• 28 May, 2024
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Stablecoins: How They Work and Their Vital Role in Crypto

What are Stablecoins?

Stablecoins are a type of cryptocurrency designed to maintain a stable value by being linked to the value of another currency, commodity, or financial instrument. Their primary purpose is to offer a solution to the significant volatility seen in major cryptocurrencies like Bitcoin (BTC), which has hindered their use in everyday transactions.

How Does Stablecoin Work?

Stablecoins strive to anchor their market value to an external benchmark, typically a conventional fiat currency. Stablecoins, often more stable than other volatile cryptocurrencies, are more suitable for transactions. 

They can be pegged to a fiat currency like the U.S. dollar, linked to the value of commodities such as gold, or use algorithms to manage their supply. Alternatively, some stablecoins use algorithms to manage their supply. Furthermore, they preserve their stability either by holding reserve assets as collateral or through algorithmic methods designed to manage supply.

What are examples of Stablecoins?

1.Tether

Launched in 2014, Tether (USDT) is among the earliest stablecoins and remains highly popular, ranking as one of the top cryptocurrencies by market capitalization. USDT’s main function is facilitating rapid funds transfer between exchanges, enabling traders to capitalize on arbitrage opportunities when cryptocurrency prices vary across different platforms. Additionally, it has been utilized for other purposes: notably, Chinese importers in Russia have used USDT to transfer substantial sums, circumventing China’s stringent capital controls.

Tether Ltd., the issuer of USDT, found itself in a contentious legal dispute with the New York Attorney General. The conflict, lasting 22 months, centered around accusations that Bitfinex, a company affiliated with Tether, used Tether’s funds to conceal a deficit of $850 million. The dispute concluded on February 23, 2021, with Tether and Bitfinex ordered to pay a $18.5 million settlement and to provide quarterly reports on Tether’s reserve backing for the following two years.

2. USD Coin

USD Coin (USDC) was introduced in 2018 by Circle and Coinbase through their joint venture, the Centre Consortium. Initially, much like Tether in its early stages, USD Coin’s value was directly tied to the U.S. dollar. It operates on an open-source protocol, allowing any individual or entity to leverage it for creating their own products.

On July 8, 2021, Circle, a notable player in the financial technology sector, revealed plans to go public. They intend to achieve this by merging with Concord Acquisition Corp, a transaction that’s valued at an impressive $4.5 billion. This announcement followed a successful funding round in which Circle raised $440 million from prominent industry players, including FTX, Digital Currency Group, and Fidelity Management and Research Company, completed a month prior.

3.Dai

Dai, a stablecoin operating on the MakerDAO protocol, was launched in 2015 and exists on the Ethereum blockchain. It is pegged to the U.S. dollar and is backed by Ethereum’s native token, ether.

What sets Dai apart from other stablecoins is its decentralized nature, as MakerDAO aims to operate without a central governing body. Rather, the system operates under Ethereum smart contracts that are programmed with unchangeable rules.

Despite the innovative approach, this model is not without its challenges. For example, in 2020, MakerDAO faced a significant setback when its smart contracts malfunctioned, leading to an $8 million loss due to an exploitation.

Types of Stablecoins

Fiat-Collateralized Stablecoins

Stablecoins that are fiat-collateralized hold a reserve in a fiat currency, such as the U.S. dollar, to back and stabilize their value. While some stablecoins may use other types of collateral like precious metals (gold or silver) or commodities (such as crude oil), the majority rely on U.S. dollar reserves.

Independent custodians manage these reserves, and they undergo regular audits to ensure transparency and reliability. Examples of such stablecoins include Tether (USDT) and TrueUSD (TUSD), both of which are supported by U.S. dollar reserves and maintain a value equivalent to the dollar.

Algorithmic Stablecoins

Algorithmic stablecoins are unique in that they may not rely on holding reserve assets. Instead, their stability is maintained by an algorithm which regulates the coin’s supply according to a set formula, functioning similarly to a computer program.

This approach somewhat mirrors the methods of central banks, which also do not depend on reserve assets to stabilize the currency they issue. However, central banks like the U.S. Federal Reserve operate with transparency, setting monetary policy based on well-established criteria and backed by their authority as legal tender issuers, lending significant credibility to their policies.

In contrast, issuers of algorithmic stablecoins lack these advantages, particularly during crises. A stark example occurred on May 11, 2022, when the value of TerraUSD (UST), an algorithmic stablecoin, plummeted by over 60%, losing its parity with the U.S. dollar. This crash coincided with a more than 80% decline in the value of Luna, the token linked to TerraUSD, leading to a significant destabilization.

Crypto-Collateralized Stablecoins

Stablecoins that are crypto-collateralized use other cryptocurrencies as their backing asset. Due to the inherent volatility of these reserve cryptocurrencies, such stablecoins typically maintain a higher level of collateralization. This means the cryptocurrency reserves held are worth more than the issued stablecoins to safeguard against significant price fluctuations in the reserve currency.

For instance, to issue a crypto-collateralized stablecoin worth $1 million, reserves worth $2 million in cryptocurrency might be held, providing a buffer against a potential 50% drop in the reserve cryptocurrency’s value. A prime example is MakerDAO’s Dai (DAI) stablecoin, which, while pegged to the U.S. dollar, is backed by Ethereum (ETH) and other cryptocurrencies valued at 150% of the circulating DAI.

How Are Stablecoins Used?

Stablecoins provide a way for investors to transition between different cryptocurrencies while remaining within the digital currency ecosystem.

According to Richard Gardner, CEO of Modulus Global in the US, Stablecoins serve as a conduit between traditional fiat currency and cryptocurrencies, mitigating volatility. He also notes that stablecoins enable individuals in high-inflation economies to preserve their savings’ value by anchoring it to a more stable currency like the US dollar.

These coins combine the advantages of cryptocurrency, such as immediate transactions and minimal fees, with the absence of significant value fluctuations. As a result, investors can maintain their holdings in stablecoins without the concern of drastic portfolio value changes.

A key application of stablecoins is in international banking transfers. Traditionally, such transfers would necessitate foreign exchange conversions involving several banks and intermediaries, incurring multiple fees and taking several business days. In contrast, transferring stablecoins is a rapid process, often involving low or no fees.

Why are Stablecoins important?

Bitcoin, a highly recognized cryptocurrency, exhibits significant price volatility. For example, from March 2020 to April 2021, its value soared from about $5,000 to over $63,000. However, in the following two months, it experienced a drastic decline, almost halving in value. Moreover, substantial fluctuations exceeding 10% in just a few hours are not unusual for Bitcoin.

Such volatility can be advantageous for traders, but it makes regular transactions, like buying goods, a gamble for both buyers and sellers. Long-term cryptocurrency investors also face risks, as they don’t want to be remembered for making disproportionately expensive purchases, like the infamous case of 10,000 Bitcoins spent on two pizzas. Similarly, merchants are wary of accepting cryptocurrencies that might significantly drop in value soon after a transaction.

For a currency, especially one not recognized as legal tender, to function effectively as a medium of exchange, it needs to maintain relative stability to assure its users of its short-term purchasing power. In contrast to cryptocurrencies, traditional fiat currencies rarely see daily fluctuations exceeding 1% in the foreign exchange market.

Stablecoins are designed to solve this problem. Their primary goal, as their name suggests, is to maintain a consistent value through various mechanisms.

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