What Are Stablecoins?
This step-by-step guide will walk you through the ins and outs of stablecoins.
By: Rahul Nambiampurath •Beginners
Electronic cash is nothing new. In fact, over 150 years has passed from the first wire payment made by Western Union in 1871. Since then, people have gotten used to cashless payments via e-banking, credit, and debit cards. But electronic money is not digital money.
It may feel like you’re using digital cash when you buy something with a smartphone app. However, these are just communication systems interacting with traditional banks and their supply of paper money issued by a central bank. Stablecoins differ from this in that they are true digital money, native to the internet.
Here’s a primer on what that means and why stablecoins are so important for the future of finance:
The Purpose of Stablecoins Explained
Anyone familiar with penny stocks knows how volatile they are. Because these companies have low market capitalization, it doesn’t take much for a whale to drastically shift their stock’s price in either direction. The same is true of cryptocurrencies.
A large cap cryptocurrency less susceptible to swings in price would have to be worth at least $500M. Bitcoin has been mainstreaming the concept of cryptocurrencies since 2009. Since then, over 10,000 crypto coins have popped into existence.
Yet, out of those 10,397 altcoins, only 131 have a market cap greater than $500 million, or a measly 1.26%. In other words, almost 99% of the crypto market is prone to wild price swings, commonly called volatility. This is made worse by the fact that most crypto assets gain value based on speculation, future potential, and social media engagement.
Elon Musk’s impact on DOGE price. Source: TheStreet
Just look at Elon Musk’s tweet history to see the tight relationship between Dogecoin’s price moves and the billionaire’s meme coin escapades. All of this translates into the need for stability, and you guessed it, stablecoins are there to provide it.
Stablecoins provide crypto market stability by being pegged to a fiat currency like the U.S. dollar, the world’s No. 1 reserve currency. Prior to stablecoins, crypto traders were forced to completely convert crypto assets to fiat currency or else take heavy losses the next day.
After stablecoins, they can simply keep this blockchain asset in a crypto wallet and immediately jump into crypto trading when the opportunity arises. In fact, the stablecoin supply ratio (SSR) on crypto exchanges is often viewed as a market signal.
The greater the weight of stablecoins on exchanges, the more likely it is that Bitcoin’s price will surge. Source: @OnChainCollege
This makes perfect sense. Because the crypto market is a closed system, the inflow of stablecoins indicates a buy-in preparation from whales (high net-worth investors). In turn, when SSR is low, there is a high potential buying pressure, creating a bullish market sentiment. Likewise, when SSR is high, there is a low potential buying pressure, creating a bearish market sentiment.
Therefore, stablecoins are important both as a stable bridge from fiat to crypto and as an indicator for trading strategies. However, their use doesn’t end there. By being native assets to blockchain networks, stablecoins offer a superior alternative to electronic money transfer.
One may notice that e-banking transfers don’t work over the weekend. That’s because much of the banking industry’s computer systems date back to the 1970s and have patched up ever since. With stablecoins, financial service is available 24/7. Not only are stablecoin transfers faster and cheaper, but smart contracts eliminate the need for banking clerks.
What Are the Most Popular Stablecoins?
The first stablecoin was created in 2014 by Tether Limited, a company based in Hong Kong. Dubbed Tether with a ticker symbol USDT, this stablecoin has a substantial first-mover advantage. It came to dominate the stablecoin market at an $81B market cap.
Top stablecoins near or above $1 billion market cap. Source: CoinMarketCap
The overall value of the stablecoin market has multiplied 25 times in the last two years, to $186B. Ethereum’s dApps are the main driver. During this Ethereum’s decentralized exchanges, lending, and borrowing protocols gained enormous traction.
As decentralized finance (DeFi) DApps got more popular, so did the demand for stablecoin supply. Source: The Block
Stablecoins again found a new use in these lending protocols as a reliable source of passive income. Because there is greater demand for stablecoins than there is supply, stablecoins often generate premium interest rate yields. While the national average for interest rates in banking savings accounts is 0.06%, stablecoins in DeFi protocols can yield up to 9% APR (annual percentage rate).
Both centralized (CeFi) and decentralized (DeFi) lending and borrowing platforms offer much greater earning potential than the traditional banking system. Source: DeFiRate.com
However, while stablecoins provide numerous benefits to usher in web3, not all of them are the same. Many have their own mechanisms for how to maintain the 1:1 peg to the dollar.
Different Types of Stablecoins
Broadly, stablecoins can be divided into centralized and decentralized. This mirrors how they are backed to maintain the 1:1 USD peg. In other words, because stablecoins are tokenized fiat currency, one has to look at who is collateralizing a particular stablecoin and how.
From this metric, stablecoin can be:
Collateralized by Fiat
These are the most centralized stablecoins because companies are in charge of maintaining their collateral. After Tether (USDT), managed by Tether Limited, there is USD Coin (USDC), managed by Circle and Coinbase, Binance USD (BUSD), managed by Binance, Gemini dollar (GUSD), managed by Gemini, Pax Dollar (USDP), managed by Paxos, and TrueUSD (TrueUSD), managed by TrustToken.
