What are Stablecoins and Why Do They Matter?
You probably have heard about stablecoins before and thought, ‘Well, they are just coins that are stable’.
If so, you are right!
You see, cryptocurrencies are extremely volatile; their prices fluctuate regularly, going up and down every second. Nobody wants to store their money in an unstable currency or asset unless they are seasoned investors looking for long-term gain.
This volatility was a huge problem for the crypto market until 2014, when the first stablecoin was created.
The introduction of stablecoins addressed these challenges by offering a level of price stability that traditional cryptocurrencies lack.
In this article, we will explore what stablecoins are, their types, why they matter, and the risks associated with them.
Let’s get into it.
What are Stablecoins?
Stablecoins are cryptocurrencies whose value is pegged to stable assets like USD, gold, and other cryptocurrencies.
Stablecoins, at all times, maintain the same value or worth as the underlying asset. This protects investors and crypto users from price fluctuations in the crypto market.
As of this writing, there are about 200 stablecoins, with Tether (USDT), USDC, and DAI constituting the top three.
Why Stablecoins?
As crypto gains more momentum in the global economy, thought leaders in the space figured out a way to protect users from the instability of cryptocurrencies, leading to the emergence of stablecoin.
Let's see this analogy:
Assume you go to a store to purchase a few groceries worth $100. It is time to checkout, and you decide to transfer $100 worth of Bitcoin to the store attendant. The attendant tells you he does not accept Bitcoin as the price may drop or rise, and he is not ready for the risk that comes with it.
To put this into context, the image below shows a 24-hour price movement of Bitcoin.
That’s what happens when a currency is unstable.
The emergence of stablecoins has been one of the greatest innovations in the cryptocurrency space.
They provide a stable alternative to volatile cryptocurrencies and allow the mainstream adoption of cryptocurrencies as a medium of exchange in day-to-day transactions.
Types of Stablecoins
Stablecoins are of different categories.
- Fiat-collateralized stablecoins
- Crypto-collateralized stablecoins
- Algorithmic stablecoins
Fiat-collateralized stablecoins
This is the largest class of stablecoins. These coins are tied to stable fiat currencies, especially the US dollar.
The most popular example of this class is Tether (USDT), which is backed by the United States dollar.
It is worth the same value as USD, i.e., 1 USDT = 1 USD.
USDT has a market cap of about $107 billion as of April 2024.
Tether and other fiat-backed stablecoins have reserves for the target currencies.
Certain authorities safeguard these reserves and audit them from time to time. As such, Tether is a centralized fiat-backed stablecoin since one still needs to have faith in some authorities regarding the integrity of the reserves.
The second most popular type is the USDC stablecoin. It is a tokenized or digital version of the US dollar and is also backed by a 1:1 ratio.
As of April 2024, the market cap of USDT was $33 billion.
Crypto-collateralized stablecoins
This is the second-largest class of stablecoins. Other cryptocurrencies serve as collateral for this class of stablecoin.
"Why use a volatile asset to back another volatile asset?" is a question that may arise in one's mind.
The idea behind this is that the stablecoins are over-collateralized, i.e., there are more collateral assets in reserves than stablecoins in circulation.
The multi-collateralized DAI issued by MakerDAO is a classic example. Currently, Ether (ETH), Basic Attention Token (BAT), USDC, and Wrapped Bitcoin (wBTC) serve as the collaterals for DAI.
DAI is 150% over-collateralized; for every 1 DAI in circulation, there is 1.5 ETH (or the other collaterals) in the reserves.
Since DAI runs on a smart contract program on the blockchain, it is a decentralized crypto-backed stablecoin that requires little or no trust.
Algorithmic Stablecoins
This type uses an algorithm or smart contract program to control the stability of the stablecoins. Most of these stablecoins have a 1:1 correlation with the USD.
The algorithm is simply based on the law of supply and demand: if supply exceeds demand, the price will fall, and vice versa.
When the stablecoin price rises above $1, the algorithm increases supply by minting more stablecoins until the price returns to the $1 peg.
Alternately, when the stablecoin falls below $1, the algorithm decreases supply by stopping the minting process or burning the coins to return the price to $1.
The smart contract automatically stabilizes the stablecoin’s price; hence, it is decentralized, as there is no need for trust.
Current examples of algorithmic stablecoins include Empty Set Dollar (ESD) and Ampleforth (AMPL)
What’s the point of stablecoins?
There are many questions about why stablecoins are necessary when they are just the equivalent of fiat currencies.
Some benefits of stablecoins are:
- Stablecoins allow the immediate conversion of other cryptocurrencies to less volatile coins. Converting directly to fiat takes time — maybe days — but swapping to stablecoins is almost immediate. Therefore, it provides a haven for crypto users and traders from the price fluctuations in the crypto market.
