Stablecoins: Everything to Know
By Beluga Research July 7, 2023
- Stablecoins are digital currencies pegged to a stable asset like the U.S. dollar
- In an often volatile crypto market, stablecoins can be more predictable than most other cryptocurrencies
- Stablecoins can be used for everyday transactions because of their stability
- This allows users to access the benefits of blockchain technology while lessening the risks of traditional cryptocurrencies
Stablecoins are digital currencies with values tied to stable assets, like gold or the U.S. dollar. They are not subject to the wild price fluctuations that are common for other cryptocurrencies. Stablecoins are designed to maintain stable values.
Traditional cryptocurrencies, including bitcoin and ether, can experience significant price fluctuations whereas stablecoins are more predictable. They can be used for everyday transactions. Stablecoins have become increasingly popular in recent years, with a market capitalization of over $138 billion as of January 2023.
A Brief History
The first stablecoin, Tether (USDT), launched in 2015. Tether is a cryptocurrency pegged to the U.S. dollar where one USDT token represents one U.S. dollar. Tether quickly became popular among cryptocurrency traders and investors, as it provided a way to trade cryptocurrencies without having to convert them back to fiat currency.
Tether's launch catalyzed the development of many other stablecoins, each with their own features and advantages. The most popular stablecoins include USDT, USD Coin (USDC) and Dai (DAI). Each of these stablecoins is pegged to the U.S. dollar and is backed by reserves of U.S. dollars or other assets.
What are Stablecoins?
Stablecoins are cryptocurrencies that are designed to maintain a stable value. There are three types of stablecoins: fiat-backed stablecoins, commodity-backed stablecoins and algorithmic stablecoins. The most common type of stablecoin is the fiat-backed stablecoin.
Fiat-backed stablecoins are backed by reserves of the underlying fiat currency. For example, for every USDC token in circulation, there is a corresponding U.S. dollar held in reserve. This ensures that the stablecoin maintains its value and can be used without the risk of price fluctuations. Stablecoins offer a number of advantages over traditional cryptocurrencies, including lower volatility, faster transaction times and lower fees.
The commodity-backed stablecoin is pegged to a commodity like gold. Commodity-backed stablecoins are backed by reserves of the designated underlying commodity. The supply of the commodity ensures that the stablecoin maintains a stable value.
There are also algorithmic stablecoins. These are not backed by any underlying asset and instead, use complex algorithms to maintain a stable value. Algorithmic stablecoins are still relatively new and more sensitive to market conditions.
In particular, issues around algorithmic stablecoins include price volatility due to supply adjustments based on market conditions that can lead to unpredictable price swings. They also introduce more risk from their complexity and uncertainty. In some cases, they are prone to failure in maintaining their intended peg to the target value, resulting in the stablecoin's price deviating from its desired stability. This can erode user confidence and affect the algorithmic stablecoin's use as a reliable store of value. As a result, they are not as widely used as fiat-backed and commodity-backed stablecoins.
Of note is the stablecoin cryptocurrency tale of Luna. It starts with UST, an algorithmic stablecoin tied to the Terra network, which had experienced a significant crash due to its connection to Luna and the uncertainties surrounding its stability. Unlike traditional stablecoins like Tether and USDC, UST was not backed by actual U.S. dollars, but instead relied on algorithms linked to Luna. The crash was triggered by a massive unstaking of UST and subsequent liquidation, possibly in response to rising interest rates or a malicious attack. This caused UST to lose its peg to the dollar, leading to panic selling and a decrease in its value. As UST depegged, more Luna was minted, resulting in a surplus of Luna tokens that caused the cryptocurency to become worthless. As a consequence, crypto exchanges delisted Luna and UST pairings.
When the Luna crypto network collapsed, it's estimated that $60 billion got wiped out as it reverberated through the digital currency space.
Stablecoins are designed to maintain a steady value regardless of market conditions. This makes them ideal for use in transactions. They provide a stable medium of exchange. Anyone can use fiat currency or other cryptocurrencies to acquire stablecoins. Users can then make transactions or hold them as a store of value.
- Stability. Stablecoins are designed to maintain a stable value, making them ideal for use in transactions. This stability is achieved through the use of a pegged asset or algorithm. These ensure that the stablecoin's value remains consistent.
- Bridge the gap between traditional finance and cryptocurrencies. Stablecoins provide a stable medium of exchange that can be used to make transactions, much like traditional currencies. This makes using stablecoins an attractive option for businesses and individuals looking to enter the world of cryptocurrencies. The parties do not have to face the risks inherent for other cryptocurrencies.
- Offer privacy and security that is not available with traditional fiat currencies. Transactions made with stablecoins are recorded on a public blockchain, without revealing personal specific user information. This offers the user a high level of transparency. Yet the identities of the parties involved in the transaction are not revealed.
- Types of stablecoins. There are fiat-backed stablecoins, commodity-backed stablecoins and algorithmic stablecoins.
- Stability. Stablecoins aim to eliminate the volatility that is inherent in many cryptocurrencies. By pegging their value to a fiat currency, stablecoins offer a stable store of value that can be used for transactions, trading and other purposes. To clarify, fiat-backed stablecoins are backed by a fiat currency. Commodity-backed stablecoins are backed by a commodity, like silver. Algorithmic stablecoins are not backed by any currency or substance. They use complex algorithms to maintain their value.
- Accessibility. Stablecoins offer a bridge between the crypto and fiat worlds. This makes them a more accessible and user-friendly option for people who are new to cryptocurrencies. Stablecoins can be purchased with fiat currency or other cryptocurrencies such as bitcoin or ether.
- Speed. Stablecoins can be transferred quickly and easily across borders. Traditional fiat currencies can take days or even weeks to transfer (and incur significant fees). Stablecoins can be sent in a matter of seconds or minutes.
- Privacy. Stablecoins can offer greater privacy and anonymity than fiat currencies. Transactions are typically conducted on a decentralized blockchain network. As a result, users do not have to reveal their personal information to complete a transaction.
- Decentralization. Some stablecoins are built on decentralized blockchains. This means they are not controlled by any central authority. Such stablecoins are resistant to censorship and government interference.
- Versatility. Stablecoins can be retained as a store of value or used for transactions.
- Centralization. Some stablecoins are centralized, which means that they are controlled by a single entity or organization. This can create issues around transparency, accountability and censorship resistance.
- Counterparty risk. Some stablecoins require users to trust a third-party custodian to hold the underlying assets that back the stablecoin. This creates counterparty risk. Users are relying on the custodian to maintain the value of the stablecoin.
- Regulatory risk. Stablecoins are still a relatively new asset class. There is a risk that they could face regulatory scrutiny in the future. This could lead to restrictions or even bans on their use.
- Limited adoption. While stablecoins have gained popularity in the crypto ecosystem, they are still not widely adopted outside of this niche market. Users may have limited options for engaging with stablecoins in the real world.
- Accessibility. A user needs to research and seek out an exchange that supports stablecoins.