Stablecoin: The future of cryptocurrency or its downfall.
The Stablecoin is not a new idea. The need for a cryptocurrency that operates like a dollar, stable and reliable, has been widely discussed since the beginning of cryptocurrency as a financial instrument. With all the hype and attention on cryptocurrencies, it is no surprise that Stablecoin swooped in to address the volatility problems with cryptocurrency.
However, despite its name, the stability of these coins has been seriously questioned. As with other cryptocurrencies, Stablecoins have their own pros and cons. In this article we cover everything you need to know about Stablecoins from how they work to their different types and noteworthy examples.
What is a Stablecoin?
A Stablecoin is a cryptocurrency designed to maintain a stable price by pegging its value to another currency, asset or commodity. This means that its value does not fluctuate as regular cryptocurrencies do.
The value of a Stablecoin is generally pegged to assets such as US dollar, Government bonds or Gold. For example, if one "fully collateralized" Stablecoin is pegged to the US dollar and a US dollar is worth $1, then one Stablecoin look will be worth $1.
Do we need Stablecoins?
Bitcoin's price rose from an intraday low barely above $4,000 in March 2020 to nearly $65,000 in April 2021 only to plunge almost 50% over the next two months. On January 1st 2022, a Bitcoin was worth circa $40,439. As of the 6th of July 2022, the price of Bitcoin had crashed to circa $20,104. This trend was seen across the whole Cryptocurrency market, and represent the volatility we usually associate with Cryptocurrencies.
Some believe that Stablecoins can solve this volatility problem and may eventually replace or coexist with fiat currencies such as the Dollar. For example, Stablecoins could be used in areas with limited access to banks while also enabling people in countries with more developed financial networks to benefit from the advantages of blockchain technology without having to deal with the volatility associated with most cryptocurrencies.
Additionally, for any currency, which is not a legal tender, to serve as a medium of exchange, it must remain relatively stable, assuring those who accept it that it will retain purchasing power in the short term. Cryptocurrency doesn’t fall into this category due to it volatility.
Types of Stablecoins
Fiat-Backed Stablecoin: Cryptocurrencies which are backed by a national currency are called fiat-backed Stablecoins. For example, Tether Stablecoin is pegged 1:1 to the US Dollar. A fiat-backed token is known to be the easiest way to develop a Stablecoin. One of the cons of a fiat-backed token is that it is centralized, which goes against the decentralized connotation that a cryptocurrency generally holds. Tether, in particular, receives a great deal of criticism owing to this.
With Fiat - Backed Stablecoins, there is a physical centralised reserve or Escrow, acting as collateral. This reserve or escrow is regularly audited by a third party to provide investors assurance on the collateral. If the Stablecoin doesn’t have enough fiat collateral it could lose its peg, leading to a massive buyout demand by investors worried they would lose money, and subsequently the collapse of the Stablecoin. Tether aka USDT is a great example of a Fiat backed Stablecoin.
Crypto-Backed Stablecoin: As the name suggests this is a Stablecoin collateralized by a cryptocurrency rather than a fiat currency. For example, Ethereum is locked up in collateral for MakerDao’s DAI. Although it seems illogical to back a Stablecoin with another volatile asset, this is normally compensated by a “security pledge” which means that the token might not have a 1:1 ratio towards the collateral cryptocurrency despite the fact that it holds a 1:1 ratio to the pegged asset.
Non-Collateralized - These Stablecoins make use of a Seigniorage Shares system. Basically, the tokens rely on an algorithm generated mechanically which is able to change the supply volume if needs be so as to maintain the token’s price which is pegged to an asset. Non-collateralized Stablecoins rely on smart contracts to sell tokens if the price falls below the peg or to supply tokens to the market if the value increases. In this way, the token remains stable and holds its peg.
Since Stablecoin relies on algorithms and mechanically maintains its peg, there is no need for collateral to back the token’s value, hence the name. Additionally, unlike fiat backed Stablecoins, Non-collateralized Stablecoins stay true to the decentralised embodiment of cryptocurrencies. Neutrino USD aka USDN, is a great example of a non collateralised Stablecoin.