- Stablecoins provide quick and easy access to stable currencies. If you live in a country or environment where the local currency is highly volatile or valueless, and there is no quick and easy access to USD, stablecoins are your go-to assets to store your money.
- Stablecoins allow you to transfer funds across borders and countries without being affected by price volatility. Sending fiat currencies is time-consuming, more expensive, and involves a lot of processes, especially if it is outside the country; sending stablecoin is quick, swift, easy, and less expensive.
- Stablecoins are essential for Decentralized Finance (DeFi) because they allow users to participate in DeFi activities like lending, borrowing, and staking without risking price fluctuations.
- Stablecoins also allow the widespread adoption of cryptocurrencies for everyday transactions.
The Risks of Stablecoins
Stablecoins are not risk-resistant; they can ‘depeg’
Depegging of stablecoin occurs when the price of the stablecoin deviates from that of the asset to which it is pegged.
Many factors cause a stablecoin to depeg.
Some factors include:
Supply and demand in the market: A sudden increase in the demand for a stablecoin can create a shortage in the coin supply, resulting in a temporary price increase.
Yet, stablecoin’s price may fall below the pegged price if supply exceeds demand.
- Smart Contract Problem: For algorithmic stablecoins, bugs or flaws in the smart contract programs may cause the stablecoin to deviate from the pegged price.
- Black Swan Events: These are unexpected, unpredicted occurrences that affect the crypto or financial market. For instance, the COVID-19 pandemic. These events may result in the depegging of stablecoins.
- Lack of liquidity: For fiat-backed stablecoins, the stablecoins in circulation may be more than the fiat in reserve. This causes the coin to depeg as there is insufficient liquidity.
- Regulatory or legal issues: The government can introduce new regulations that impact stablecoins, resulting in depeg.
Can Stablecoin Crash?
The simple answer is yes!
Just like any other cryptocurrency, stablecoins can crash due to various reasons.
Here are some of the causes:
- Lack of Transparency: A lack of transparency in the operations and reserves backing stablecoins can reduce the trust of investors. News of insufficient reserves or questionable practices can lead to a loss of confidence, causing the stablecoin to crash.
- Algorithm Failure: For algorithmic stablecoins, a failure of their algorithm to function accurately or respond to market conditions can result in crashes.
- Market Volatility: A huge fluctuation in the crypto market can cause stablecoins, especially algorithmic stablecoins, to crash. An example is the crash of TerraUSD (UST).
Which Stable Coin is the Safest?
Stablecoins aim to offer price stability in the volatile cryptocurrency market. However, the question of their safety still lingers.
Let’s examine three popular options: USDT, USDC, and DAI.
Based on Market Capitalization
Market Capitalization is the total value of a coin and is calculated by multiplying the coin's price with the circulating supply.
The larger the market cap, the more stable and less risky the coin is.
UDST
The chart above shows the market capitalization for USDT, which is currently over 100 billion dollars. A large market cap like this indicates greater stability.
USDC
From the chart above, the market capitalization for USDC is just above 30 billion dollars.
DAI
Dai Market Cap is just above $5 billion.
Based on Decentralization
The safest type of stablecoin is usually the fully decentralized one.
- USDT is not decentralized. It is controlled by the company, Tether Holdings.
- USDC is also not decentralized. It is controlled by the company Circle.
- DAI is fully decentralized as it runs on a smart contract program. This eliminates a central point of control. However, since it is backed by other cryptocurrencies, it is still dependent on the stability on the crypto market
Based on Reserves Transparency
- USDT: This is not the best when it comes to reserve transparency. Tether Holdings claims that every USDT is fully backed, however, there has been no attestation to that.
- USDC: USDC is quite assuring in terms of transparency. The Circle company publishes monthly audit reports to show the reserves.
- DAI: Doesn’t require the same level of transparency as it’s not controlled by a central entity. However, its value depends on the stability of the cryptocurrencies backing it.
There is not a single “safest” stablecoin. Each has its advantages and risks.
USDC might appear the most balanced based on this analysis, followed by DAI, but further research is crucial before making any investment decisions.
Conclusion
Stablecoins have brought much-needed stability to the crypto market and helped drive mainstream adoption.
Stablecoins has provided a reliable and stable alternative to traditional cryptocurrencies, enabling users to transact, store value, and engage in DeFi activities with reduced exposure to price fluctuations.
However, it is important to weigh the pros and cons when choosing stablecoins to invest in.
My name is Tomi Tom and I am a Web3 content writer. Feel free to reach out to me on X(Twitter) and LinkedIn.
