What are Stablecoins?

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robertstevens

Robert has reported for a variety of international publications including the Associated Press, The Guardian, Vice, and Decrypt. Current areas of interest include the political economy of technology, cryptocurrencies, and privacy. Robert has a Bachelor of Science from UCL, and a Master's degree from the University of Oxford's Internet Institute.

If the cryptocurrency market is known for one thing, it’s volatility. Prices, even of major cryptocurrencies with large market caps, like Bitcoin and Ethereum, can crater and shoot straight to the moon within a few hours.

But there are some cryptocurrencies, known as stablecoins, that are designed to limit that volatility and maintain a stable value. These products aim to always be equal to one unit of a fiat currency — whether it’s the dollar, the yen, or the euro — and they’re a critical part of the cryptocurrency industry.

The most popular type of stablecoin tracks the US dollar. This is because the dollar is the world’s de facto reserve currency. It is traded internationally, which is useful considering the global nature of the crypto market.

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Why stablecoins could be important

Holding a stable crypto that maintains a peg to a fiat currency is valuable for several reasons. Here are five:

  1. Traders want to be able to “cash out” of their positions in more volatile assets without actually cashing out of the crypto economy. Why? For one thing, it’s expensive to change traditional money for crypto (and vice versa). For example, to buy $100 of Bitcoin using US dollars on a major cryptocurrency exchange, you could end up having to pay a wire transfer fee of about $10, a fee of about $2.99 to make your purchase, and an eventual withdrawal fee of $25. But if you were to buy $100 of Bitcoin using $100 of USDC (a US dollar stablecoin), however, you generally have to pay far less – as little as 0.1% on many leading exchanges, or $0.1.

  2. Trading stablecoins is a quick process. Wiring US dollars onto a crypto platform takes a few minutes, and you can’t just use those dollars to buy any coin — especially the smaller ones. On the other hand, trading the top stablecoins on a cryptocurrency trading platform is near-instantaneous. In the event of a short-lived spike or market crash, those seconds may count.

  3. Decentralized finance protocols do not accept traditional currencies – they only accept cryptocurrencies. By contrast, national currencies are minted by central banks and they are represented on ledgers maintained by major banks, not blockchains. This means that if you want to trade something that represents a national currency within a DeFi protocol, you’ll need to use a stablecoin.

  4. Most DeFi protocols generate yields. Yields are kind of like interest on your investments. Lots of DeFi yields are volatile, and to make matters more complicated, are issued in volatile cryptocurrencies. Many traders use stablecoins to generate returns in US dollars; since the US dollar is comparatively stable, it’s easier to predict how much money you’ll make. If you’re in Canada, a Canadian dollar stablecoin could reduce currency risk even further; however, CAD stablecoins are not the most popular stablecoins on the market.

  5. Creating stablecoins that are pegged to the value of assets outside of a decentralized finance ecosystem lets traders expose themselves to new kinds of assets. Stock tokens on Mirror, for instance, are stablecoins pegged to the value of equities. Wrapped Bitcoin, Ren, and others are synthetic versions of Bitcoin. These are necessary because one blockchain is often incompatible with another — bitcoins will not work on Ethereum, for instance — so synthetic Bitcoin tokens are stablecoins that always represent the price of Bitcoin. While Bitcoin is not the most stable cryptocurrency by any stretch, a Bitcoin stablecoin should nevertheless reliably track its price. Think of these coins as fulfilling the same purpose of a Bitcoin ETF on a public stock market: a bitcoin stablecoin allows you to gain exposure to Bitcoin’s price without having to hold bitcoin directly.

How stablecoins work

Centralized stablecoins are the largest and most popular type of stablecoin, and the most-traded coins on the entire cryptocurrency market, in terms of market cap. As of January 11, 2022, Tether (USDT) was the largest, with a market capitalization of $78 billion, followed by USD Coin (USDC) with a market cap of $43.94 billion. After that it was Binance USD and the Pax dollar, with respective market caps of $14 billion and $1 billion. With a daily trading volume of $73 billion, in January 2022 Tether was also the most traded coin. By comparison, only $34.5 billion Bitcoin traded in the same time frame, and $20.38 billion worth of Ethereum.

All of these stablecoins differ in specific composition, but they are similar in that they are maintained by privately run companies. Tether maintains USDT; Centre, a consortium led by Coinbase and Circle, maintains USDC; and the crypto trading platform Binance looks after BUSD.

Theoretically, these stablecoins are backed by reserves of real US dollars. Stablecoin companies issue new coins whenever someone, mostly market makers and liquidity providers, sends them US dollars. These real US dollar deposits aren’t just kept in cash in bank accounts, but in theoretically low-risk assets, like treasury bonds. So if you want to redeem your stablecoins for US dollars, the companies could liquidate the appropriate amount of those holdings and pay you back.

