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Stablecoins: definition and operation


OOver the past few years, through market highs and painful downturns, stablecoins have become an integral part of both DeFi and broader cryptocurrency ecosystems. With a total market capitalization of over $150 billion, stablecoins have attracted crypto novices and experienced investors alike, fascinated by their compelling value proposition: the stability of a low-risk traditional asset with the flexibility of a digital currency. But with the recent crash of the once revered Terra ecosystem, stablecoins have found themselves under scrutiny, with many investors seeking answers regarding their safety and usefulness.

What is a Stablecoin?

A stablecoin is a type of cryptocurrency whose value is pegged to an external, usually stable, asset class such as fiat currency or gold. Given the wild volatility of most cryptocurrencies like Bitcoin and Ether, stablecoins offer a less risky alternative for storing money on the blockchain and facilitating payments between individuals and institutions.

To maintain this price fixing, stablecoins often build a reserve of a single asset or basket of assets responsible for backing up the stablecoin. For example, the reserve of a fiat-backed stablecoin like USDC might hold US$1 million to act as collateral for one million USDC. The stablecoin and the reserve move in unison, so when a stablecoin holder chooses to cash out their tokens, an equal amount of the supporting fiat asset is taken from the reserve and sent to the bank account of the stablecoin. user.

Compared to fiat currency, stablecoins have many advantages:

Accessibility: Stablecoins are available to anyone with an internet connection worldwide and operate 24/7. Unlike central banks, the crypto market, and by extension the stablecoin market, never closes.

Speed ​​and cost: Stablecoins are fast and cheap to use. International payments can be sent in seconds and seven-digit transactions cost no more than a dollar to execute.

Programmable: Through the use of smart contracts, stablecoin transactions can be executed automatically according to specific parameters.

In addition to individual and business payments, stablecoins can be used for trading, borrowing and lending, earning yield, alternatives to banking, sending funds, stores of value, and more.

Types of stablecoins

Fiat-Collateralized
The most popular and generally safest stablecoins are backed 1:1 by a fiat currency like USD, Euro or British Pound. As mentioned in the USDC example above, each trust-backed stablecoin has a reserve with an equal amount of fiduciary collateral held by a central bank or regulated financial institution. Many popular exchanges like Coinbase and Gemini offer their own fiat-backed stablecoins.

Fiat-backed stablecoins include:

  • USDC (Coinbase)
  • Attached
  • GUSD (Gemini)
  • BUSD (Binance)

Crypto-guarantee
As their name suggests, crypto-backed stablecoins are backed by cryptocurrencies (usually ETH), rather than fiat currencies. Instead of relying on a central issuer to store the reserve, crypto stables use smart contracts to secure assets as collateral. To account for the unpredictable volatility in the cryptocurrency market, many decentralized crypto stablecoins like MakerDAO’s DAI token are over-collateralized, with most requiring a 200% collateralization ratio. This means that for every $100 of DAI you wish to borrow, you must back it with $200 of ETH. This allows ETH to maintain its peg even during periods of intense market volatility.

To buy DAI, users can use any major exchange, like Coinbase and Gemini.

But to borrow DAI, users must lock the cryptocurrency into a smart contract called Collateralized Debt Protocol (CDP) through the MakerDAO ecosystem. Once a user locks the cryptocurrency into the CDP, they will then receive an equally representative amount of DAI. When it is time to withdraw the original collateral amount, the user must return the original amount of DAI, plus interest, to the smart contract.

Algorithmic
Rather than being backed by cryptocurrency, algorithmic stablecoins use specialized algorithms and smart contracts to control token supply. It is important to note that algorithmic stablecoins have no reservations. Instead, these algorithms link two coins (a stablecoin and a cryptocurrency that backs it) and adjust their price based on the principles of supply and demand. If the market price of the stablecoin falls below the price of the fiat currency it tracks, the token supply is reduced. If the price of the stablecoin rises above the price of its pegged fiat currency, the algorithm increases the supply of tokens to exert downward pressure on the value of the stablecoin.

As the groundbreaking crash of algorithmic stablecoin Terra indicates, algorithmic stablecoins need sufficient demand to sustain their value. And while the idea of ​​algorithmic stablecoins has merit, there’s still a lot to understand here, so proceed with caution.

Backed by raw materials
Commodity-backed stablecoins are backed by reserves of physical assets like precious metals, oil, and real estate. It is important to note that while commodity markets may not be as volatile as cryptocurrencies, commodity-backed stablecoins are still riskier than fiat-backed stablecoins. That being said, they offer high return potential. While not particularly popular among the general cryptocurrency population, most commodity-backed stablecoins are used as a way to access asset classes that were previously inaccessible to retail investors.

Examples of gold-backed stablecoins include Tether Gold (XAUT) and PAX Gold (PAXG).

Risks and Disadvantages of Stablecoins

Once considered infallible digital equivalents, the past 12 months have highlighted a handful of major downsides to stablecoins. It is important to note that even though stablecoins are considered low risk compared to other digital assets, this does not mean that they are no risk.

Security: Unlike traditional bank accounts, digital wallets – and digital currencies for that matter – are not FDIC insured. If your hot or cold wallet is hacked, lost or stolen, your funds disappear with it.

Counterparty risk: Given recent developments with Celsius, BlockFi, and even Coinbase, there is significant counterparty risk where you buy and transact with your stablecoins. Be sure to do your research on the third parties responsible for storing your cryptocurrency.

Reserve risk: Does the entity behind the stablecoin actually have assets and reserves guaranteed to support the stablecoin? Even a token like Tether, which is considered one of the most reliable, has raised concerns about the legitimacy of its reservations.

Technical risk: This is especially important for algorithmic stablecoins, which do not have real liquidity reserves behind them. As we saw with the Terra fiasco, stablecoins may not be as stable as they seem. Algorithms aren’t perfect, and with the novelty of space, very few have been battle tested during slowdowns or periods of low demand.

Conclusion

Despite the recent market downturn, stablecoins are still a promising, relatively low-risk, and legitimate way to gain exposure to cryptocurrency. But as with all investments, it’s more important than ever to do your own research when deciding which coins to invest in and where to store them. For security reasons, it is best to stick with fiat-backed stablecoins associated with major exchanges, as they provide the best insight into their reserves and have the least counterparty risk.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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