What are Stablecoins and How do They Work?
Stablecoins are cryptocurrencies that maintain a stable price. This is done in either of two ways. Firstly by backing the stablecoin with assets or adjusting the supply of the coins in circulation. The coin is kept stable to avoid wild price swings that you get with regular cryptocurrencies.
The Idea Behind Stablecoins
Someone came up with the idea for stablecoins because cryptocurrencies are volatile. In fact even within an hour the price of a cryptocurrency can fluctuate wildly. Due to this you never really know where you stand. So people cannot use regular cryptocurrencies for day to day payments.
As a result stablecoins were created to take advantage of the best of both worlds. They benefit from being a crypto while at the same time they have a stable price. Like this you always know where you stand.
How Stablecoins Work
There are two ways in which stablecoins maintain a peg for their price to remain stable:
1. Asset Backed Peg
Stablecoins that have an asset backed peg are backed by one or more assets. The assets that are picked to back the stablecoin are usually:
- fiat currency like for example the US Dollar,
- precious metals,
- other investments or
- a mix of all or any of these assets.
One of the reasons why cryptocurrencies are volatile is because they have small market capitalisations. For this reason the assets that are chosen to back the stablecoins have larger markets. As a result they are less prone to volatility and their prices remain stable.
Stablecoins that are backed only by cryptocurrencies are still pegged by other assets like the US dollar. Since cryptocurrencies are volatile, stablecoins that are backed by them hold more than 100% of the dollar value. They usually hold a minimum of 150% just in case there is a sudden large price drop in crypto.
2. Algorithmic Peg
These stablecoins are pegged to an asset like the asset backed peg. However the assets are not held by the company that issues the coins. Instead the asset is only used as a measure on which to set the peg. More often than not the US dollar is used as a basis for the peg.
The peg is maintained by using a smart contract on the Ethereum platform. The smart contract is coded in a way to increase (inflate) or decrease (deflate) the money supply of the stablecoin. It does this to make sure the stablecoin maintains the peg. It does this when there is an increase or decrease in demand for the coin.
If there is more demand for the coin, supply and demand principles would result in the price going up. However the smart contract will increase the supply of the coin to lower the price. The opposite applies for a decrease in demand.
Market Cap of Stablecoins 2017-2021
Stablecoins started gaining popularity slowly over the years. Additionally as the years went by, more and more stablecoins were launched on the market. They started out worth millions and have ballooned to a market cap worth billions.
Sourced from Brookings
Examples of Stablecoins
Tether is one of the first and most popular stablecoins. It used to be backed one-for-one with US dollars. However over time the assets backing it have changed.
In fact in March 2021 Tether disclosed they have 75.85% in cash and cash equivalents. They have 12.55% in secured loans and 9.96% in corporate bonds and precious metals. Only 1.6% is in other investments.
Learn more about Tether.
Gemini Dollar (GUSD)
The Gemini Dollar is pegged and backed 1-to-1 to the US dollar. It has been developed by the Winklevoss twins who own the Gemini exchange. Gemini is one of the largest US crypto exchanges.
Learn more about the Gemini Dollar.
Dai is backed by Ether which is the native token on the Ethereum platform. It is pegged to the US dollar.
Read the Dai whitepaper
Terra is a US Dollar algorithmically pegged stablecoin.
There are 50+ stablecoins on the market. The top 5 are Tether, USD Coin, Binance USD, TerraUSD and Dai.
You can check real time and updated data on CoinMarketCap.
What Are Stablecoins Used For
Initially when stablecoins started out, the idea was to use them for everyday transactions. They ended up getting adopted by traders. In fact stablecoins have the most popular trading pairs against cryptocurrencies. They are more popular than fiat currencies to trade crypto.
You can check out the live real time total stablecoin supply on TheBlockCrypto.
Sourced from Chainalysis
The reason stablecoins are used for trading is because they benefit from being cryptocurrencies themselves. They are quicker to transfer in between exchanges. Additionally they also have cheaper fees than those associated with traditional fiat currencies.
Stablecoins are also getting popular on DeFi platforms. You can stake (lock) stablecoins on DeFi platforms and is a way on how to earn interest on stablecoins. Additionally if you need a loan you can borrow from DeFi platforms.
You can only stake stablecoins or any cryptocurrency that works with proof-of-stake consensus.
Staking means users on the network need to lock their crypto in the network. So you cannot touch your funds for a certain period of time. The more someone stakes the more likely chance that person has to validate transactions on the network.
Additionally different cryptocurrencies give different percentage rewards and some have exceptionally good rates. You could get anywhere from 1-23% APR depending on the crypto or stablecoin.
