Cryptocurrencies are enjoying a resurgence and for a good reason. They offer a new way to conduct faster, more secure, and more efficient transactions than traditional methods. However, one issue with cryptocurrencies is their volatility – their value can change daily. This can make them difficult to use as a form of currency. To solve this issue, a new type of cryptocurrency is called “stablecoins.” Stablecoins are designed to maintain a stable value, which makes them ideal for use as a form of currency. This guide will explain what stablecoins are and how they work. We will also discuss the pros and cons of using stablecoins compared to other forms of cryptocurrency and why they are not fully risk-free.
What Are Crypto Stablecoins?
A stablecoin is a cryptocurrency based on a more stable asset as its value foundation. Stablecoins are often associated with fiat currencies like the U.S. dollar, but they may also be connected to precious metals or other cryptocurrencies. Stablecoins are less volatile cryptocurrencies with more significant potential to replicate the types of currencies people already use daily.
“It aims to provide price stability among fiat currencies, cryptocurrencies, and other digital money systems since crypto markets may be volatile,” explains Doug Boneparth, a financial adviser and president of Bone Fide Wealth in New York.
Some asset or a combination of investments in reserve backs all stablecoins; it might be gold, cash, or even short-term corporate debt known as commercial paper. The idea is that the money in the reserve serves as collateral for the stablecoin – whenever a stablecoin holder sells their tokens, an equivalent amount of assets is removed from the account.
Several distinct varieties of stablecoins, and they aren’t all made equal. Tether (USDT) is the first and most familiar stablecoin established in 2014. According to tether’s website, roughly 85% of its assets are cash, cash equivalents, short-term deposits, and corporate paper. “Tether has on hand $1 for every stablecoin because it owns USDT,” Yang explains.
Circle’s USD Coin is one of the most well-known stablecoins. Circle launched USD Coin in 2018, linked to the U.S. dollar and short-term U.S. Treasuries. According to Circle, USD Coin is pegged to the U.S. dollar and short-duration U.S. Treasuries with a circulating supply of $49 billion. Other popular stablecoins include Dai, Binance USD, and TerraUSD, but they all have smaller market caps and different reserve breakdowns than USD Coin.
Here Are Some of The Famous Stablecoins:
To give you a sense of the innovation going on in the stablecoin world, let’s go through some of the most well-known stablecoins.
It’s one of the most valuable cryptocurrencies by market capitalization. USDT is often used to quickly move money between exchanges when the price of different cryptocurrencies differs on two platforms. Traders can earn money on this difference. However, it has also been utilized for various purposes: millions of dollars worth of value have been sent over the border via trade settlements using USDT.
Tether Ltd., the firm that creates USDT, was accused of attempting to deceive creditors by hiding an $850 million deficit using funds taken from the tether in a 22-month legal battle with the New York Attorney General. On February 23, 2021, the lawsuit was resolved. Tether and Bitfinex agreed to pay $18.5 million and submit quarterly reports that show the stablecoin reserves for the next two years. This was because of their actions.
USD Coin ($USDC)
USD Coin, a stablecoin launched in 2018, is jointly administered by cryptocurrency businesses Circle and Coinbase through the Centre Consortium. USD Coin is linked to the U.S. dollars with a circulating supply of almost $26 billion, like a tether before it transitioned to a combination of collateral assets. By 2023, Circle predicts that the collection will reach $190 billion in a recent investor presentation.
On July 8, 2021, Circle announced it would go public via a $4.5 billion SPAC merger with Concord Acquisition Corp. The news was revealed one month after closing a $440 million funding round that included prominent industry figures such as FTX, Digital Currency Group (the parent company of CoinDesk), and Fidelity Management and Research Company.
Facebook is developing a stablecoin called Diem (formerly known as libra), which was first conceived by the powerful, worldwide social media platform. While libra hasn’t launched yet, it has had a more significant psychological impact than any other stablecoin. Governments worldwide are now researching their crypto-inspired digital currencies because they’re concerned Diem might compete with Facebook since the company is a multinational corporation with millions of users worldwide.
