What is a stablecoin? If you have ever wanted to know what if the difference between a stablecoin and other cryptocurrencies, then you have come to the right place. Stablecoins have rapidly risen in popularity in recent years due to the promise of stable and predictable value they offer over more volatile cryptocurrencies. As the ‘stablecoin invasion’ gains momentum, we explain what stablecoins are, how they work, the types of stablecoins and their benefits and risks. We also investigate successes, failures and criticism, regulation and their future.
What is a stablecoin?
Stablecoins are cryptocurrencies that are designed to maintain a stable value relative to a specific asset or currency. They are often pegged to a fiat currency, such as the US Dollar, or the price of a commodity, such as gold.
The demand, importance and usefulness of stablecoins has grown swiftly for cryptocurrency users because they provide a way to mitigate more volatile cryptocurrencies such as Bitcoin and Ethereum and they offer some protection for investments from price instabilities.
The purpose of stablecoin tokens, unlike other cryptocurrencies that can be affected by rapid price fluctuations, is to provide a more predictable and stable value, hence their name. Before these types of coins came into existence, cryptocurrency investors and traders had no way to lock in a profit or avoid volatility without converting crypto assets back into fiat (everyday money). Backed by more traditional investments, stablecoins theoretically now bridge the gap between fiat and cryptocurrencies to offer markets greater confidence in their price.
The stability of these coins allows them to be used as a functional currency within a crypto brokerage. For example, crypto traders might convert Bitcoin into a stablecoin such as Tether, rather than into dollars. As stablecoins are always available and accessible, they are lauded as being more convenient than cash obtained through the traditional banking system.
Stablecoins can also be used with smart contracts, which are computer codes that automatically execute all or parts of an agreement when its terms are fulfilled and is stored on a blockchain-based platform.
Through these advantages, these “stable” types of crypto increasingly are the preferred option for financial decisions from both institutional and retail users of cryptocurrencies. However, not all stablecoins are the same.
Types of stablecoins
In the cryptocurrency market, stablecoins are divided into four main categories and use a variety of assets as backing.
Fiat-backed stablecoins
Also known as fiat-collateralised stablecoins, these are the most common type. They are backed at a 1:1 ratio, allowing one stablecoin token to be exchanged with one unit of fiat currency. Fiat-backed stablecoins are collateralised by fiat currencies such as the USD, Euro, GBP or the Chinese Yuan. The most popular fiat-backed examples are Tether, USD Coin, Binance USD, Gemini and True USD.
With this stablecoin type, fiat currency is held in the treasury to back up each stablecoin that exists, aiming to create a fixed-price stablecoin by real fiat in real bank accounts or by cash equivalents. Fiat-backed stablecoins are the most centralised, because a central entity acts as the fiat reserve custodian, managing issuance of fiat-backed tokens and receipt of new fiats.
Benefits
- Simple structure of fiat-backed stablecoins.
- High degree of certainty.
- Low volatility because fiat currency is considered stable.
Risks
- Capital sits frozen and is unable to be used for anything else.
- Even though centralised, this structure still allows opportunity for hacks and bankruptcy.
- Counterparty risk: required proof of solvency.
- Requires regulations and audits similar to those on exchanges.
Crypto-backed stablecoins
Cryptocurrencies are also used to back stablecoins. Cryptocurrency asset-backed stablecoins work in a similar way to fiat-backed, but instead of using fiat, cryptocurrencies act as collateral.
Here’s an explanation of how they typically function:
Collateralisation: To create a crypto-backed stablecoin, an issuer collects a pool of cryptocurrencies or digital assets as collateral. These assets might include well-known cryptocurrencies like Bitcoin or Ethereum.
Smart Contracts: Smart contracts are used to govern the stablecoin’s operation on a blockchain. These contracts automatically execute predefined rules and actions based on the predefined conditions.
Minting: When a user wants to obtain crypto-backed stablecoins, they can deposit a certain amount of the collateralised cryptocurrency into the system. This deposit is locked and held as collateral.