Examples of Stablecoins
Tether - The most well-known Stablecoin is Tether, which is “fully collateralized” and backed by US dollars. As such, the value of one Tether is meant to be equal to one US dollar. Tether has been in the news recently due to allegations that it has not been fully backed by USD.
bitUSD - bitUSD is a "non-collateralized" Stablecoin that is pegged to the value of the US dollar. While bitUSD does not hold dollars in escrow, it uses an algorithm to maintain a 1:1 exchange rate with the USD.
GUSD - The "GUSD" is a "fully collateralized" Stablecoin that is also pegged to the value of the US dollar. It is operated by the Gemini exchange, which was founded by the Winklevoss twins.
Cons of Stablecoin
While Stablecoins may seem like a great idea, their existence has raised a lot of controversy and debate in the cryptocurrency space. For example, fully collateralized stablecoins may not be as stable as many people think, particularly if the value of the underlying asset plummets. GUSD and Tether are both "fully collateralized" coins, but what happens if the value of the US dollar plummets? This is not a far-fetched scenario. It has happened in the past, and it could happen again in the future. For example, what happens if there is a major market crash and the value of the US dollar drops significantly? Even if GUSD and Tether are fully collateralized up to the value of the USD, they will not be worth their pegged value.
The collapse of TerraUSD
TerraUSD (UST), is a stablecoin pegged to the U.S. dollar and showed a lot of potential as a cryptocurrency that could upend traditional payment systems across the world. Unfortunately, this didn’t happen and the value of TerraUSD was wiped out in the span of days when investors panicked and started pulling out their money, causing a vicious, self-enforcing bank run. The crash bankrupted many investors and pulled down the entire crypto market with it. Over $400 billion in value was wiped out in terms of crypto market capitalization.
Some Stablecoins derive their value from being fully backed by reserves, and If investors decide they ever want out, the Stablecoin’s foundation should theoretically have enough cash on hand to repay all of them at once.
UST, on the other hand, is an algorithmic Stablecoin, which relies upon code, constant market activity, and sheer belief in order to keep its peg to the dollar. UST’s peg was also theoretically propped up by its algorithmic link to Terra’s base currency, Luna.
The collapse of TerraUSD started when investors started buying UST to profit off a borrowing and lending platform called Anchor, which offered a 20% yield to anyone who bought UST and lent it to the protocol. Many critics immediately likened it to a Ponzi scheme, saying it would be mathematically impossible for Terra to give such a high return to all of their investors. Terra team acknowledged that this was the case, but likened the rate to a marketing spend to raise awareness, in the same way that Uber and Lyft offered severely discounted rides at the beginning of their existence.
It wasn’t long before wealthy investors started borrowing huge amounts of Bitcoin to buy UST, with the intention of making huge profits when the value of UST fell, otherwise known as short-selling. This caused UST to depeg from the dollar and a bank run ensued, with investors who had earned interest via Anchor scrambling to get out the door before it was too late. Their activity caused the linked currency Luna to also crash in what is known as a “death spiral.”
The hype surrounding cryptocurrencies and their potential has often overshadowed the fact that they are extremely volatile. While Stablecoins do have their benefits, they are far from stable as shown in this article. Stablecoins are still developing and are not a game changer in the financial world. However, they do have their place in the growing and evolving cryptocurrency ecosystem, and they may even be helpful for some people.
If anything collateralised Stablecoins seem to be the most stable cryptocurrencies out there but the fiat assets they peg themselves to can also fall in value. On the other hand non-collateralised Stablecoins like TerraUSD have shown that there is a limit to which algorithms can balance supply and demand before they are unable to maintain their peg to a financial asset.
It is important to remember that the volatility of cryptocurrency is one of the traits that attracts traders looking for a large returns in a short time. This is not something Stablecoins can offer.
Please note this is not financial advice and all we are saying is that Stablecoins might solve the volatility issues with cryptocurrency but they come with their own risks which you should be aware of.