While cryptocurrency can serve a useful monetary function as a means of exchanging money, they are too volatile to be used for a unit account or as a store value. The unreliable nature of popular cryptocurrencies like bitcoin is the reason why cryptocurrency still hasn’t made its way to mainstream commerce. Investors in crypto can make millions overnight, but then lose their entire investment within weeks.
Stablecoins allow investors to reap the rewards of cryptocurrency but without high volatility.
Stablecoins can be pegged to assets such as gold or the U.S. dollars at 1:1. This allows them to have an intrinsic value much higher than other cryptocurrencies. Stablecoin market demand is increasing rapidly, and the total market capital of stablecoins rose from US$0.02 trillion in January 2017, to US$181.73 trillion as of April 2022.
Learn everything about stablecoins. What are the pros and cons of investing with different stablecoin types?
What is a stablecoin?
Stablecoins are designed to offer the benefits of both worlds—the security and privacy of instant payments of cryptocurrencies and the stability of fiat currencies.
An underlying asset is any cryptocurrency that has the same value as its stablecoin. This could be a fiat currency or precious metals such as gold. Some stablecoins have a 1:1 ratio to certain fiat currencies like the U.S. dollars, which are traded on an exchange.
The underlying collateral of crypto-collateralized stablecoins is another cryptocurrency. Such stablecoins are over-collateralized—i.e., a larger number of cryptocurrencies are kept as a reserve for issuing a lower number of stablecoins due to the high volatility of the reserve cryptocurrency.
What is the best way for stablecoins to keep their peg?
Stablecoins can achieve price stability through collateralization, or algorithmic markets modules.
Collateralization
To issue sufficient crypto coins, collateralized stablecoins must have a reserve of fiat currencies, such as the U.S. dollars. You can also use cryptocurrency or gold as collateral, and commodities such as oil.
These reserves are regularly audited and maintained by companies and independent custodians. Fiat-backed stablecoins can be backed by a 1:1 ratio. Real fiat currency should be held in a banking account to support each stablecoin. If a person needs to redeem cash with stablecoins, the entity that manages the stablecoin will take out the amount of fiat from their reserve and send it to the person’s bank account. The equivalent stablecoins are then “burned” or permanently removed from circulation.
A USDC stablecoin, for example, is fully supported by U.S. Dollars and dollars-denominated assets in a 1:1 ratio. It would keep its peg by keeping one dollar when it’s minted. You can initiate an order to purchase one USD Coin by using fiat money. Once the transaction is completed, that fiat currency will be denominated and stored in one U.S. dollars. If you sell a USD Coin in exchange for fiat currency, then the USDC is “burned” when the fiat money is transferred back to your bank account.
However, most stablecoins pegged to a fiat currency aren’t backed entirely by money. Stablecoins may be partially backed by corporate bonds, secured loans and precious metals. Their total value should equal the number of stablecoins minted thus far. For example, the bulk of Tether’s reserves is in cash, commercial paper, treasury bills, reverse repo notes, and fiduciary deposits.
Others stablecoins like Terra ( UST ) and Dai are backed with crypto locked in Maker vaults. They also employ stability algorithms.
Algorithmic market modules
An alternative model is using an algorithm and associated reserve token to peg a stablecoin to USD — instead of using cash reserves. Algorithmic stablecoins do not have any collateral by design – the collateral is its governance token that can be minted or burned to stabilize the price.
Terra protocols, for instance, allow users to exchange LUNA tokens and USTs at a fixed price of $1. If UST prices rise above $1 and demand rises, LUNA holders will be able to swap 1 LUNA for UST.
During swapping, a portion of LUNA tokens is burnt and the rest are deposited in a community treasury. A percentage of LUNA tokens is burned to reduce their overall circulation. This makes them less common and therefore more valuable. You can bring the price back to the $1 mark by minting more UST coins.
If there is little demand for UST, and the price drops below $1, UST owners can swap their tokens for LUNA at a 1:1 ratio.
Ampleforth’s (AMPL), another coin, uses a rebasing system. The software programmatically adjusts its AMPL currency supply every 24 hours. Supply will grow if AMPL tokens are in high demand and the price of each AMPL token is higher than $1. Supply will fall if demand is lower.
BASED tokens and RMPL are also intended to enhance this mechanism.
Stablecoin Pegs at Risk
While stablecoins may appear to be low risk, they present some risks. The primary risk of stablecoins is if they aren’t fully backed by the reserve currencies. These are the risks:
Reserve Risk
Stablecoin reserves are critical to the sustainability of the ecosystem.
Risk from Counterparty
The currency must have a bank that holds the reserves, and a stablecoin-emitting organization. They need to do the right thing (security, proper reserving etc.) in order for it to remain worth its weight.).
Security
Stablecoins, like other cryptos, must be stored in a digital wallet. A trading platform could be vulnerable to hackers.
Protocol Malfunctioning
Stablecoins that depend on algorithmic markets modules are at risk of protocol malfunctioning. A stablecoin’s peg can be lost if it has vulnerabilities or flaws in its code for burning and minting.
A large portion of stablecoins are held in liquidity pools. Some Decentralized Finance protocols, such as Compound, have tokens tracking underlying assets (cTokens), like cDai and cUSDC. An attacker could quickly sell these tokens on the open markets if the DEX pool or smart contracts that govern cTokens is compromised. As a result, the stablecoin’s supply will outweigh its reserves; the price swings will exacerbate selling pressure and break the peg.
Summary
Stablecoins can offer both the best and worst of both worlds but there are risks involved in investing in them. Neben the above-mentioned risks, stablecoins such as Neutrino USDN (USDN) are also losing their pegs. Recently, the US$1.00 target was dropped to US$0.76.
There’s also the case of Iron Finance, where a significant delay between the price feed oracle and real-time data rendered arbitraging unprofitable. The result was that the base token, TITAN had almost lost all its value. Additionally, IRON stable coins dropped to US$0.94.
Each stablecoin comes with its unique advantages and drawbacks and uses diverse collateral methods to achieve price stability, so make sure to check the issuer’s reserve reports and the implemented audits before investing in them.
