Stablecoins have been around for some time, but today, the buzz around it is no longer limited to the crypto and blockchain community alone. Traditional finance analysts and Institutional investors are looking to grab a piece of the pie by exploring the prospects of leveraging stablecoins for DeFi investments. Likewise, Regulators and Law enforcement agencies around the world are getting increasingly interested in regulating stablecoins to mitigate potential systemic risks. Therefore, it goes without saying that there is heightened demand across the board for comprehensive information regarding stablecoins.
In this article, you will learn all about what stablecoins are, how they work and the different types of stablecoins that exist in the Decentralized finance markets today.
What are Stablecoins?
Stablecoins are cryptocurrencies that have their value pegged against some specific assets that have relatively stable prices such as the US Dollar or other fiat currencies. Since the turn of the century, the US Dollar has emerged as the most widely accepted currency in global trade. Therefore, it’s only logical that the USD-pegged stablecoins have dominated the blockchain finance world as well. At press time, only 2 of the top 20 ranking stablecoins are pegged to non-USD currencies.
Understanding the Need for Stablecoins
Essentially, the premise for the establishment of stablecoins is to counter the inherent volatility that has come to be synonymous with the cryptocurrency markets. However, stablecoins play a crucial role in many other areas of decentralized finance.
Benchmarking DeFi Products & Services
The development of blockchain technology effectively elicited the introduction of completely new financial products and services tagged DeFi. In order for these Decentralized Finance protocols to thrive, there was a need for an element of price stability to benchmark financial products and services rendered on the blockchain. Since Crypto assets such as Ethereum and Bitcoin could present high levels of volatility, Stablecoins emerged as the most reliable solution.
Hedging Against Volatility
Similar to any nascent market with emerging asset classes, cryptocurrencies have also been subject to the adverse influence of market forces. This exposes investors and users of DeFi services to a lot of market volatility. During times of volatile market trends, Stablecoins serve as neutral vehicles to help users shield their crypto assets.
Easy On-Ramp For New User
For users that are new to crypto, stablecoins provide a neutral starting point for them to explore the world of decentralized finance. In addition to offering an easy on-ramp route, they also offer users fluidity to move between different blockchains while they explore different decentralized finance products and services. They also allow users to easily off-ramp and convert their crypto back into cash.
Unique Features of Stablecoins
Primarily stablecoins can be identified and differentiated from other forms of cryptocurrencies on the basis of two factors – An independent pegged asset (i.e fiat currency). And secondly, the Reserve asset that backs them up.
This feature points to the specific asset or currency whose price each unit of a stablecoin is perpetually pegged to. Essentially, the value of the pegged currency is uncorrelated with neither blockchain markets nor the stock price of the company that issues the stablecoin.
Although dollar-pegged stablecoins are the most prominent in terms of adoption rates and market capitalization, It is important for you to note that not all stablecoins are pegged to the United States Dollar. For example XSGD is tied to the Singaporean dollar. While STASIS EURO is pegged to the Euro.
This is where things really get interesting. Reserve assets refer to the underlying assets that back up each unit of the stablecoins that is issued to investors.
Theoretically, every unit of stablecoin issued is a liability to the issuing entity. To ensure the viability of the stablecoin system, the issuer then needs to acquire an asset that is at least equivalent to the face value of the circulating supply.
These reserves may be composed of any valuable asset. It can range from illiquid assets like gold, real-estate, or art pieces. On the other hand, you can have blue-chip stocks, cash deposits, money market instruments like Treasury notes, and bonds or even other cryptocurrencies. In general, stablecoin issuing entities have to find a balance between ease of liquidity, passive yield-generation and price stability of its reserve assets. Concisely put, Reserve assets serve as collateral that guarantees the viability of the peg. The stablecoin is only as good as it reserves.
Types of Stablecoins
Having explored the different features of stablecoins, we can now go ahead to examine the different types of the stablecoins. This time, we will be drawing parallels on the basis of reserve assets. You see, in reality, stablecoin issuing bodies operate different types of reserve mechanisms to ensure that the holders of the stablecoin can always redeem their holdings at the pegged face value at all times.
Keep in mind that this categorization is indicative of the composition of reserve assets that back them.
