Stablecoins 101

In the constantly evolving world of cryptocurrency, stablecoins have emerged as a special type of digital asset. Unlike volatile traditional cryptocurrencies, such as Bitcoin or Ethereum, stablecoins are designed to maintain a stable value. This post will explore what they are, how they maintain their stability, and their advantages and disadvantages.

What are stablecoins?

Cryptos offer many benefits for investors and customers. But along with the benefits comes volatility. The purpose of stablecoins is to have some advantages of digital currencies and mimic the stability of traditional financial assets such as the US dollar or gold.

Stablecoins are a type of cryptocurrency designed to have a relative stable price by being backed by a reserve asset. Their value is pegged to a fiat currency like the US dollar, a commodity like gold, or even another cryptocurrency. Therefore, successful stablecoins should maintain the same value as their peg.

Types and how they work

There are four types of stablecoins depending on the assets used to stabilize their value: fiat-collateralized, commodity-collateralized, crypto-collateralized and algorithmic. How they maintain a steady value varies by type.

1. Fiat-collateralized: These are backed by a reserve of a fiat currency, such as the US dollar or euro, assuring the stablecoin's stability. Since they are pegged 1:1 to a fiat currency, reserves must remain proportionate to the number of stablecoin tokens in circulation. Ideally, reserves should be liquid assets, such as cash or cash equivalents, and be audited periodically. This is the most popular type of stablecoin and examples include Tether's USDT and Circle's USDC which are the largest by market capitalization and pegged 1:1 to the US dollar.

2. Commodity-collateralized: These are cryptocurrencies that are collateralized using physical assets like gold, silver, oil, or real estate. Usually, issuers of these tokens hold the commodities using third-party custodians or by investing in financial instruments that hold them. Tether Gold (XAUT) and Paxos Gold (PAXG) are prominent examples of this category, and gold is the most popular commodity to be collateralized.

3. Crypto-collateralized: These are backed by another cryptocurrency as collateral. Because of the volatile nature of the cryptocurrency used as collateral, crypto-backed stablecoins require overcollateralization. This means that the value of cryptos held in reserve must exceed the value of the stablecoin in order to buffer against price fluctuations of the collateral. In this category, MakerDAO's DAI is the most important by market capitalization.

4. Algorithmic: Unlike the other types of stablecoins, this one doesn't need to hold assets in reserve. On the contrary, algorithms and smart contracts are used to stabilize their value by controlling the supply of tokens in circulation, similar to a central bank conducting monetary policy. For instance, the number of tokens in circulation will be reduced when the market price falls below the target. But if the price of the stablecoin rises above its target, new tokens are minted to increase the supply and reduce the price. Examples include Ampleforth (AMPL) and TerraUSD (UST). However, TerraUSD (UST) is an example of a failure because it lost its peg to the dollar and nowadays trades at around 1 cent.

Advantages and disadvantages

Advantages

• Stability: The main advantage is stability, making stablecoins ideal for everyday transactions without worrying about price fluctuations.
• Investment in commodities: Commodity-backed stablecoins facilitate investments in assets, such as gold, while maintaining the mobility advantage of digital assets.
• Lower fees: Stablecoins offer a cost-effective way to send money across borders at lower fees compared to the traditional financial system and fiat currency.
• Hedging: Traders can use stablecoins to hedge during periods of high volatility.

Disadvantages

• Centralization: Some fiat-collateralized and commodity-collateralized stablecoins are issued by centralized entities. This poses a risk if the entity is not transparent and doesn't manage reserves properly.
• Collateral risk: Stablecoins are subject to the volatility of their underlying assets and the level of reserves. If the value of the collateral falls sharply, it could impact its stability. Also, the lack of availability and quality of reserves can break the peg.
• Algorithmic failure: Algorithmic stablecoins rely on complex mechanisms to maintain their peg. If they fail, it could lead to significant losses for users.