The Diem Association, a group established by Facebook, initially announced that the currency would be backed by a “basket” of money, including the U.S. dollar and the euro. However, due to worldwide regulatory issues, the association has retreated from its audacious, original goal. Instead, it aims to focus on creating numerous solid coins backed by a different national currency. The diem dollar, intended to debut in January 2021, was supposed to be the organization’s initial stablecoin.
Dai is a stablecoin created by the MakerDAO system that runs on Ethereum. Dai is linked to the U.S. dollar and backed by ether, Ethereum’s money. Unlike other stablecoins, MakerDAO wants dai to be decentralized, implying no central authority has custody of the system. Instead, smart contracts based on Ethereum’s scripting language – which can’t be modified – are in charge of it.
There are still difficulties with this revolutionary approach, for example, if the intelligent contracts underlie MakerDAO do not function as planned. Indeed, they were gaming in 2020, which resulted in a loss of $8 million.
Types of Stablecoin Collateral
The collateralized stablecoins, for example, utilize a variety of forms of assets as backing:
Stablecoins can also be “secured” by other cryptocurrencies, such as ether, the native currency of the Ethereum network or Bitcoin itself.
Tether’s USDT was formerly supposed to be backed 1-for-1 with U.S. dollars. However, the collateral’s composition has evolved, and in 2021 it claimed half of its reserves were in commercial paper, a form of short-term corporate debt. It has not identified the paper’s issuers. Still, it says they are all rated A2 or higher (A2 is the second-best grade available for a business borrower from credit rating agencies like Standard & Poor’s).
In its monthly disclosures, the USDC of Circle similarly includes unspecified “approved investments” alongside federally insured bank accounts (notably, it does not say whether the funds themselves are insured).
The most popular stablecoins are based on the fiat currency of a single country, such as the U.S. dollar for fiat currencies. Fiat currencies are more popular. But some firms are creating stablecoins linked to other fiat currencies, such as BiLira, which is connected to the Turkish lira.
Some cryptocurrencies are linked to the value of precious metals such as gold or silver.
How Do Stablecoins Work?
Stablecoins are cryptocurrencies linked to another asset’s price through algorithms or huge reserves. The peg is the minimum target for a stablecoin about the thing it’s pegged to. In the example of a U.S. dollar steady, it’s $1.
The hypothesis is that stablecoins may be readily exchanged or traded for the equivalent of the linked asset. In contrast, some stablecoins are backed by tangible assets, such as PAX Gold, supported by gold bullion bars kept in vaults, and more volatile cryptocurrencies back to others. A stablecoin pegged to a cryptocurrency with significant price fluctuations might experience considerable changes in value over a short period. The most common stablecoins are based on fiat currencies (nearly every nation’s regular currency).
Consider them to be digital cash. You may exchange cryptocurrencies experiencing price swings for fiat-backed stablecoins that would not move significantly due to their fiat peg during market volatility. Such a transaction would be faster than cashing out your cryptocurrency, yet you’d still retain ownership since crypto exchanges work like this.
Stablecoins let traders invest in an off-chain asset (an asset not on the blockchain, such as gold) within a decentralized finance (DeFi) protocol. This enables them to port assets from one blockchain to another. They also allow traders to move assets from one blockchain to another.
Wrapped Bitcoin (WBTC) is a Bitcoin stablecoin. This means you can invest in an asset representing the price of Bitcoin on the Ethereum network. Bitcoin is the most profitable cryptocurrency by market cap. This means it is a good investment because its price is likely to mirror other cryptocurrencies. Ethereum has more applications and supports more kinds of transactions, making it a good choice if you’re looking to spend your WBTC.
What Are the Risks of Stablecoins?
Stablecoins may appear to be a low-risk investment at first. In comparison to cryptocurrencies that are backed by nothing, they are. However, stablecoins come with their own set of risks, including one that is unique in the world of cryptocurrency:
Unlike other cryptocurrencies, stablecoins must be stored somewhere in your digital wallet or with a broker or exchange. And this brings dangers since a specific trading platform may not be secure enough or have flaws.
While cryptocurrency may be highly decentralized, you deal with several third parties in each transaction, including the bank holding the reserves and the firm creating the stablecoin. For the currency to retain its value, it must perform all its duties correctly (security, adequately securing, etc.).
