Cryptocurrency quotes tend to show extremely high volatility. However, some types of cryptocurrencies – stablecoins – have a relatively stable exchange rate due to a different operating principle. We tell you how stablecoins work, what types they come in, and why investors use them.
What is a stablecoin and what are its principles of operation?
Stablecoin (from the English stable coin – “stable coin”) is a type of cryptocurrency. Unlike a regular cryptocurrency, the rate of stablecoins is tied to the value of the underlying asset: this can be the rate of a real currency (for example, the dollar or yuan), a cryptocurrency (for example, Bitcoin), the value of a commodity (for example, oil futures) or a security (a stock of a certain companies).
Stablecoins are less volatile than other cryptocurrencies due to their pegging to fiat money or other assets. Therefore, the conditions of the cryptocurrency market, as well as other factors affecting the industry, are less reflected in the quotes of stablecoins.
However, stablecoins, like all cryptocurrencies, are an instrument with a high risk of complete loss of funds.
Differences between stablecoins and other cryptocurrencies
The fundamental difference between a stablecoin and a regular cryptocurrency is the source of issue. Traditionally, the issuance of cryptocurrency is carried out using a decentralized system of algorithms; it can be carried out by any person who fulfills the conditions of issue. The emission of stablecoins occurs differently: they are issued by a specific organization. The issue is carried out on an existing blockchain (for example, Ethereum).
Stablecoins and regular cryptocurrencies have other differences: issuers of stablecoins, for example, disclose information on the collateral of the issued “coins”.
What types of stablecoins are there?
All stablecoins can be classified as follows:
By provision
Stablecoins backed by real (fiat) currencies. These stablecoins tend to be the least volatile. Most often they are tied to the US dollar exchange rate. Such stablecoins are issued by the government (that is, they are central bank digital currencies, CBDC) or private companies.
For example, the rate of the most popular stablecoin – Tether (USDT) – is pegged to the US dollar in a 1:1 ratio. The rate of this token is always equal to 1 dollar. The value of USDT is provided by the issuer – Tether, which has reserves to back each stablecoin. The stablecoin Euro Coin (EUROC) is backed by euros.
Stablecoins backed by cryptocurrency.
The rate of such coins is tied to the rate of cryptocurrencies, most often to popular ones, for example, Bitcoin or Ethereum. Such “coins” are more volatile, but they allow you to hedge the risks associated with the use of fiat currency.
The Wrapped Bitcoin (WBTC) stablecoin is backed by Bitcoin at a 1:1 rate, and the DAI stablecoin is backed by the Ethereum cryptocurrency (however, it does not reflect the Ethereum rate, but uses loans in this cryptocurrency to maintain a 1:1 rate to the dollar.
Stablecoins backed by commodities
Such tokens can be issued by private companies and are a digital analogue of goods. The dynamics of their value and volatility depend on the type of security: for example, the price of gold is less volatile than the price of oil, especially in the medium and long term.
The demand for such tokens is low, but, for example, a stablecoin pegged to gold allows those investors who do not have the opportunity to buy bullion to invest in this precious metal.
For example, the stablecoin Tether Gold (XAUT) is backed by gold. Its owner can order the delivery of metal of the appropriate mass or convert its value into real currency. Petro, a stablecoin issued by the Venezuelan government, is backed by oil.
Stablecoins that are algorithmically regulated.
Algorithmic stablecoins have no collateral reserves. The linking of their rate to the underlying asset is ensured by the issue and redemption of the associated cryptocurrency. Such tokens are considered the riskiest stablecoins to buy. Expert notes that due to the increased risk, algorithmic stablecoins “theoretically provide more opportunities for profit.”
For example, the Frax stablecoin (FRAX) is pegged to the dollar through an algorithm with the Frax Share (FXS) service token, and the TerraUSD stablecoin (UST) is pegged to the LUNA cryptocurrency.
Centralized stablecoins
Centralized stablecoins are issued and managed entirely by issuing institutions. As a rule, issuers offer stablecoins pegged to fiat currencies – dollar, euro, and so on. The centralized stablecoin market is represented by Tether (USDT stablecoin), Circle (USD Coin, USDC) and Binance (BUSD).
The advantages of centralized stablecoins are high liquidity and availability for working in various protocols, the disadvantages are opaque security and blocking of addresses. The key disadvantage is the AddedBlacklist function in the smart contract of these stablecoins, which can block funds at any address.
Decentralized collateral stablecoins.
The rate of decentralized collateral coins is supported by the most significant and liquid cryptocurrencies – Bitcoin, Ethereum, Binance Coin (BNB), which are placed in a smart contract in the form of collateral.
The advantage of such stablecoins is decentralization, the disadvantage is high competition from other stablecoins and the difficulty of issuing new tokens. Popular decentralized collateral stablecoins are Dai (DAI) and Magic Internet Money (MIM).
