What is a Stablecoin?
- Stablecoins address the volatility of traditional cryptocurrencies by maintaining a consistent value, making them practical for everyday transactions.
- Different approaches to stability nclude fiat-collateralized, crypto-backed, commodity-backed, and algorithmic, each with its own advantages and disadvantages.
- Stablecoins are crucial in the DeFi ecosystem for payments, remittances, realizing trading gains, and providing predictable DeFi rewards.
- The history of stable cryptocurrencies shows an evolution, from early attempts like BitUSD to recent challenges with algorithmic stablecoins like TerraUSD. The future depends on balancing innovation and stability.
Imagine walking into your favorite café to grab a coffee and a pastry. You decide to pay with cryptocurrency, but there’s a catch: by the time you reach the counter, the value of your crypto has dropped. Suddenly, your simple purchase costs more than you expected. Volatility is a major obstacle in crypto’s quest to become a payment method – but stablecoins aim to provide a solution.
Stablecoins provide stability where it’s needed most—your wallet. And beyond that, they are also an incredibly important component of the DeFi ecosystem; BDC Consulting highlights that $245 billion of stablecoins are traded daily, offering traders a safe haven from fluctuating cryptocurrencies. In this article, we’ll explore stablecoins in more detail, and highlight their advantages and risks. Let’s get started.
What is a Stablecoin?
Stablecoins are cryptocurrencies that aim to maintain a steady value, usually by linking them to regular money, such as USD, or valuable assets like gold.
Why do we need stable crypto anyway? Traditional cryptocurrencies like Bitcoin and Ethereum are known for their price fluctuations. One day, a Bitcoin might be worth $37,000; the next day, it could drop to $28,000 or shoot up to $72,000. The fluctuating nature of crypto hinders its utility as a payment method by making it hard for traders to know exactly how much value will be changing hands in a given transaction.
Stablecoins solve this problem by keeping a steady value. They offer the advantages of cryptocurrencies, such as transparency and decentralization, while minimizing the risk of losing money due to price changes. This makes them an essential tool for crypto traders wanting to realise their profits without offramping.
Types of Stablecoins
Stablecoins achieve their stability in different ways, but broadly speaking they fall into two categories:
Pegging: Stablecoins often maintain value by being pegged to reserve assets like fiat currency or commodities. This backing ensures that the stablecoin’s value tracks that of the asset it’s pegged to.
Algorithmic Regulation: Other stablecoins use algorithms and smart contracts to manage their supply and demand, maintaining their value without being backed by physical assets.
This article explores these methods in more detail later on.
Why Do We Need Stablecoins?
DeFi ecosystems rely heavily on stablecoins. Their stability and reliability are indispensable in several key areas:
- Payments
- Remittance
- Realizing trading gains
- Making DeFi rewards predictable (APR)
The sections below further explain these points.
Payments
Stablecoins offer a compelling advantage for payments. They provide stability that’s valuable for international transactions. By using a crypto with stable value, both transacting parties can have peace of mind knowing that the transaction’s value remains stable.
Remittance
Instead of traditional remittance services with high fees and slow processing, stablecoins offer a faster, cheaper way to send money across borders. As digital assets with stable value, they are instantly transferable, eliminating the risk of currency exchange losses.
Realizing Trading Gains
Traders often move their funds into stablecoins to lock in their gains when they believe the market may shift downwards. By converting their assets into a crypto with no price fluctuations, they can protect their profits from market volatility. Once the market stabilizes, they can reinvest into other cryptocurrencies.
Making DeFi Rewards Predictable (APR)
DeFi platforms frequently reward users with annual percentage rates (APRs). These rewards can be unpredictable when the value of the underlying cryptocurrency fluctuates. Stablecoin rewards, however, offer consistent value. Users can rely on this predictability to calculate their potential earnings with greater accuracy and make well-informed investment plans.
Types of Stablecoins
Having discussed why stablecoins are so important, let’s take a closer look at the different types. There are two main categories: collateralized and algorithmic. Each category has variations, each with benefits and disadvantages.
