Everyone has heard about stablecoins by now. They are crypto assets backed by a stable asset like fiat currency or commodity, backed by a pool of cryptocurrency funds or held in check algorithmically. In this blog we’ll cover most basic questions about stablecoins.
announcementDisclaimer The information provided here is for educational purposes only and should not be treated as investment advice.
What is a stablecoin?
Stablecoins are cryptocurrencies that are backed by an asset, most often a fiat currency and in other, rarer cases, commodities like gold.
They are designed to always hold a stable value in the currency that they are “pegged” to. This means that a stablecoin pegged to USD will always hold value near 1 USD. If you look at a graph of a stablecoin like Tether USD, you will see rapid fluctuations but the value rarely exceeds +/- 2% of the underlying asset. The value is kept stable by the trust that the backer holds sufficient assets and is acting in a transparent way.
What are stablecoins used for?
Stablecoins have three main purposes: fast transfer of stable value, hedging against volatility and decentralized exchange.
Transfer of value
Stablecoins, in essence, are tokenized assets pegged in value to an existing stable asset like the U.S. dollar or Euro. This makes them useful for transferring value over exchanges and systems with reduced volatility risk. They are also much cheaper to transfer than fiat currency over traditional bank rails. There exist a plethora of stablecoins, most of them pegged to USD.
The most well known stablecoin is Tether USD (USDT) and it was created to use the Bitcoin network 2nd layer solution Omni Layer. It is most widely used today on the Ethereum network as an ERC20 token but can also be transferred over EOS, Tron, Algorand, SLP, and OMG blockchains.
Hedging against volatility
Crypto coins and tokens are an exceptionally volatile asset class and trivial events can trigger major volatility on the markets. For investors, this can be good in case there are rapid increases in value and very frustrating when the value drops in a short period of time.
Now, because stablecoins are pegged to a more or less stable currency, their value remains relatively constant even in times of high volatility. For this reason they are a great tool in times when prices are trending downwards to keep the portfolio value level. When prices start trending upwards again, stablecoins can be traded back to other crypto assets that are seeing increases in value.
Actual fiat money does not exist on the blockchain yet. There are ongoing efforts to create central bank digital currencies (CBDC) on the blockchain but they have not actually come to life yet.
This is where stablecoins come in handy. Because their value is analogous to the value of actual fiat currency, they have the ability to contextualize the prices on the markets. We still rely very heavily on USD prices for crypto coins and tokens and decentralized exchanges would be very difficult to navigate without this context.
Stablecoin backing and collateralization
You have more types of stablecoins collateral. That means they use a variety of types of assets for backing:
The most known and popular stablecoin among them is USDT or Tether. This was the first stablecoin that came to market and it had the most range in adoption and in market capitalization. Tether is pegged 1:1 to the USD.
Another stablecoin backed by Fiat is USDC or USD Coin that is pretty popular and was launched in 2018 by Coinbase and Circle. These coins are centralized, meaning that they are held and managed by an exchange (Coinbase and Circle).
One of the concerns about them is that they have a central authority and that means we just need to trust them to maintain their supply of dollars the same as the supply of stablecoins. We can understand why this could often be criticized since it goes against the concept of decentralization.
For example: If an issuer has $1000 of fiat currency, it can only distribute 1000 stablecoins, valued one dollar precisely. Next to USDT and USDC the best known stablecoins in this category by market value are GUSD (Gemini Dollar), TUSD (True USD), and PAX (Paxos Standard).
These are very similar to fiat-backed stablecoins, except that they are pegged to different real-life assets or commodities like precious metals or real estate. These assets should in principle have low volatility similar to fiat currencies to better serve their purpose.
As evident from their description this version of stablecoins use other cryptocurrencies as collateral.
One example of this kind is DAI. DAI is a decentralized crypto-backed stablecoin whose value equals 1 U.S. dollar. It is a token like BTC and ETH and exists on a blockchain, except it has no volatility. Its goal is to keep the value equal to the U.S. dollar and this is done on the Ethereum blockchain network by allowing people to use their Ethereum assets to generate DAI on the Maker platform with no intermediate agent. It has become very important to many DeFi applications.
Crypto-based stablecoins can be decentralized and allow transparent issuance and hold their value trustlessly. There is no central authority in charge of such stablecoins and they can be backed by multiple cryptocurrencies to distribute risk.
They use an algorithmically governed approach to control the supply. If there is an increase in demand, new stablecoins need to be created so price volatility can be kept in check. If the coin is traded too low, then coins are bought back so the circulating supply is reduced.
The advantage of these types of stablecoins is that these allow a decentralized approach without the need to collateralize another asset. They do, however, require continual growth to be successful. If there is a rapid decrease in value of crypto, there is no collateral for liquidation available and the value locked in the stablecoin is effectively lost.
What else can I do with stablecoins?
Stablecoins can be used in savings accounts to earn yields. Most of the time services that offer yields provide higher yields on fiat and stablecoins so they are a good option for earning steady and reliable income over extended periods of time. This works by lending your crypto or stablecoins for a percentage of the profits. In most cases, you are also able to borrow these assets but in that case, you need to collateralize the borrowed amount with another asset.
Should I invest in stablecoins?
As explained earlier it is highly unlikely that a stablecoin will earn you any profits through its volatility. Its strength is its stable value which means that it can hold the value of your portfolio (or a part of it) for periods when there is uncertainty or when prices are declining. You should be aware of the fact that holding a stablecoin through a bull market will almost certainly result in you missing out on opportunities deriving from the volatility of other crypto assets like coins and tokens.
What should I look for in a stablecoin?
This largely depends on what you wish to do with a stablecoin. Like with every other crypto asset it is always a good idea to educate yourself about the technology, and team behind the asset, which exchanges support the stablecoin, how fast and cheap it can be transferred, etc.
If, for example, you wish to do arbitrage, it’s best to select a stablecoin that is supported by the exchanges you are using and look for a cheap and fast underlying technology for transfer. If you wish to hedge through a bear market without cashing out, you can use any stablecoin that can be exchanged conveniently from the assets you are investing in.
Stablecoins have brought a lot to the crypto table in recent years. They are used widely across the industry to boost market liquidity, contextualize prices, provide an on and off ramp to crypto for the underbanked and to hedge against volatility.
Regulation on this front can bring a few downsides in the short term if bad backing practices are discovered and punished. In the longer run, however, they offer many benefits that can be utilized by anyone, and more stringent regulation will almost certainly help make the space safer and even more exciting.