Unsurprisingly, stablecoins are designed to be stable! Therefore, they do not have the wild volatility of more well-known cryptocurrencies like Bitcoin. They play a pivotal role in keeping the crypto machine well-oiled, so learning their purpose and how they function is essential.
Usually, the price of a stablecoin is pegged to traditional ‘fiat’ currency such as the US dollar. For example, one Tether (USDT) = 1 USD (displayed below).
The selling point about stablecoins is that they offer the benefits of a cryptocurrency (immutable, anonymous, transparent, etc.) but without high levels of volatility. It’s hard to justify using Bitcoin as a medium of exchange, knowing that its price could well have altered by 5% or more the next day. This is where stablecoins come in. They offer a safe haven for crypto investors to park their funds during times of high volatility.
It is easier for a Bitcoin investor to trade their Bitcoin for a stablecoin pegged to the US Dollar (e.g. Tether) than to cash out the Bitcoin for actual US Dollars. However, unlike holding your money in a traditional bank, stablecoins lack consumer protection through official safeguards or insurances, so invest (and hold) at your own risk.
Their demand is surging, with the total market cap of stablecoin assets increasing just shy of 300% in 2020.
Stablecoins are usually backed by a reserve asset. There are several ways they can be collateralised:
The most straightforward and safest way for a stablecoin to operate is to have their total amount of tokens correlating to their collateral. For example, a stablecoin issuer has $100m in reserves, corresponding to $100m worth of tokens/coins.
But, despite stablecoins being a ‘stable’ form of cryptocurrency, this is crypto we’re talking about, so of course, there’s risk, uncertainty, and drama!
Stablecoins have been under the spotlight throughout their short-lived history. The main suspect has always been the world's largest stablecoin, Tether, with a market cap of $84bn (as of October 2023).
As mentioned earlier in the article, stablecoins are unregulated, so stablecoin issuers are by no means obliged to be fiat-collateralised.
Roughly speaking, fiat money is money made legal tender by a government. Because a government backs it, it is not backed by a physical commodity such as gold. Fiat money has no intrinsic value (i.e. the value from within); it derives its value from the faith that people place in it as a medium of exchange. Examples of fiat money include the US Dollar, the Euro and the Japanese Yen.
Because there is no obligation to be fiat-collateralised, many stablecoin reserves are made up of assets other than cash, as with Tether.
It’s fair to say that Tether’s had a troubled past - including alleged evidence of price manipulation, shady deals with banks in the Bahamas, an $18.5m fine from the NY District Attorney’s office for illegal activities in the state and a recent $41m fine for lying about currency backing.
Critics point to the fact that in the past, Tether has come up with fragmentary unaudited accounts of their reserves. For example, most of its reserves are held in short-term corporate debt known as commercial paper, which is not the same as having previously claimed all Tether to be 100% backed by US Dollars. Crypto supporters will argue that Tether having cash reserves of 2.9% is nothing to worry about, as it is similar to how fractional reserve banking works, except those banks are subject to strict regulations and Tether is not.
Crypto-collateralised stablecoins are backed by other cryptocurrencies. Issuers of crypto-collateralised stablecoins tend to over-collateralise themselves by holding cryptocurrency reserves worth more than the value of the tokens distributed. For example, holding $100m worth of Bitcoin reserves whilst issuing $50m worth of tokens. Issuers do this to factor in any unexpected volatility.
Such stablecoins are not collateralised, meaning that they do not use reserves. Instead, they use an algorithm to retain their stability. The supply of tokens is based on levels of demand. Imagine it similar to a central bank (e.g. US Federal Reserve) printing US Dollars to maintain its valuation. Algorithm-collateralised stablecoins do so by implementing smart contracts.
A smart contract refers to computer code programmed onto a blockchain that automatically carries out all or part of an agreement, following a specific trigger or input. Being part of a blockchain, they come with the features of being secure, permanent and immutable.
Given that stablecoins support the entire cryptosystem, it is in all cryptocurrency owners' interest that stablecoins are as legitimate as they claim / have working algorithms and do not ‘collapse’.
Stablecoins have grown tremendously over the years, to the point where regulators believe that they could impact the broader financial landscape if they were to fail. As a result, you’ll likely see a lot of politicians calling for greater transparency and oversight of stablecoins soon.
INTRO TO STABLECOINS. COMPLETED. ✅
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