1. Fiat-collateralized Stablecoins
Fiat-collateralized stablecoins are the most popular variant of stablecoins that you will come across in the DeFi world. Typically, the organizations that issue them back them up with reserves that consist of cash or money market assets denominated in specific fiat currency. Alternatively, it can also be a basket of currencies i.e. Euro, GBP, or the US Dollar.
The 1:1 ratio pegging implies that one stablecoin would be equal to one unit of the reserve currency i.e such the USDC – USD or Stasis EURO and the Euro.
Fiat-collateralized stablecoins are quite simply the easiest type of reserve mechanism to understand. In theory, it means that every fiat-backed stablecoin minted has real fiat currency equivalent, deposited in a reserve bank account or money market instrument. Conversely, when users decide to redeem their coins, an equivalent amount of the stablecoins are taken out of circulation or permanently destroyed.
Fiat-backed stablecoins are one of the most popular stablecoin categories due to their structural advantage. However, blockchain maximalists often criticize them for their lack of decentralization and proneness to regulatory restrictions.
2. Commodity-backed Stablecoins
As the name indicates, commodity-backed stablecoins have the reserve backing of different types of interchangeable assets such as precious metals, real estate or valuable art pieces. The owners of commodity-collateralized stablecoins basically obtain ownership of a tangible asset. And this presents a formidable advantage.
Another major advantage is that the underlying assets are uncorrelated with the crypto markets, and they may appreciate in value over time. Hence, these types of stablecoin tend to offer better incentives for users to hold them long-term.
3. Crypto-backed Stablecoins
As the name implies, Crypto-collateralized stablecoins are backed by other cryptocurrencies, while having their face value pegged to a fiat currency. It is important to note that since the reserve asset, in this case another cryptocurrency, crypto-backed stablecoins are inherently exposed to some volatility. To mitigate these risks, issuers usually deploy a number of mechanisms such as
This involves deploying a basket of mega-cap cryptocurrencies to back up the underlying stablecoin, while its face value remains pegged to fiat.
Overcollaterization means that the issuing body sets out to back the stablecoin by a disproportionately large amount of the reserve cryptocurrency. This is to ensure that the value of the total reserve asset never falls below the circulating capital of the stablecoin.
The most advantageous trait of crypto-backed stablecoins is the decentralization and censorship-resistance.
Some well-known crypto-backed stablecoins include: MakerDAO – MKR/USD, and Reserve (RSV/USD). Essentially, Crypto-backed stablecoins allow users to process trustless transactions with improved security and better transparency without the possibility of interruption by any single entity.
While crypto-collateralized stablecoins are one of the most complex stablecoin types in use right now, they indeed offer superior liquidity and transaction efficiency compared to other types.
4. Algorithmic Stablecoins
Algorithmic stablecoins, sometimes called non-collateralized stablecoins, are a unique category of crypto assets. They do not have any concrete assets or collateral backing them, instead, they depend on algorithm to simulate and enforce the rules of demand and supply.
When demand rises, new stablecoins are autonomously minted to reduce the price to the normal level. In the event of considerably low coin trading, coins on the market are purchased or destroyed to reduce circulating supply. Which ultimately props up the price back to the pegged level.
Algorithmic stablecoins are regarded as the category that is most susceptible to risk depeg or a bank-run. Typical examples of Algorithmic failure are Iron-Finance’s Titan Token and Terra UST. However on the upside, they offer the highest level of decentralization and capital efficiency.
Are Stablecoins Regulated?
At the moment, Stablecoins remain outside the purview of legal jurisdiction of major financial regulators. However, in recent times, multiple cases of stablecoin de-pegs have led Government agencies such as the International Monetary Fund and European Central Bank (ECB) to begin considering ways to regulate stablecoins in a bid to mitigate systemic risk. Likewise, the Securities & Exchange Commission in the USA is also mooting strong actions against issuers that may have misrepresented their reserve holdings.
DYOR – Do your own research
If you’re considering buying stablecoins, you should be well-aware of the depeg risk. Not only do you need to know what assets are backing the token, but you also need to be certain that those assets are not pledged against other liabilities.
In addition to the information provided in the issuing organization’s website or whitepaper, should seek out an Independent audit report, and consult a financial advisor when necessary.