Stablecoin Issuance: Once the collateral is deposited, the smart contract mints an equivalent amount of stablecoins and assigns them to the user. The ratio of collateral value to stablecoin value is determined by the rules of the specific stablecoin.
Stability Mechanisms: To maintain stability, the smart contract employs various mechanisms. For example, if the value of the collateral decreases significantly, the smart contract may trigger actions such as liquidating a portion of the collateral to ensure the stability of the stablecoin’s value.
Redemption: When a user wants to redeem their stablecoins, they can return them to the system. The smart contract releases the equivalent amount of collateral, allowing the user to retrieve their deposited assets.
Collateral
By backing stablecoins with collateral, these crypto-backed stablecoins aim to provide stability and reduce the price volatility commonly associated with non-collateralised cryptocurrencies like Bitcoin or Ethereum. The collateralisation mechanism helps maintain confidence in the stablecoin’s value and enables users to transact with a digital asset that approximates the value of a specific currency, such as the US dollar.
Mechanisms and protocols can vary among different crypto-backed stablecoins. Each stablecoin may have its own unique design and collateralisation requirements.
The most popular cryptocurrency asset-backed stablecoin is Dai (DAI), an industry leader among the approximately 200 stablecoins distributed globally.
Benefits
- Decentralised because based on blockchain.
- No need for a custodian.
- No requirements for regulations or audits.
Risks
- Extremely volatile.
- Much more complex structure.
- Heavy dependency on the collateralized crypto.
Algorithmic stablecoins
Imagine you have a regular coin that you use every day, like a dollar bill. The value of a dollar is pretty stable, meaning it doesn’t change much over time. Algorithmic stablecoins work in a similar way, but instead of being backed by a physical currency like the dollar, they use algorithms (a set of rules) to maintain a stable value. Examples of algorithmic stablecoins include Frax and Ampleforth.
Algorithmic stablecoins have a digital currency, let’s call it “CoinX.” The value of CoinX is designed to stay close to a target value, like one dollar. If the value of CoinX goes above the target value, more coins are created. If the value goes below the target value, some coins are burned or removed from circulation.
Algorithmic stablecoins use smart contracts, which are like computer programs that automatically execute certain actions when specific conditions are met. These smart contracts monitor the supply and demand of CoinX and make adjustments to maintain its stability.
To determine the value of CoinX, algorithmic stablecoins often rely on price oracles. These oracles provide real-time information about the current value of different assets or cryptocurrencies. The algorithm uses this information to make decisions about whether to create or burn coins.
Incentives
Algorithmic stablecoins often have a mechanism to incentivise people to help maintain the stability of the coin. For example, if the value of CoinX is below the target value, people can buy and hold the coin, which can drive up the demand and increase the value. In return, they might receive some rewards or interest for holding the stablecoin.
By adjusting the supply of CoinX based on the demand and using smart contracts, algorithmic stablecoins try to keep their value stable over time. This stability makes them useful for things like digital payments and decentralised finance (DeFi) applications.
Does it work?
That’s the theory anyway. But in the real world, it doesn’t always work like that. Algorithmic stablecoins can be complex, and their stability is not always guaranteed. They can be influenced by market forces and may experience fluctuations in value. So, it’s essential to do your research and understand the risks involved before using or investing in algorithmic stablecoins. There have been some high-profile stablecoins that have collapsed in a ridiculous heap, such as Terra Luna. Algorithmic stablecoin Neutrino on the Waves blockchain lost its peg to the dollar after the price of the underlying token fell.
The theory behind algorithmic stablecoins, also referred to as non-collateralised stablecoins, is that they remove the need for reserves by relying on complex algorithms and smart contracts to manage the supply of the tokens issued and to keep their prices stable. This is model is more complex and rarer than crypto-backed or fiat-backed stablecoins, making it harder to run successfully.
Essentially, algorithmic stablecoins function somewhat similarly to the way central banks do, as their system will defend the peg of their currency in the market. An algorithmic stablecoin will reduce the token supply if the price falls below the fiat currency it tracks, via locked staking, burning, or buy-backs. If the price surpasses the value of the fiat currency, new tokens are issued for circulation to bring down the stablecoin’s value.
