What are Stablecoins?
Stablecoins are cryptocurrencies that aim to maintain a stable value, typically by pegging their market value to a stable asset such as the US dollar. This helps address the volatility often associated with cryptocurrencies, making them more attractive for everyday transactions.
The stablecoins have become increasingly crucial as they provide much-needed stability and trust in the market. The stablecoins serve as a safe haven during market downturns as you can easily trade out of something unstable for something stable and offer increased opportunities for global cryptocurrency adoption.
There are currently several stablecoins on the market, including Tether (USDT), USD Coin (USDC), Binance USD (BUSD), and Dai (DAI). These coins aim to provide users with a reliable store of value and means of exchange.
First, why do we need Stablecoins?
Cryptocurrencies, including the king itself, Bitcoin (BTC), are known for their high levels of volatility. In just one day, the price of Bitcoin can swing dramatically. This level of volatility can be detrimental for both investors and businesses, but also for the crypto ecosystem itself, as it can prevent individuals from wanting to enter the space.
Stablecoins solves this. Fiat currencies, like the US dollar, don’t have the same level of volatility, so a stablecoin pegged to the US dollar will increase stability in the market by providing a reliable option for storing and exchanging value. This is particularly important in times of uncertainty, when other cryptocurrencies may experience sharp drops in value.
So, with this, you have a fiat-backed stablecoin, not affected by price volatility, that still can benefit from the unique blockchain technology of instant transfers and low fees.
Types of Stablecoins
There are several types of stablecoins, primarily differentiated by the asset that backs them and by the different ways and methods used to maintain the price peg. Let’s take a look at the the different types.
Fiat-backed Stablecoin
So we’ve already addressed the first type with how stablecoins can be pegged with a fiat currency, known as fiat-backed stablecoins. USD Coin (USDC) is an example, as it’s pegged with the US dollar. One USDC equals one US dollar, and for every new USDC in circulation - a US dollar is kept in reserve.
The fiat-backed stablecoin is the most popular and can be purchased on all of the largest crypto exchanges, including Binance and Coinbase. To put it in perspective, Tether (USDT), another stablecoin pegged to the US dollar, is the third largest cryptocurrency in the world in terms of market cap.
Crypto-backed Stablecoin
A crypto-backed stablecoin is a type of stablecoin that is backed by a reserve of cryptocurrencies, such as Bitcoin or Ethereum. This means that for every unit of the stablecoin in circulation, an equivalent amount of cryptocurrency is held in reserve.
To ensure the stability of the stablecoin, the collateral must be over-collateralized, meaning there must be more collateral held in reserve than the value of the stablecoin. This creates a cushion in case the value of the collateral drops.
The stability of a crypto-backed stablecoin is also dependent on proper risk management, such as regularly auditing reserves and implementing measures to prevent and mitigate hacks.
The crypto-backed stablecoin makes an attractive option for those within the crypto community who prioritize decentralization and might distrust traditional financial systems.
Commodity-backed Stablecoin
Like we have stablecoins pegged with fiat currencies, we also have stablecoins with the promise of stability by tying themselves to physical assets, known as commodity-backed stablecoins. Examples of assets are gold, silver, platinum, oil, metal, or even real estate. Investing in a commodity-backed stablecoin can offer several benefits compared to fiat-backed stablecoins. Let’s look at some examples.
- The underlying asset's value is typically more stable than that of fiat currencies, which can be subject to inflation and fluctuating market conditions.
- A commodity-backed stablecoin offers greater decentralization and autonomy from government control or manipulation.
- Holding a commodity-backed stablecoin gives investors access to the potential gains in the commodity markets while also providing stability and ease of use of a digital currency.
Algorithmic Stablecoin
The algorithmic stablecoin stands out from the rest as it uses algorithms and smart contracts to maintain its peg to an asset or a currency. This stablecoin usually relies on two tokens - one stablecoin and one cryptocurrency that backs the stablecoin, with the smart contracts regulating the relationship between the two.
This differs from other types of stablecoins, such as those backed by collateral or fiat reserves, as it does not rely on the actions of external parties. Instead, supply and demand dynamics within the network automatically adjust the price to maintain the desired peg.
While algorithmic stablecoins offer advantages in decentralization and automation, their stability may also be more vulnerable to external factors such as market fluctuations and technical errors. Let’s look at one of the biggest disasters in the history of DeFi. The fall of Terra.
The fall of Terra
Terra’s journey is insane, so let’s break down how it went from a $60 billion crypto ecosystem to arguably the most significant failure we’ve ever seen in the crypto market.
Terra started as a decentralized stablecoin platform built on the Ethereum blockchain. Its native currency, TerraUSD (UST), was pegged 1:1 with USD and was backed by collateral in Luna, Terra's protocol token. Using algorithms, they automatically adjusted the supply of Luna and UST in response to market fluctuations, allowing them to maintain price stability.
However, something went critically wrong on May 7th, 2022. Terra ran into trouble when its protocol failed to manage price fluctuations and maintain the peg properly. This ultimately led to Terra becoming depegged and losing value drastically, and the crisis was a fact. The stablecoin that was designed to maintain a $1 peg lost its purpose, and within two days, the value had dropped to 35 cents.
The ripple effects were felt throughout the crypto ecosystem. Hundreds of thousands of people collectively lost billions of dollars through the stablecoin promoted as a safe savings account rather than a risk-on investment. The life savings of many Terra and Luna investors vanished in a matter of days.
The Terra disaster has undoubtedly raised many questions about the regulation and oversight of the crypto market, and many industry experts are calling for stricter regulations to prevent similar incidents from occurring in the future. This triggers a heavy debate, as the lack of regulation allows innovation and decentralization.
Conclusion
Stablecoins present a promising solution for facilitating global transactions by mitigating one of the biggest concerns with cryptocurrencies, volatility in the market. This allows for real-world use cases like making payments or sending cross-border transfers without experiencing drastic fluctuations in price. Being backed by a fiat currency or asset like gold creates transparency and trust and is a step in the right direction of mass adoption of blockchain technology.
Only time will tell how it plays out. However, stablecoins inevitably have the potential to improve and shape our financial system by providing a reliable and accessible form of digital currency.