Reserve Currency risk
The reserves backing a stablecoin are an essential component of the stablecoin ecosystem. The last line of defense for a stablecoin’s value is the reserves. The coin issuer can’t promise the value of a stablecoin with complete confidence unless it has them.
Lack of confidence
A run could occur in a stablecoin that isn’t fully backed by hard assets, such as cash. In May 2022, for example, the algorithmic stablecoin TerraUSD lost its peg when it wasn’t backstopped by money but rather other cryptocurrencies. The value of the stablecoin broke and plummeted, leading traders to doubt its ability to keep the peg.
“The main danger of stablecoins is that they aren’t fully backed by the reserves they claim,” Citrano adds. “The issuer of the stablecoin should have enough reserves (in cash or other highly liquid, safe investments) to back the stablecoin in an ideal world fully.
Failed Stablecoins in the past?
Stablecoins got caught up in a more significant cryptocurrency sell-off that began when the Federal Reserve increased interest rates by half a percent. Higher interest rates, inflation, and supply chain difficulties have investors concerned about the coming U.S. economy crumbling beneath strain shortly.
Due to the increasing economic uncertainty, many investors have moved their portfolios away from riskier assets and bought more stablecoins.
However, in the past we have already seen many failed Stablecoins like the Iron Finance Stable Coin or the latest big event of the fall of Terra-Luna.
According to CoinMarketCap data, most cryptocurrencies’ values dropped from 5% to 85% in the past week.
Are Stablecoins Safe?
Stablecoins are not less secure than U.S. bank accounts or money market funds, according to many investors. Investors may reduce this risk in two ways: doing your study is the first approach; check out the issuing company’s history and prior accomplishments before putting your money into them. Investors can easily switch to other stablecoins or even other cryptocurrencies if they lose confidence in a coin because of its volatility. However, established stable currencies adequately pegged by the issuers pose near zero risk of failure or volatility owing to their nature and mechanism.
Stablecoins have yet to be regulated in many jurisdictions, and the existing laws are still under debate. The President’s Working Group on Financial Markets, composed of the heads of the U.S. Treasury Department, Federal Reserve, SEC, and CFTC, released a report in November 2021 proposing stablecoin regulation. However, no legislation regulating stablecoin issuers has been passed yet.
Disadvantages of Stablecoins
The major disadvantage of stablecoins is counterparty risk. Counterparty risk is the chance that a partner in a contract might default. A stablecoin issuer may not have the reserves they claim or refuse to redeem tokens for them, putting their credibility at stake.
Stablecoins that rely on central authorities and auditors are vulnerable to human error, as audits may miss flaws or potential issues. Furthermore, fiat currency-backed stablecoins are frequently kept in commercial paper, a type of short-term unsecured debt. The use of commercial paper raises counterparty risk because the firm issuing the debt might default on its obligations.
Risk premiums are another way investors may benefit from turmoil in the market or the failure to provide audits. Risk premiums represent the extra premium received by investors for taking on greater risk when investing in a digital asset (i.e., stablecoins). The lower value of stablecoins compared to their peg implies that purchasing cryptocurrencies with these currencies becomes somewhat more expensive than buying them using fiat currencies.
Algorithmic stablecoins may frequently lead to Ponzi schemes in which new tokens are generated by depositing new collateral by existing users. A Ponzi method is a fraud in which people are paid returns using money from new investors. The ultimate collapse is caused by the lack of new investors making investments. If new users stop coming, these assets’ value could rapidly plummet.
Finally, the central entities that issue tokens may have the authority to freeze them at the request of law enforcement. Even during money laundering, counter-terrorism financing, or other illicit activities investigations, authorities may demand that tokens be frozen.
Stablecoins, on the other hand, provide some of the stability lacking in most cryptocurrencies, making them impossible to use as actual currency. Those who use stablecoins should be aware of the dangers they’re taking when they own them. While stablecoins may have little trouble in most cases, stablecoins may become riskier than ever during a crisis when people attempt to flee authorities by hiding their wealth inside secure digital systems.
Moritz Pindorek (Moritzpindorek.com)
Social Media, Marketing & Blockchain
Crypto/Web 3 Advisor, Top 10 Crypto Influencer 2022(Forbes Monaco) & Top 10 Entrepreneur 2022 (Forbes Monaco)
Owner and writer for Cryptouserguide.com