently, there are four major ways issuers use to maintain a stablecoin’s peg, including;
- Fiat-Collateralized Stablecoins
These stablecoins are backed by fiat currencies such as the US dollar or the Euro. For every stablecoin issued, the issuer holds an equivalent amount of fiat currency in reserve.
The fiat collateral typically remains in a reserve with a central custodian or financial institution. Notable examples include USDT (Tether) and USDC (USD Coin). As of February 2023, fiat-collateralized stablecoins account for approximately 94% of the overall stablecoin market, with USDT dominating around 52% of the market.
- Commodity-Collateralized Stablecoins
These stablecoins are backed by commodities such as gold, silver, or oil. Similar to traditional central banks, the issuer holds an equivalent amount of a commodity in reserve for each stablecoin issued.
For instance, Tether Gold (XAU₮) is backed by gold reserves, and Digix (DGX) is backed by physical gold stored in a vault in Singapore. Commodity-collateralized stablecoins provide exposure to commodities without the complexities of owning physical assets.
Some issuers use a combination (or “basket”) of both commodities and fiat to collateralize their stablecoin.
- Crypto-Collateralized Stablecoins
Initially popularized by MakerDAO’s DAI, these stablecoins are backed by other cryptocurrencies. The issuance process is automated using smart contracts.
Users deposit a certain accepted crypto asset into the smart contract and receive the equivalent value in stablecoins. This method allows for greater decentralization and transparency, as all assets are held on the blockchain.
However, crypto-collateralized stablecoins face challenges, including volatility due to the price fluctuations of the underlying cryptocurrencies.
- Algorithmic Stablecoins
Algorithmic stablecoins are mostly deemed as the dark horse of the stablecoin world. But why? Algorithmic stablecoins do not rely on collateral to maintain their stability. Instead, they use complex algorithms to adjust the supply of the stablecoin in response to changes in demand.
One project that used this type of stability was TerraLuna’s UST stablecoin — the hybrid algorithmic/under-collateralized stablecoin that depegged in early 2022, causing the entire crypto market to crash.
Even though the whole algorithmic stablecoins have a bad reputation, there is still optimism that such a method could be successful and achieve mainstream usage again in the future.
What are the Use Cases for Stablecoins?
We now know that stablecoins offer a stable, reliable, and decentralized alternative for numerous users around the world who do not have access to traditional financial tools. Therefore, they can easily be used for different cases:
- Saving: One of the most used cases for stablecoins is that it is a safe store of value.
- Sending Payments: Stablecoins can be used to make cross-border payments, bypassing the traditional banking system.
- Trading: Stablecoins are commonly used as a base pair on decentralized cryptocurrency exchanges, meaning that they are used as a reference currency to price other cryptocurrencies.
Examples of Stablecoins
Here are the key stablecoins to be familiar with:
- Tether (USDT): It is the cryptocurrency created by Tether Limited Inc. in 2014. USDTR is one of the earliest stablecoins in existence. It plays a crucial role in the crypto ecosystem and has variants pegged to various fiat currencies beyond the U.S. dollar. These include EuroTether (EURt), Mexican PesoTether (MXNt), and Chinese YuanTether (CNHt).
- USD Coin (USDC): This coin was introduced in 2018 and is a widely used stablecoin that maintains a 1:1 peg to the U.S. dollar. A group known as Centre, which was founded by major fintech players Circle and Coinbase, developed it.
- DAI (Dai): The coin operates on the Ethereum blockchain and employs an algorithmic mechanism to maintain its peg to the U.S. dollar. Unlike centralized stablecoins, Dai doesn’t rely on U.S. currency stored in a bank account. Instead, it is backed by collateral within the MakerDAO platform, a decentralized autonomous organization (DAO) that operates on the Ethereum network. This unique setup enables individuals to engage in lending and borrowing activities using cryptocurrencies.
Challenges that Surround Stablecoin
Several issues surround the stablecoin space, which mainly includes;
- Centralization and Control: Unlike decentralized cryptocurrencies, stablecoins are centralized. Entities or organizations control their issuance and operation. For example, Tether (USDT) is ultimately controlled by the owners of the crypto exchange Bitfinex in the British Virgin Islands. Additionally, USDC is owned by an American consortium consisting of payments provider Circle, bitcoin miner Bitmain, and crypto exchange Coinbase. Binance USD (BUSD) is owned by Binance, another crypto exchange headquartered in the Cayman Islands. This centralization contradicts the decentralized ideal of cryptocurrencies.
- Counterparty Risks: Stablecoins aim to provide stability by pegging their value 1:1 to a financial asset (usually the US dollar). However, their reliance on trusted custodians and centralized reserves introduces counterparty risks. If stablecoin providers face liquidity issues or fail to honor redemptions, investors may panic and seek to convert stablecoins back to fiat currencies, potentially causing instability.
- Regulatory Concerns: The total dollar value of stablecoins has surged from the low billions to over $139 billion recently. Regulators worry about the risks stablecoins pose to the financial system. Their rapid growth and widespread use raise questions about investor protection, systemic stability, and potential market disruptions.
- Algorithmic Stablecoins: Algorithmic stablecoins, such as Dai, have sparked additional controversies. These stablecoins maintain stability through complex algorithms rather than direct backing by fiat reserves. However, their vulnerabilities in stability mechanisms and concerns about market manipulation have led to skepticism.
Final Thoughts
Stablecoins have demonstrated a real product-market fit, even despite the entire wipeout of UST and the market instability that came with it. This is because stablecoins serve two main purposes; Firstly, they offer capital efficiency to cryptocurrency High-Frequency Trading (HFT) and market-making companies.
Secondly, they provide a way for people in regions without traditional banking infrastructure, such as LATAM and South Africa, to access stable digital assets.
We have seen that stablecoins merge the benefits of conventional cryptocurrencies and fiat currency. They offer a low-risk, convenient method for individuals to safeguard against inflation and facilitate international money transfers.
As regulatory frameworks become clearer and global adoption grows, stablecoins are likely to find even broader applications in the years ahead.