It’s no secret that volatility and cryptocurrency come hand in hand. But there’s one type of crypto specifically designed to offer a steady price: stablecoins.
A stablecoin is a cryptocurrency whose value is pegged to the price of another asset, hence the term “stable.” For example, if functioning correctly a stablecoin pegged to the U.S. dollar should always be valued at $1.
Recent events have taught us that not all stablecoins are created equal. In May, the meltdown of TerraUSD showed that not every stablecoin can guarantee price stability.
Here’s a general guide to understanding the different stablecoins available on the market today.
What Are Stablecoins?
Stablecoins are a type of cryptocurrency designed to maintain a stable price over time, pegged to the value of an underlying asset, like the U.S. dollar. They aim to offer all the benefits of crypto while attempting to avoid rampant volatility.
Crypto’s total market capitalisation can rise and fall by billions of dollars a day. Even the top cryptocurrency—Bitcoin (BTC)—is subject to significant fluctuations in value. Over the past month, investors have seen around a 4% daily change in the value of BTC.
Fiat currencies, such as the U.S. dollar or the British pound, don’t see this level of price volatility. So another way to think about stablecoins is as a tokenised version of a fiat currency. In theory, a U.S. dollar-based stablecoin is a token that will reside on a blockchain and always trade for one dollar.
Types of Stablecoins
Stablecoins are typically pegged to a currency or a commodity like gold, and they use different mechanisms to maintain their price peg. The two most common methods are to maintain a pool of reserve assets as collateral or use an algorithmic formula to control the supply of a coin.
Collateralised stablecoins maintain a pool of collateral to support the coin’s value. Whenever the holder of a stablecoin wishes to cash out their tokens, an equal amount of the collateralising assets is taken from the reserves.
USD Coin (USDC) is a prime example of a collateralised stablecoin. The graph below shows USDC’s collateral reserves as of August 2022—at $54 billion, the coin’s reserves are slightly greater than its liabilities of $53.8 billion.
USDC’s reserves are held in safe assets that should retain their value, such as cash and U.S Treasurys.
USDC is a stablecoin outlier in disclosing precise data regarding its assets and liabilities. There has long been controversy about the reliability of the collateralising reserves regarding certain stablecoins (i.e., that the stablecoin’s liabilities are higher than its reserves).
The most prominent and oldest stablecoin is Tether (USDT). At a market cap of $66.9 billion, USDT is currently the third biggest cryptocurrency, behind Bitcoin and Ethereum (ETH). However, it has been besieged by doubt around the reliability of its reserves for years.
Stablecoins, and cryptocurrencies, are now under increased scrutiny by federal regulators.
In October 2021, the Commodity Futures Trading Commission (CFTC) issued a statement ordering Tether to pay a civil penalty of $41 million for making “untrue and misleading statements” and for the fact it “misrepresented to customers and the market that Tether maintained sufficient U.S. dollar reserves to back every USDT in circulation with the ‘equivalent amount of corresponding fiat currency.’”
Tether still maintains that it has sufficient reserves to back the $66.9 billion of Tether tokens in circulation. Additionally, the company has yet to default on any redemption request.
“Our journey towards increased transparency is not finished yet,” Paolo Ardoino, Tether’s chief of technology, stated in April, pledging he would continue to assure the market that Tether is dependable.
Stablecoins can also be collateralised by other cryptocurrencies. The biggest example in this category is the DAI (DAI) algorithmic stablecoin, which is pegged to the U.S. dollar but is backed by Ethereum and other cryptocurrencies.
But due to the underlying collateral being in cryptocurrency, it is prone to more volatility.
Experts say the DAI stablecoin is overcollateralised, which means that the value of cryptocurrency assets held in reserves might be greater than the number of DAI stablecoins issued.
Algorithmic stablecoins maintain their price peg via algorithms that control the supply of the token.
TerraUSD (UST) was the biggest algorithmic stablecoin, reaching a market cap of more than $18.7 billion at its peak on May 5 before it began to plummet sharply after it slipped below its peg.
TerraUSD’s price was pegged at $1 via the minting (creation) and burning (destruction) of a sister coin, Luna. There was no collateralisation, with the entire model running via this algorithmic minting and burning of Luna tokens each time a UST stablecoin was bought or sold.
This proved to be a problematic model. TerraUSD suffered what has since become known as a “death spiral,” as a wave of panic ultimately caused the crypto equivalent of a run-on–the bank in May, with a flood of selling “de-pegging” TerraUSD from its $1 price and ultimately sending the “stable” coin to close to zero, alongside its sister coin, Luna.
At this point, the fear in the markets caused Tether to slip under its 1:1 dollar peg to 94 cents on May 12.
Although not to the same extent as TerraUSD, investors worried about the reliability of reserves, and whether Tether was fully collateralised.
TerraUSD now trades under TerraClassicUSD (USTC) since the Terra blockchain was officially halted and de-pegged from the U.S. dollar on May 9. USTC trades at barely 3 cents.
How Are Stablecoins Used
Stablecoins allow investors to move in and out of different cryptocurrencies while staying within the cryptocurrency realm.
“Stablecoins are used to bridge the gap between fiat currency and cryptocurrencies without the volatility,” says Richard Gardner, CEO of Modulus Global. “Stablecoins also allow people from high inflation economies to store the value of their savings in an asset pegged to a more stable currency, like the U.S. dollar.”
These coins offer the benefits of cryptocurrency, namely instant transfers and low fees, without the drawback of volatility. That means investors can hold them without worrying about wild swings in the value of their portfolios.
International bank transfers are a prime example of one use case. Conventionally, this would require foreign exchange (FX) conversions with multiple banks and intermediaries. This route would then involve a series of steps and various fees and often take a few business days to complete, as opposed to a stablecoin transfer which would be instant and come with low, or zero, fees.
How Stablecoins Make Money
The first method stablecoin issuers use to make money is through the straightforward charging of redemption and issuance fees.
Thereafter, it often varies depending on the type of stablecoin. For centralised issuers, this desire to make money leads to the controversy surrounding the transparency of reserves, as discussed above. For many, this is the drawback of the centralised model—the fact investors holding such stablecoins are taking on counterparty risk.
Counterparty risk is the probability that the other party in the asset may not fulfill part of the deal and default on the contractual obligation.
“(Centralised) stablecoins make money through investing their dollar reserves in higher yielding asset classes, for example, commercial paper or Treasury bills,” says Ganesh Viswanath Natraj, assistant professor of finance at Warwick Business School in the U.K. “In contrast, their liabilities incur zero interest.”
On the other hand, decentralised stablecoins have revenue modes that vary from protocol to protocol.
Typical examples include selling governance tokens that allow buyers to gain voting control over the stablecoin’s future or locking up funds into smart contracts on the blockchain to earn interest.
But with these investments from stablecoin issuers comes risk. The stablecoin issuer faces a trade-off.
“While investing their dollar reserves can increase profits, it also increases the risk of a (bank) run, and not having sufficient liquid reserves to meet redemptions in response to an investor panic,” Natraj says.