Go through this detailed guide to know what stablecoins are and a case study where a stablecoin went miserably wrong.
The only thing that continuously makes a mockery of cryptocurrencies is their volatility.
Computer coins like Bitcoin, Ethereum, etc., are simply not dependable and can’t survive as a medium of exchange. For instance, would you accept a USD 100k worth of payment in Bitcoin, knowing it can plummet to 80k in value while you finish watching Avengers endgame?
I wish it were a mountain range, but unfortunately, it’s Bitcoin, swaying in value from $10k to over $60k, then back to 30k in fewer than two years.
And this is the mightiest cryptocurrency we’re talking about, sparing the altcoins.
Conclusively, something had to come up to keep the revolutionary idea of cryptocurrencies intact while having some stability for real-world currency-like behavior.
Eureka! We invented stablecoins.
What are Stablecoins?
Stablecoins are stable cryptocurrencies backed by real-world assets or algorithms to avoid any massive fluctuations in value. This starkly contrasts with standard cryptocurrencies, which are backed by nothing but public speculation.
Take a look at the value of a popular stablecoin:
This is Tether (USDT), currently the front runner in daily trading volume, ahead of Bitcoin, Ethereum, and a few more cryptocurrencies combined.
Even the spikes, representing the extreme points, indicate less than 10% change from the Tether’s peg (~1 USD) in the past several years.
Peg is a specific value of a stablecoin it must maintain as a testament to its stability.
So, the only objective of stablecoins is to avoid wild price swings. This stability inspires trust among people promoting its usage as an exchange medium, much like fiat currencies.
Up next, we see stablecoins types and how they avoid fluctuations.
Types of Stablecoins
Based on the collateral, one can divide the stablecoins into four types:
#1. Fiat-Backed Stablecoins
These stablecoins are issued against the equivalent amount of fiat currencies on a 1-to-1 basis.
Typically, the issuing authority maintains the exact amount of cash or cash-equivalent reserves before going on with token distribution. And ideally, the authenticity of their reserves is verified by 3rd-party auditors confirming the token company claims.
However, there is no certain way to know if the issuing company won’t default and the collateral is actually reserved.
In addition, though these are called fiat-backed stablecoins, the actual cash share can be quite low.
For instance, the USDT is not entirely backed by fiat but by a collection of cash-like entities, including precious metals, bonds, other digital tokens, etc. As of this writing, the actual fiat share in the USDT reserve is about 5.81%, also mentioned on their website.
#2. Crypto-Backed Stablecoins
Since crypto is volatile itself, crypto-backed stablecoins are backed with substantially more collateral than the value of stablecoins issued.
For instance, DAI, a popular stablecoin, is supported with 50% excess crypto assets than its issued value, just to take care of the volatility of the reserve.
However, since the crypto price variations aren’t restricted in any fixed range, these stablecoins can lose their pegs if the underlying crypto sways above a certain threshold.
#3. Commodity-Backed Stablecoin
As evident by the name, these coins are issued against the commodities reserves, like that of investment-grade gold. So for each distributed token, an equivalent amount is stored with a trusted custodian.
Besides, the best thing about these stablecoins is that the investors can redeem the tokens for the commodities whenever they see fit.
For instance, PAX Gold (PAXG) is a digital token equal to one fine troy ounce of a 400 oz London Good Delivery gold bar. And you can return your PAXGs and get the equivalent amount in the LBMA-accredited physical gold as per the company norms.
#4. Algorithmic Stablecoins
Algo-backed stablecoins are programmed to defend their value and avoid major changes.
The supporting algorithm sends more coins into supply when stablecoin’s value soars above a point to bring it back to its peg. Similarly, it cuts the distribution rate to appreciate the stablecoin when it slides.
Conclusively, these stablecoins aren’t based on any asset and are the most dangerous of the four.
Now that we know about the types, let’s look at a few…
Since each project is unique and there are various factors to rank stable coins, we will simply go by the current total market value as per CoinMarketCap.
Tether is a multi-blockchain, stable token enabling a hassle-free alternative to fiat transactions. Some of the blockchains supporting Tether are Bitcoin Cash’s Simple Ledger Protocol (SLP), Ethereum, EOS, Liquid, Omni, Avalanche, etc.
Tether is pegged to the US dollar and is only behind Bitcoin and Ethereum in the market cap.
This is also one of the most transparent stablecoin with its issuing company, Tether Holdings. Ltd, listing the reserve amount and the composition on its website.
USD Coin (USDC)
USDC is another stablecoin that lives on different blockchains improving accessibility. The list of compatible blockchains includes Ethereum, Alogorand, Solana, TRON, and Stellar.
As per market cap, it’s second among all stablecoins and fourth if you consider all cryptocurrencies.
The brainchild of Circle Internet Financial Ltd., USDC, is also pegged to the US dollar and can be redeemed on a 1-to-1 basis.
Owing to this heritage, you get sweeter deals like minimum or zero fees while buying BUSD or trading it with other stablecoins.
BUSD is also one of the most regulated stablecoins getting approval from the New York State Department of Financial Services (NYDFS).
DAI is different in that there is no underlying central authority like it is with the ones mentioned above.
It is governed and regulated by MakerDAO, a decentralized autonomous organization. DAI operates on the Ethereum blockchain and is valued equivalent to one US dollar.
As a crypto-backed stablecoin, DAI is overcollateralized to maintain its peg in worst market scenarios.
Can a Stablecoin Crash?
The answer could be no, had it been asked before 11th May 2022.
That day shook the entire crypto industry with a spectacular crash of a stablecoin-TerraUSD (UST).
It was an algorithmic stablecoin connected indirectly with LUNA, a non-stablecoin cryptocurrency created by the same parent company, Terraform Labs.
Prior to the UST debacle, its sister coin, LUNA, was already facing tough times along with most other cryptocurrencies. It had started sliding nearly from $119 (4th April 22) to almost $17 (10th May 22).
Around the same time, close to 10 billion UST were unstaked from its Anchor protocol (Terra’s lending and borrowing platform), and reportedly huge chunks were sold, creating pressure on its ecosystem.
This apparently depegged UST.
And due to the algorithmic connectivity and panic among its takers, this depegging took away whatever was left in the already struggling LUNA.
Currently, the Terra blockchain is no longer in action, and both the coins (LUNA & UST) lost almost 100% of their value.
Though there are efforts to revive LUNA underway, Terra’s stablecoin is gone for good.
Conclusively, no matter whether they are called stablecoins, each project is different and can be subjected to horrifying downturns shattering dreams and vaporizing wealth.
Stablecoins are trying to replace fiat and standard crypto. And indeed, some have excellent protocols in place to maintain their value against the day-to-day crypto market onslaughts.
However, in the end, they are pieces of code that can have vulnerabilities. And there have been instances these bugs resulted in huge losses.
So, while they are known to sustain value, read through the fine print, the whitepaper, and interact with the community to get your cues.