Decentralized algorithmic stablecoins
Decentralized algorithmic stablecoins regulate the price using an algorithm. Only one crypto asset is used as collateral. Popular decentralized algorithmic stablecoins are Frax (FRAX) and TerraUSD (UST) (before its collapse in May 2022).
The advantage of such stablecoins is also decentralization, their disadvantages are the lack of highly liquid cryptocurrencies and a new technology that has not stood the test of time.
The most popular stablecoins
The most popular and largest stablecoin by capitalization is Tether (USDT). The daily trading volume of USDT is almost 30% higher than the daily trading volume of Bitcoin.
The “coin” is presented in several standards, of which the most popular are TRC-20 on the Tron blockchain network and ERC-20 on the Ethereum blockchain. In second place in popularity is the stablecoin USD Coin (USDC).
In total, USDT and USDC account for almost two-thirds of the stablecoin market. Their popularity is due to the fact that these stablecoins act as an analogue of the American dollar on crypto exchanges. If an investor needs to exit a cryptocurrency or lock in a profit or loss, he will most likely use dollar-pegged stablecoins.
The top popular stablecoins also include Dai (DAI), Binance USD (BUSD) , and TrueUSD (TUSD). According to CoinMarketCap data, they are followed by Pax Dollar (USDP), USDD, Gemini Dollar (GUSD), Frax (FRAX) and USDJ. It is these “coins” that are primarily used for mutual settlements and stored as reserves.
Advantages and disadvantages of stablecoins
Advantages
The organizer of the stablecoin issue can issue any number of tokens for which he has collateral. This is how stablecoins differ from regular cryptocurrencies, the volume of emission of which is usually set in advance and limited.
Resistant to exchange rate manipulation.
The exchange rate of stablecoins is subject to speculative influence to exactly the same extent as the price of the underlying asset. The scheme of artificially increasing the rate of a cryptocurrency followed by a price collapse (Pump & Dump) does not work well in the case of stablecoins.
Opportunity to invest in various assets.
By purchasing stablecoins, an investor can diversify their investment by purchasing “coins” pegged to different underlying assets.
Flaws
Possibility of manipulation by the issuing company. Stablecoins are issued and provided with assets by a certain company; theoretically, there is a possibility of manipulation and fraudulent actions on its part.
Another feature of stablecoins is their relatively low volatility. This characteristic can be both an advantage and a disadvantage of the “coin”. Low volatility allows you to save investors’ funds.
What are stablecoins used for?
Stablecoins allow for fast and cheap cross-border transfers. They also provide the opportunity to make periodic payments.
Such tokens can also be a long-term savings tool. In countries with currency restrictions, stablecoins allow you to invest in the US dollar and thereby protect against inflation of the local currency.
Stablecoins are also of interest to traders and investors who actively participate in trading or over-the-counter transactions.
Why stablecoins are interesting for investors
Investors can use stablecoins to hedge positions. For example, during a period of increased market volatility, in order to save savings in classic cryptocurrencies, many transfer them to “stable coins”.
Stablecoins can also be used to form low-risk crypto portfolios. Some cryptocurrency funds accept cryptocurrencies, including stablecoins, for staking. Stablecoins, like other cryptocurrencies, can be purchased on crypto exchanges.
Risks associated with using stablecoins
According to experts, the main problem with stablecoins is the lack of confidence in issuers, which calls into question the stability of cryptocurrencies. In the absence of collateral for the stablecoin from the issuer, the token will be untied from the underlying asset.
Another risk is possible questions regarding “stable coins” from regulators.
The US Securities and Exchange Commission (SEC) saw signs of a security in the Binance stablecoin. As a result, against the backdrop of pressure from the regulator, the issuer of the token, the Paxos company, decided to stop issuing the “coin”.
Regulatory uncertainty does not allow large amounts of funds to be stored in stablecoins. In addition, there are difficulties in transferring funds from stablecoins to fiat currencies. Each country has its own rules and quickly exchanging even 10 thousand USDT is not always easy, especially when it comes to EU countries.
Regulatory and legal aspects of stablecoins
There is currently no universal regulation of stablecoins; each jurisdiction has its own nuances and legislation.
Most jurisdictions do not have a clearly defined legal framework for “stable coins.” Some stablecoin issuers, including Paxos and Circle, are working with regulators. The latter are responsible for confirming the reserves that ensure the issuance of stablecoins by companies.
There is now a global trend towards tightening requirements for issuers of stablecoins (especially after the collapse of the UST stablecoin and the Luna cryptocurrency).
This is especially true for the disclosure of financial information and the provision of bank deposits for the entire issue. The centralized nature of stablecoins makes them vulnerable to regulatory pressure. If the regulatory authorities want to terminate the project, they will have the necessary leverage to do so.