Benefits
- Low fees, global accessibility, speed and efficiency.
- Decentralised — no collateral required.
- System works via smart contracts
- Interactive tools through coin shares and bonds.
Risks
- Questionable solution – most complex mechanism.
- Volatility, regulatory uncertainty, lack of liquidity.
- Historically failed pegging mechanisms (i.e., Terra Luna).
Commodity-backed stablecoins
Commodity-backed stablecoins are collateralised by physical, interchangeable assets such as real estate, oil and precious metals. These stablecoins are fundamentally blockchain-based representations of commodities and are backed by reserves held by a central entity or trusted third party.
Gold is the most common precious metal commodity used to back these stablecoins. Although the price of gold may be less affected by movements in other asset classes, commodity-backed stablecoin investors need to understand that any commodities can and will fluctuate in price and can potentially lose value.
The attractiveness of these stablecoins to investors is the ease they bring to investing in assets that might otherwise be unmanageable on a local level. For example, physically obtaining and safely storing gold bars or other precious metals is difficult and costly in many areas of the world. Commodity-backed stablecoins provide a way for investors to redeem tokens for cash or gain custody of the underlying tokenised asset.
Examples
Examples of gold-backed cryptocurrencies include CACHE gold (CACHE), whereby each CACHE is backed by 1g of pure gold held in vaults stored around the world. Sending CACHE tokens is the equivalent of sending 1g of gold per token and they are easily redeemable for physical gold at any time. Tether Gold (XAUt), with vaults in Switzerland and PAX Gold (PAXG), with vaults in London, operate similarly, but they are each pegged to one troy ounce of investment-grade gold and have a higher minimum redemption amount than CACHE.
Benefits
- Each commodity-collateralised stablecoin backed by real assets.
- Relatively stable commodities prices.
- Commodities tokenisation brings more liquidity to the market.
Risks
- Centralisation increases risks of potential hacks due to a single point of failure.
- Audit process required to ensure authenticity.
While stablecoins aim to provide an alternative to the high volatility of popular cryptocurrencies, the stablecoin market has experienced challenges and uncertainty in its short history and continues to be affected by major impacts to the whole cryptocurrency space.
Tether USDT is the leading stablecoin
Tether USDT is the most popular stablecoin with the highest market capitalisation, currently at around $83.5 billion. While it presently dominates the stablecoin market, and has been described by its CTO Paolo Ardoino as the “holy grail of stability right now”. Tether and its sister company Bitfinex were investigated by the New York Attorney General (NYAG) in 2021 for misappropriating $850 million in funds in 2018-2018 and allegations that it was not fully backed by reserves at certain times.
This was a major issue for Tether because unless a stablecoin commits to holding 100 percent (or more) of its reserves in cash, there’s no guarantee that the cash will be there to redeem coins. As part of its settlement, Tether agreed to pay a penalty of USD$18.5 million, halt trading activities in New York and report quarterly assurances. Daily balance snapshots can now be accessed on their website.
Investigations
Tether has also been in the spotlight as part of the recent investigation into Binance by the US Securities and Exchange Commission, which alleges that it lied to regulators and put customers and investors at risk. Binance is also now under investigation by French authorities for alleged illegal canvassing of clients and money-laundering. Tether is one of over 350 cryptocurrencies and stablecoins traded on Binance, but rather than being impacted negatively, Tether’s CTO believes traders from Binance may be driven to Tether directly as a result.
Additionally, Tether has faced recent depegging issues, keeping it firmly in the discussion space across crypto news sites.
As the prominent stablecoin in the cryptocurrency market, Tether plays a crucial role in facilitating transactions and maintaining price stability. Since 2021 it has publicly defended its transparency regarding compliance procedures and operations and has addressed each concern at it has arisen, which is crucial to maintain trust for users and the cryptocurrency community.