Of the bunch, USDC, GUSD, and USDP are the most regulated stablecoins by federal agencies. Meaning, they are not only fully backed by an equivalent value in cash, but they are also regularly audited. The same cannot be said of USDT, which uses “cash and cash equivalents” like treasury bonds for its backing.
In October 2021, the Commodity Futures Trading Commission (CFTC) issued a $41 million fine to Tether for misrepresenting the claim that USDT is backed with sufficient U.S. dollar reserves. Likewise, Tether representatives didn’t even show up at November’s congressional hearing on stablecoins.
This may be concerning for investors because of a bank run risk. This is a potential situation in which a large number of USDT holders decide to convert the asset. If there is no proper Tether backing, it will hang them out to dry, relieving them of investment opportunities. Although such a scenario is highly unlikely, it may push investors toward more regulated stablecoins — USDC, USDP, and GUSD.
Collateralized by Other Cryptocurrencies
This is the case with one of the most popular decentralized stablecoins, DAI. Its origins stem from MakerDAO, a decentralized autonomous organization (DAO) on Ethereum blockchain, serving as a decentralized blockchain treasury. Through the use of smart contracts called Collateralized Debt Positions (CDPs), DAI stablecoins are backed by locked-in ETH, BAT, and other cryptocurrencies.
However, because crypto assets themselves are volatile, it means that DAI has to be over-collateralized. For instance, if ETH depreciates significantly, DAI’s peg to USD still wouldn’t be lost as ETH to DAI collateral ratio is 2:1. Therefore, even a 50% ETH depreciation wouldn’t destabilize DAI.
Collateralized by an Algorithmic Ecosystem
On the cutting edge of stablecoin technology are algorithmic stablecoins. Judging by the fact that TerraUSD (UST) stablecoin increased its market cap by 36% in the last two months, from $11b in February to over $15b in March 2022, Terraform Labs created a successful stablecoin experiment.
Terra’s UST peg to the dollar works by contraction and expansion of Terra’s LUNA, a native token for the Terra blockchain, just like ETH is the token for Ethereum. In fact, Terra is now the second-largest smart contract platform, outcompeting the likes of Solana, Binance Smart Chain, Avalanche, and Fantom at $26.34 billion.
Represented by a light blue donut portion, Ethereum is facing stiff competition in purple Terra. Source: DeFiLlama.com
Terra’s UST algorithmic stablecoin maintains its peg thanks to Band oracles feeding price data to the blockchain. This data draws the price from the International Monetary Fund’s Special Drawing Rights (SDR). This is a basket of currencies tied to USD in a 1:1 ratio. Therefore, a peg between 1 TerraSDR to 1 UST has to be maintained.
Terra’s native LUNA tokens are then either burned (removed from circulation) or added:
- If TerraSDR value peaks over 1, SDR converts to TerraSDR. Consequently, TerraSDR’s increased supply brings the peg back to 1:1.
- If TerraSDR bottoms under 1, TerraSDR converts to SDR as LUNA. Consequently, TerraSDR’s reduced supply pushes the peg up to 1:1.
For such a system to work, LUNA has to have its own relatively stable value. So far, Terra’s blockchain shows no signs of stopping. The South Korean CHAI payment app uses Terra’s blockchain to serve over 25 million customers. Likewise, Terra’s recently deployed Anchor protocol provides a viable substitute for a banking savings account.
On top of all that, Terraform Labs’ co-founder, Do Kwon, recently announced a $10B worth acquisition of Bitcoin in order to collateralize UST further against market volatility.
The first step in that shoring up of UST happened on March 22, with a $125 million BTC purchase. This is a major milestone for the entire crypto space as Terra effectively made Bitcoin Standard. Just like the USD was collateralized by gold between 1944–1971, it appears that Bitcoin will serve that purpose for algorithmic stablecoins.
Collateralized by Commodities
Lastly, outside of cash, crypto coins, and burning mechanics, stablecoins are collateralized by commodities — oil, gas, minerals. One of the most common minerals for this purpose is gold. Thanks to its scarcity, gold derives value, making it a suitable stable collateral. One of the most prominent gold-backed stablecoins is Digix Gold (DGX). As an ERC-20 token, each DGX is backed by 1 gram of gold. Furthermore, the tokens themselves are redeemable for physical gold. The caveat is that one has to travel to Singapore.
Land can also be collateral. SwissRealCoin (SCR) is backed by an assortment of real estate in Switzerland. Investors holding SCR gain an extra benefit of voting rights for diversifying their Swiss commercial real estate portfolio.
The Future of Stablecoins
Stablecoins have clearly demonstrated that digital cash may determine the future of finance. Just as data freely roam the Internet, so have stablecoins become the Internet’s native money, attached to the crypto ecosystem.
As such, one could even say that stablecoins already serve the purpose of CBDCs — central bank digital currencies. However, because stablecoins are not under the control of central banks, we are yet to see if there will be room for them after multiple CBDCs launch in the coming years.