Stablecoins Explained: Everything to Know
By Beluga Research September 18, 2023
- Cryptocurrency stablecoins are digital coins pegged to a fiat currency or another cryptocurrency
- Examples of stablecoins include Tether (USDT), USD Coin (USDC), DAI and Binance USD (BUSD)
- Stablecoins that are pegged to fiat currencies such as the U.S. dollar offer the benefits of blockchain technology and the stability of fiat currencies
- Disadvantages include the risk of centralization, counterparty risk, regulatory challenges and the risk of price manipulation
Cryptocurrency stablecoins are digital coins pegged to a fiat currency or another cryptocurrency, or stabilized through other means like an algorithm to ensure that they do not significantly depreciate in value. Stablecoins allows users to engage in fast and secure transactions. Yet the coins maintain relatively stable values over time. Stablecoins are useful for investors who do not want to deal with significant volatility and lose other benefits. Such benefits include voting rights and the ability to stake coins.
A Brief History
The concept of stablecoins originated in the early days of cryptocurrencies. In 2014, BitShares made the first notable attempt to create a stable digital currency. It introduced BitUSD, a coin that aimed to maintain a value pegged to the U.S. dollar. BitUSD used a collateralized system backed by BitShares' native token.
2015 saw the launch of the first widely adopted stablecoin, Tether (USDT). Tether gained popularity because of its 1:1 peg with the U.S. dollar and integration with major cryptocurrency exchanges. Tether eased many investors' fears about cryptocurrencies. Its success ensured that stablecoins would be desirable in the crypto ecosystem.
Initially, investors were concerned that Tether was not operating in a transparent manner and would not keep enough fiat currency in reserves. Later, other platforms launched different stablecoins. Today, there are four basic types of stablecoins, those backed by fiat currency, those backed by other cryptocurrencies, those backed by algorithms and those backed by a combination of collateral of some sort as well as algorithms.
Stablecoins Explained: Everything to Know
- Fiat-collateralized Stablecoins. Collateralized stablecoins are backed by reserves of fiat assets. The value of these stablecoins is directly tied to the value of the underlying collateral. The reserves are held in audited bank accounts or smart contracts. This ensures transparency and full backing. Usually the issuer ensures a 1 to 1 peg with the fiat currency. TrueUSD (TUSD) is an example. It relies on a fully collateralized model. Each token is backed by an equivalent amount of the U.S. dollar held in reserves.
- Crypto-Collateralized Stablecoins. Crypto-collateralized stablecoins use cryptocurrencies as collateral for stability. Users lock up a certain amount of cryptocurrencies, which serve as collateral for the stablecoins. The value of the collateral must exceed the stablecoins' value to provide sufficient security. MakerDAO's Dai (DAI) is an example. It is backed by Ethereum (ETH).
- Algorithmic Stablecoins. These rely on complex algorithms and smart contracts to maintain stability. They use mechanisms such as expanding or contracting the token supply to keep the price stable. The algorithmic control adjusts the supply based on demand and market conditions. Ampleforth (AMPL) is an example.
- Hybrid Stablecoins. These stablecoins combine elements of collateralized and algorithmic stablecoins. They have a collateralized reserve for stability and use algorithms to adjust the token supply when needed. This combination aims to provide a more robust and flexible stability mechanism. Terra (LUNA) is an example.
- Establish a wallet. First, a user should acquire and set up a wallet to hold their stablecoins.
- Acquire stablecoins. Next, the user should research stablecoins and purchase or trade for one or more of their picks.
- Develop strategies to generate a profit. The user should determine what investment opportunities are available for the stablecoins they have chosen.
- Potential for borderless transactions. Stablecoins are digital assets built on blockchain technology. They enable frictionless and near-instant transfers across borders without intermediaries like banks. This makes stablecoins attractive for remittances and cross-border payments. These coins have the potential to reduce costs and increase efficiency for their holders.
- Provide financial stability in regions with volatile or inflationary fiat currencies. Stablecoins allow individuals and businesses to hedge against the depreciation of their local currency. They offer users the opportunity to maintain the value of their assets and engage in more reliable transactions than with fiat currencies. Users in countries with unstable economies and/or limited access to traditional banking services may be able to realize significant benefits from investing in stablecoins.
- Introduce programmability. Certain stablecoins offer smart contract functionality. This means the stablecoins allow users to automate and execute certain actions such as trades. Each stablecoin operates according to its platform's predefined conditions and rules. Programmability introduces options such as the utilization of decentralized finance (DeFi) applications in which stablecoins can be used as collateral for lending and borrowing. Stablecoins also allow liquidity provision and yield farming.
- Offer transparency and auditability. Since stablecoins are based on blockchain technology, transactions involving stablecoins are recorded on a public ledger. The transparency enhances trust among users and regulators. It enables monitoring of stablecoin issuers and their compliance with regulations and audits.
- Stability: Stablecoins offer a stable value. They are more suitable for everyday transactions than volatile cryptocurrencies like Bitcoin. Stability is important to merchants and individuals who want to avoid the risk of price fluctuations.
- Accessibility: Many stablecoins enable wider access to the benefits of cryptocurrencies. They can be easily integrated into existing payment systems and used across various platforms. Their stability makes them more appealing to users who live in countries where fiat currencies and financial systems are extremely volatile.
- Cross-border transactions: Stablecoins facilitate fast and low-cost cross-border transactions. They eliminate the need for intermediaries such as banks and payment processors.
- Financial inclusion: Stablecoins have the potential to promote financial inclusion. They can provide a digital currency option to individuals with no or limited access to traditional banking services. People in underbanked regions or countries with unstable fiat currencies may use stablecoins as a reliable and accessible medium of exchange.
- Programmability: Stablecoins built on smart contract platforms like Ethereum offer programmability. They allow developers to build decentralized applications (dapps) and implement complex financial transactions. This opens up a wide range of possibilities to create innovative financial products and services.
- Transparency: Many stablecoins operate on public blockchain networks. They provide transparency and immutability. Users can verify the supply and transactions of stablecoins. This ensures the integrity of the transactions and reduces the risk of manipulation.
- Risk of centralization: Some stablecoins are centralized. They rely on a central authority or an underlying reserve of assets. This introduces a risk of centralization. The stability and value of the stablecoin depend on the credibility and solvency of the issuing entity. If the central authority fails or faces regulatory issues, the stablecoin will lose value.
- Counterparty risk: Centralized stablecoins introduce counterparty risk. Users must trust the issuer to hold the underlying assets in reserve. A lack of transparency or mismanagement of the reserve by the issuer could lead to a loss of confidence. This could result in a dip in value for stablecoin holders.
- Regulatory challenges: Stablecoins, especially those pegged to fiat currencies, are likely to face regulatory challenges. Governments and regulatory bodies may impose restrictions or require licenses for stablecoin issuers. This could limit the adoption, functionality and value of stablecoins.
- Price manipulation risk: There are stablecoins that lack transparency or proper auditing are susceptible and as such are prone to price manipulation. A lack of oversight and regulation could result in malicious actors exploiting vulnerabilities in the stablecoin's design or market liquidity. This could cause significant price fluctuations.
- Single point of failure: Stablecoins pegged to a single asset like the Euro carry the risk of a single point of failure. If the underlying asset experiences significant volatility or loses its value, this will negatively impact the stability of the stablecoin. Significant dips in value will erode trust in individual stablecoins and this category of cryptocurrency.