Fiat-Collateralized Stablecoins
Fiat-collateralized stablecoins are backed by reserves of traditional currencies, like the US dollar or the Euro. A central authority or trusted third party holds an equivalent amount of fiat currency in reserve for every stablecoin issued. This reserve ensures the stablecoin maintains its value and can be redeemed for fiat currency.
For example, Tether (USDT) and USD Coin (USDC) are popular fiat-collateralized stablecoins pegged to the US dollar. Each USDT or USDC is always worth approximately one US dollar.
Benefits
- Stability: Since these stablecoins are backed by fiat currency, their value remains stable and predictable.
- Wide Acceptance: Fiat-collateralized stablecoins are widely accepted across different platforms and services, making them easy to use.
Disadvantages
- Centralization: Rather than relying on a distributed network, fiat-collateralized stablecoins depend on a central authority to maintain reserves, limiting their decentralization.
- Regulatory Risks: Governments can closely monitor fiat-collateralized stablecoins, potentially affecting their availability or operations.
- Debasement: Being consistent with the value of a fiat currency means fiat backed stable coins face the same inflationary issues as money. So if you’re using crypto as a hedge against inflation, stablecoins are not the right choice.
Crypto-Backed Stablecoins
Crypto-backed stablecoins are new digital assets that promise stability. These cryptocurrencies rely on digital assets, not traditional fiat, for stability. Stablecoins often need significant over-collateralization to reduce cryptocurrency volatility. The value of the cryptocurrency held in reserve significantly exceeds the value of the stablecoins issued.
For example, DAI is pegged to the US dollar but relies on various cryptocurrencies, including Ethereum, for collateral. Over-collateralization is a safety net, ensuring that DAI maintains its peg even if the underlying cryptocurrencies experience price fluctuations.
Benefits
- Decentralization: Crypto-backed stablecoins offer greater decentralization than fiat-collateralized ones. Instead of relying on a central authority, they use smart contracts and blockchain technology to achieve decentralization.
- Transparency: Moreover, the blockchain publicly displays the collateral backing these stablecoins, ensuring transparency and trust.
Disadvantages
- Complexity: The mechanisms used to maintain the peg in crypto-backed stablecoins can be complex, making them harder to understand and use.
- Volatility Risk: Over-collateralized stablecoins remain vulnerable to the volatility of their underlying cryptocurrencies
Commodity Backed Stablecoins
Commodity-backed stablecoins provide a convenient way to invest in physical assets. These stablecoins are pegged to the value of commodities like gold, silver, or oil, allowing you to benefit from their price fluctuations without the hassle of storing them. PAX Gold (PAXG) is one example, representing one fine troy ounce of gold-backed by physical gold in secure vaults.
Benefits
- Tangible Asset Backing: Commodity-backed stablecoins shield against inflation or currency devaluation.
- Stability: These stablecoins maintain their value by being pegged to the price of underlying commodities, providing a more reliable foundation than traditional cryptocurrencies.
Disadvantages
Storage and insurance costs associated with physical commodities like gold or silver can limit the value of stablecoins, as not all investors have easy access to them.
Algorithmic Stablecoins
Algorithmic stablecoins rely on algorithms and smart contracts to maintain their value. Instead of backing them with assets, these coins dynamically adjust their supply to match market demand.
When the price rises above its target, the algorithm increases the supply to drive it down. Conversely, when the price drops below the target, the algorithm reduces the supply to raise it.
An infamous example of an algorithmic stablecoin was TerraUSD (UST), which attempted to maintain its peg to the US dollar using an automated system of supply adjustments.
Benefits
- Decentralization: Algorithmic stablecoins bypass the need for a central authority or reserve, offering complete decentralization.
- Scalability: These stablecoins have the potential for limitless growth, unconstrained by the availability of reserve assets.
Disadvantages
- Potential Price Fluctuations: Unlike traditional stablecoins backed by reserves, algorithmic stablecoins can face significant price volatility due to market swings.
- Technical Complexity: The algorithms that govern these stablecoins can be difficult to grasp, potentially deterring less tech-savvy investors.