Other centralized stablecoins work in similar ways. Binance’s short-lived stock tokens represented real stocks held by another company, and Wrapped Bitcoin represents real Bitcoin held by institutional crypto custodians.

Unlike centralized stablecoins, decentralized stablecoins are not backed by reserves held by huge companies but instead by autonomous protocols. Different coins work in different ways, but the most popular and resilient version, as of January 2022, is made up of two issued tokens, a volatile cryptocurrency and a stablecoin. Under this model, the stablecoin protocol will automatically mint or destroy stablecoins, or use other cryptocurrencies as collateral. For instance, lending out Ethereum on Maker, the protocol that supports one of the largest decentralized stablecoins, DAI, will create new DAI coins, each equal to one dollar.

To compensate for the volatility of the cryptocurrencies that back it, DAI is overcollateralized. Data on Daistats.com shows that the $9 billion DAI in circulation is backed by $16 billion worth of cryptocurrencies. Although the backing changes over time, the currency is mostly backed by ETH, then USDC (a centralized stablecoin), then Wrapped Bitcoin (a Bitcoin stablecoin). In the event of a market crash that triggers mass liquidations, DAI can fall back on reserves of its volatile governance token, Maker. Alternatively, stakeholders can introduce backing from centralized stablecoins like USDC, as they did in March 2020.

TerraUSD (UST) is another popular decentralized model. The main difference between it and DAI is that it is backed by volatile LUNA tokens. Rather than DAI’s overcollateralized loans, UST relies on market forces to control the price. If UST is worth $1.02, you’ll still be able to swap $1 of LUNA for 1 UST on Terra Station. If enough people do that, the market should arbitrage the price of UST back to $1. Conversely, if UST trades at $0.98, you’ll be able to convert that to $1 of LUNA and make a profit of $0.02. The prices are interrelated because whenever you buy or sell UST on the Terra Station, the protocol burns and mints LUNA.

These protocols are not watertight. There is no such thing as the safest stablecoin in a stablecoins list, even though the stablecoin prices may be consistent by definition. In fact, many attempts at decentralized stablecoins, like the Empty Set Dollar or Basis, have been knocked from their US dollar pegs. Decentralized stablecoins like DAI, FRAX, and UST are still in their early days, and could falter in the event of a market collapse. If nobody wants to swap LUNA for UST, for instance, the arbitrage model would break down and the project could fail.

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One of stablecoins’ biggest controversies: Tether’s backing

People often wonder if centralized stablecoins are really backed by US dollars. There is a huge amount of controversy over exactly how Tether is backed, since the company does not disclose details about its holdings. Instead it publishes limited attestations that inform readers that it has reserved a certain amount in commercial paper without saying whose commercial paper it bought. This is important because if it turns out that Tether is backed by, say, mountains of short-term Chinese commercial debt, and those companies are wiped out in a death spiral of cascading defaults as a result of Evergrande’s debt crisis, Tether could struggle to fulfill redemptions, meaning each USDT would not be worth $1, and the coin could lose its peg. This is bad because a lot of the crypto economy relies on USDT’s peg to the US dollar. Head to any exchange and you will find hundreds of pairings against Tether, which would be meaningless if Tether was no longer worth a dollar.

Tether claims that it does not hold any paper issued by Evergrande, and a Bloomberg article cited a document that claims that Tether does include Chinese companies, many of which are tied to Evergrande’s fate. But putting Evergrande aside, commercial paper traders that make up a small clique of global traders frequently say they have never heard of Tether, whose audit logs reveal that the company is one of the largest commercial paper traders in the world.

In 2019, a New York Attorney General investigation called out Tether (and its sister company, Bitfinex) on obscuring “the true risk investors faced,” alleging that Bitfinex used Tether to cover up an $850 million hole in its finances caused by a shady banking partners, Crypto Capital, misleading investors. At the time, Tether’s lawyer admitted it was only 74% backed, and in the eventual settlement agreement, the NYAG banned Tether from New York.

Tether neither admitted nor denied claims when it settled with the NYAG. The Ontario Securities Commission doesn’t let registered crypto exchanges list coins that courts have linked to fraud. That’s why you can’t trade USDT on Wealthsimple.

Frequently Asked Questions

Stablecoins are not created equally and the risk profile of each varies. One danger with centralized stablecoins is that the companies that operate the largest ones do not disclose specifics about the short-term money market instruments they use to back their tokens. That means that stablecoin investors may unwittingly be exposed to things other than the US dollar, such as Chinese credit markets, market makers, or the success of Bitcoin lenders.

Algorithmic stablecoins may fail for other reasons. The most obvious is that the algorithm fails to work, so the coin loses its peg. Another reason is that some algorithmic stablecoins, like Terra’s UST token or Olympus DAO’s OHM token, rely on investors’ continued belief in a second volatile token that the protocol uses to help maintain the peg of its stablecoin. If this volatile token craters, the stablecoin’s peg could also be under threat.

Last Updated May 9, 2022

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