Other popular stablecoins
The other most popular fiat-backed stablecoins are USD Coin (USDC): $49 billion and Binance USD (BUSD): $17 billion. The market capitalisation of these stablecoins pales in comparison to the largest cryptocurrencies, such as Bitcoin, with a market cap of nearly $515 billion, and Ethereum, valued at more than $207 billion as of June 2023.
MakerDAO’s DAI is the leading crypto-backed stablecoin, as measured by market capitalisation (USD $4.6 billion at June 2023) and brand awareness. Even though these stablecoins are popular, there are always questions around their regulation and transparency, especially in light of the failures that have occurred in the stablecoin market.
Stablecoin failures and criticism
It is estimated that between 1,700 and 2,500 cryptocurrencies may have failed and disappeared from the market entirely, so the 23 stablecoin failures that have been documented since 2016 reflect the much smaller stablecoins market.
The most notable stablecoin failure is Terra USD (UST), which is estimated to have lost users between $80 billion to $200 billion in just 24 hours from its downfall. This blend of crypto-backed and algorithmic stablecoin used other cryptocurrencies and a sophisticated system of arbitrage to maintain its valuation at the 1:1 level. A decline in crypto markets and subsequent loss of confidence saw it lose its peg to the dollar in May 2022, causing the price of the stablecoin to break and spiral downward, as investors panicked and traders lost confidence in its ability to maintain the peg.
Another example of a failed stablecoin was Basis Cash, which launched on Ethereum in late 2020 and sought to maintain a $1 peg through code, not collateral. Basis planned to issue bond and share tokens to expand and contract the token’s supply to maintain the peg, however the project never achieved its target of dollar parity. It is now considered a $133 million failure because the team decided that it could not avoid being regulated by the SEC once regulators declared that the bond tokens were securities and demanded the tokens to be issued solely to accredited investors.
Criticisms of stablecoins include:
- Their inability to maintain the peg in the long run. History posits that all pegged currencies are doomed to fail due to the cost of maintaining them, especially when the peg comes under attack. Tether is disproving this through its current performance, but the stablecoin failures support this position.
- That they aren’t really a cryptocurrency because they aren’t decentralised. Critics maintain that stablecoins deliver the worst of both worlds – a centralised coin with a centralised bank controlling it and a questionable ability to maintain the public’s trust in it.
Stablecoin regulations
Stablecoins are regulated and compliant to use in many circumstances, depending on the jurisdiction. While we have seen Tether and other fiat-backed stablecoins help to set transparency standards by working with international law enforcement to ban addresses when needed, Tether’s recent experiences with the NYAG in the USA and the collapse of other stablecoins reinforce the need for regulators throughout the world to find a balance between managing risks and supporting innovation in the market. The Financial Stability Board (FSB), which is the international body that monitors financial systems and makes regulatory recommendations, is expected to finalise updated stablecoin recommendations by July 2023.
Stablecoins currently pose limited risks to Australia’s and other international financial systems, but this could change if they become more widely used for payments and other financial services in future. Very few banks are willing to work together with cryptocurrency exchanges and stablecoin issuers to facilitate gateways. Recent experiences of Silvergate Bank and the collapse of Silicon Valley Bank, one of the few banks to work with crypto currencies, are likely to continue banks taking the position that serving stablecoin users is extremely risky.
Future of stablecoins
The Reserve Bank of Australia has come to the conclusion that stablecoins pose a limited risk to the broader financial system. That isn’t always the case elsewhere, however. Given the restrictions and parameters that US regulators continue to impose on stablecoins, there is no doubt that users in Latin America, Asia, and Africa are most likely to continue pioneering the use of stablecoins, while the US stablecoins will find regulatory obstacles.
It is hard to know whether stablecoins will continue to have a place as the cryptocurrency system grows due to the questions surrounding them, or if they are only temporary utilities that allow traders a haven out of volatility without needing to supply a regulated fiat option. It remains to be seen if stablecoins deliver the best of both the traditional money and digital money worlds, or if they will continue to evolve.