Limited Stability: Algorithmic stablecoins often struggle to maintain a consistent peg during periods of high demand or market stress, as past failures like Terra UST demonstrate.
Pegging vs Collateralization – What’s the Difference
Understanding the difference between pegging and collateralization is crucial for any cryptocurrency enthusiast. These two mechanisms ensure stablecoin stability, but they operate in distinct ways. Let’s explore the key differences to dispel the confusion.
Pegging/Backing
Pegging, a concept borrowed from foreign exchange, ties the value of one asset to another. For stability, a weaker economy might peg its currency to a stronger one. Stablecoins apply this concept, pegging their value to a more stable asset, like the US dollar.
Tether (USDT), for instance, is pegged 1:1 to the US dollar. For every Tether, there should be a real US dollar backing it. The model ensures Tether trades close to the US dollar, offering a haven in the volatile cryptocurrency market.
Not all pegged stablecoins use the same method. Some allow slight value fluctuations within a pre-set range, known as a crawling peg. The flexibility can help the currency respond better to market conditions while maintaining overall stability.
Collateralization
Collateralization ensures an asset’s value by backing it with something else. To borrow money, you might offer your car or home. If you default, the lender can seize it.
In crypto, digital assets like Ethereum or Bitcoin serve as collateral. DAI, a stablecoin, exemplifies this. To create DAI, you lock up Ethereum in a smart contract. This Ethereum guarantees DAI’s value even during market downturns.
However, collateral value can fluctuate. Should the value of Ethereum decline significantly, it may destabilize DAI, potentially causing a liquidation event in which the collateral is liquidated. This risk differs from that of pegged stablecoins backed by more stable assets.
Pegging and collateralization, though similar in their goal of stability, differ in their approaches. Pegging links a cryptocurrency’s value directly to a stable asset, like fiat currency. Collateralization uses assets as security, making stability reliant on their value.
History Of The Stablecoin
Introduced nearly a decade ago, stablecoins wanted to change cryptocurrency by offering a stable value pegged to fiat currencies. This stability would enhance their usability for daily transactions, contrasting the volatility of coins like Bitcoin.
BitUSD
Dan Larimer and Charles Hoskinson launched BitUSD in July 2014, the first stablecoin on the decentralized trading platform BitShares. It was designed to stabilize the crypto market by pegging to the US dollar, but BitUSD faced challenges maintaining its 1:1 value. This ultimately led to its downfall in 2018, exposing the risks of using volatile assets as the reserve. Despite its failure, BitUSD paved the way for future iterations of stable crypto.
Terra Crash Explained
Do Kwon and Daniel Shin launched TerraUSD (UST) in 2020, an algorithmic stablecoin aimed to maintain a 1:1 peg with the U.S. dollar. However, in May 2022, TerraUSD’s peg collapsed, leading to a massive crash that shook the crypto world. The failure of this ambitious experiment raised serious concerns about the viability of algorithmic stability and whether we can rely on this approach.
The Future Of Stablecoins
Despite these setbacks, stablecoins continue to grow in popularity. Their potential to provide a stable, digital alternative to traditional currencies is undeniable. However, the history of BitUSD and TerraUSD shows that stability can only be achieved with careful design and reliable asset backing. As the crypto market develops, the future of stable value crypptocurrency will likely depend on finding the right balance between innovation and security.
FAQs
What’s the point of a stablecoin?
Stablecoins, pegged to currencies like the US dollar, were designed to bridge the gap between volatile cryptocurrencies and the stability of traditional fiat currencies. They offer a more predictable and reliable alternative.
What are the two types of stablecoin?
The two main approaches are:
- Fiat-Backed: These are directly backed by fiat currency reserves, ensuring their value remains stable. Examples include Tether (USDT) and USD Coin (USDC).
- Crypto-Backed: These are backed by other cryptocurrencies. To manage volatility, they often require excess collateral, meaning the value of the collateral exceeds the value of the crypto tokens issued. Dai (DAI) is a prominent example.
While both aim for stability, they differ in their underlying mechanisms. Fiat-backed cryptocurrencies offer simplicity and reliability, while crypto-backed ones appeal to those seeking decentralized systems.