Usually you need to join a staking pool because staking alone will not generate as good a reward. Moreover you might not receive a reward at all. So staking pools are the best solution. The only drawback is that the staking pool charges fees, but they are usually minimal.
Some of the better exchange will have their own staking pools. You can have a look at the best exchanges, see if they have a staking platform and the rates they offer.
Disadvantages of Stablecoins
The beauty of cryptocurrency is that it is mostly decentralised. There is no one person or group that controls it. Additionally it eliminates the use of third parties and transactions are peer to peer.
On the other hand stablecoins are managed by companies that maintain the peg. This means they are not so decentralised. For this reason some people do not think they are true cryptocurrencies. However, there are other cryptos that are more centralised. Ethereum is one of them and quite a lot of DeFi is more centralised also.
Are Stablecoins Safe: General Risks
The risks of algorithmic pegs is that it is very hard to maintain the peg by code. At times there are large fluctuations in demand and it could break the peg for some time. In this case the smart contract code would need to play catch up. This is to say until the code manages to alter the supply of the coin to match demand.
For asset backed pegs the main risk is due to third parties. Stablecoin funds say what assets they have on their balance sheet. Most do not give very much detail and are not audited.
This is because cryptocurrency is still fairly new and unregulated. Additionally politicians are still trying to figure out how to go about regulating the crypto space.
For this reason there will be trouble if suddenly there is some doubt on the assets backing a stablecoin. People will instantly sell their coins. As a result this will force the price of the coin to go down.
A lot of people would lose money if this were to happen. It would be the equivalent of a run on the bank. Additionally once trust is lost in a stablecoin or any coin there is no going back.
Are Stablecoins Safe: Risks From Regulators
Gary Gensler is the Chair of the Securities Exchange Commission is adamant on setting some boundaries. He wants to regulate stablecoins in a meaningful way.
That is to say he wants to make sure they are safe for investors and the stability of the system. Additionally he wants to make sure crypto in general is compliant with policies on taxes and anti-money laundering.
In fact he stated with David Ignatius from The Washington Post that:
So far the SEC has taken it’s time and has not imposed regulation. This is because they need to properly consider the full impact of the regulation they impose before they implement it.
Most importantly because the crypto industry has ballooned they need to take care. They do not want to implement regulation that could potentially damage the industry and hurt investors. So although regulators are taking their time, regulations are definitely on the horizon.
Are Stablecoins Safe: Tether
On the other hand there is Tether. Every so often it has featured in the news in a negative light. Here is one example:
In this article the journalist states that:
‘Tether almost certainly faces a near-term showdown with government authorities or criminal investigators.’
Tether is pegged 1-to-1 with the US dollar and it has $69 billion in circulation. This is a big deal because it is a lot of money. In fact a lot of stablecoin trading pairs are Tether pairs.
Unfortunately a lot of people including government officials do not think Tether has that money in its reserves. To clarify its because its reserves have never been audited. All Tether did is disclose their reserve amounts to investors and they expected to accept their claims at face value.
If Tether collapsed suddenly or regulation sprang up on them market liquidity would probably shrink. A lot of people could end up losing a lot of money.
Tether has already received millions worth of fines by the CFTC for lying about its reserves.
Best Stablecoins – Regulated Coins
There are many different stablecoins and some are definitely on the SEC’s radar. However some others have worked with authorities to get regulated.
These two stablecoins are regulated by the New York State Department of Financial Services. However according to Brookings the stablecoins that are regulated are not regulated in any meaningful way. Authorities only impose bare minimium requirements.
On the other hand the fact that the companies even registered these stablecoins is a good sign. Others haven’t.
These companies want to make sure they are in line with regulators. Additionally they were the first asking for regulation and oversight when they did not have to be. So it is highly likely they have their house in order. If authorities impose stricter regulation they will happily oblige and come in line with requirements.
How To Buy Stablecoins
You can find and buy stablecoins on most cryptocurrency exchanges or trading platforms. However not all exchanges support each and every stablecoin.
For most it does not matter which stablecoin they purchase. This is because you only want to hold your stablecoin short to medium term. So the best thing is to firstly pick a good exchange to use.
After that you should make sure the stablecoin you pick is one of the better stablecoins. One that is not too risky to keep short term. However you should note that a stablecoin listed as a top stablecoin, does not mean it is a good stablecoin. You can have a look at some risks which are listed in a couple of sections further down.
Buying a stablecoin from an exchange is very much like buying any other cryptocurrency. If you need a guide you can follow: how to buy cryptocurrency. It will go through the step by step process on how to buy cryptocurrency including any stablecoin.