Although cryptocurrencies have a viable monetary role as a medium of exchange, they are inherently too volatile to be used as a unit of account or a store of value. The unreliable nature of popular cryptocurrencies like bitcoin is why cryptocurrency still hasn’t caught on in mainstream commerce. Crypto investors can become millionaires overnight and lose all their money weeks later.
This is where stablecoins come in, allowing investors to enjoy the benefits of a cryptocurrency without the associated high volatility.
Stablecoins are pegged at a 1:1 ratio to other assets, such as the US dollar or gold, designed to have a much more fixed value than regular cryptocurrencies. As a result, the demand for stablecoins is increasing, with the total market capitalization of stablecoins from US$0.02 billion in January 2017 to US$181.73 billion in April 2022.
Read on to learn everything you need to know about stablecoins, the benefits and limitations of investing in various types of stablecoins, and more.
- Stable Coins
- A stablecoin is a cryptocurrency backed by the value of an underlying asset, such as fiat currency, precious metals like gold, or even other cryptocurrencies. Many stablecoins are pegged at a 1:1 ratio with certain fiat currencies, such as the US dollar, which can be traded on exchanges.
What are Stablecoins?
Stablecoins are designed to provide the benefits of both worlds: the security and privacy of instant cryptocurrency payments and the stability of fiat currencies.
A stablecoin is a cryptocurrency backed by the value of an underlying asset, such as fiat currency, precious metals like gold, or even other cryptocurrencies. Many stablecoins are pegged at a 1:1 ratio with certain fiat currencies, such as the US dollar, which can be traded on exchanges.
The underlying collateral of crypto-collateralized stablecoins is another cryptocurrency. These stablecoins are over-collateralized, i.e. more cryptocurrencies are held in reserve to issue a lower number of stablecoins due to the high volatility of the reserve cryptocurrency .
How Do Stablecoins Maintain Their Peg?
Stablecoins achieve price stability through collateralization or through algorithmic market modules.
Collateralized stablecoins maintain a reserve of fiat currency, such as the US dollar, as collateral to issue an appropriate number of crypto coins. Other forms of collateral may include cryptocurrency, gold, or commodities like oil.
These reserves are maintained and regularly audited by independent custodians and companies. Fiat-backed stablecoins are backed at a 1:1 ratio, so real fiat currency is held in a bank account to back up each stablecoin. If a person needs to exchange money with stablecoins, the entity that manages the stablecoin will take the fiat amount from its reserve and send it to the person’s bank account. The equivalent stablecoins are then “burned” or permanently withdrawn from circulation.
For example, a stablecoin like USDC, fully backed by US dollars and dollar-denominated assets at a 1:1 ratio, would maintain its peg by storing a dollar when a USDC is hit. If you initiate a transaction to buy a USD coin using fiat currency, then that fiat currency is deposited and stored as a US dollar, and the new USDC is minted. If you sell a USD coin in exchange for fiat currency, the USDC is “burned” when the fiat currency is transferred back to your bank account.
However, most stablecoins pegged to fiat currency are not fully backed by money. A stablecoin can also be partly backed by secured loans, corporate bonds, precious metals, and other investments. The idea is that their total value is equal to the total number of stablecoin units minted so far. For example, the bulk of Tether’s reserves are made up of cash, commercial paper, treasury bills, reverse repurchase notes, and fiat deposits.
Other stablecoins, such as Terra (UST) or Dai, are backed by crypto locked in Maker vaults and use algorithms for stability.
Algorithmic Market Modules
An alternative model uses an algorithm and associated reserve token to peg a stablecoin to USD – instead of using cash reserves. Algorithmic stablecoins have no collateral by design – the collateral is its governance token which can be minted or burned to stabilize the price.
For example, the Terra protocol is designed so that users can always exchange the LUNA token for UST, and vice versa, at a guaranteed price of $1. If the demand for UST increases and its price rises above $1, LUNA holders can trade $1 worth of LUNA to create a UST token.
During the trading process, a percentage of LUNA is burned and the rest is deposited in a community treasury. Burning a percentage of LUNA tokens reduces the total number of tokens remaining in circulation, making them rarer and, therefore, more valuable. By hitting more UST tokens, the overall price is brought back to its $1 level.
If demand is low for UST and the price falls below $1, UST holders can swap their UST tokens in a 1:1 ratio for LUNA.
Other coins like Ampleforth (AMPL) use a rebasing method where the software programmatically adjusts the supply of its AMPL cryptocurrency every 24 hours. If the demand for AMPL tokens is high and each AMPL token exceeds $1, the supply will increase. If the demand is low, the supply will decrease.
Other tokens like BASED and RMPL aim to improve this mechanism.
Threats to Stablecoin Pegs
Although stablecoins may appear to be low risk, they do come with some risks. The main risk of stablecoins is if they are not fully backed by reserve currencies. Risks include:
The reserves backing a stablecoin guarantee the value of a stablecoin and are essential for the stablecoin ecosystem.
For the currency to retain its value, the bank holding the reserves and the organization issuing the stablecoin must do the right thing (security, proper reservation, etc.).
Like other cryptocurrencies, stablecoins should be kept in a secure digital wallet because a trading platform can be prone to hacks.
Protocol malfunction is a big threat to stablecoins that rely on algorithmic market modules. If there are flaws or vulnerabilities in the code that handles minting and burning, a stablecoin can lose its peg.
Additionally, a considerable portion of stablecoins are held in liquidity pools, and some decentralized finance (DeFi) protocols like Compound have tokens that track underlying assets (cTokens like cDai, cUSDC, etc.). If these DEX pools or the smart contracts governing cTokens are compromised, an attacker can mint large sums of unbacked tokens or steal a pool and quickly dump them on the open market. As a result, the stablecoin’s supply will exceed its reserves; price swings will exacerbate selling pressure and break the peg.
Although stablecoins offer the best of both worlds, they come with risks associated with investing in them. Along with the risks mentioned above, some stablecoins, such as Neutrino (USDN), are losing their pegs and have recently fallen from the Target from $1.00 to $0.76.
There is also the case of Iron Finance, where a significant delay between the price feed oracle and real-time data made arbitrage unprofitable. As a result, the base token, TITAN, lost almost all of its value and the associated IRON stable coin fell to $0.94.
Each stablecoin has its unique advantages and disadvantages and uses various collateral methods to ensure price stability. So be sure to check the issuer’s reserve reports and implemented audits before investing in them.