Stablecoins | What are they? Will USDC and USDT suffer the same fate as UST?
The world of crypto is surrounded by relentless warnings of danger.
You’ll inevitably hear about it crashing and collapsing, leaving investors ruined and down bad. It’s all a reminder that cryptocurrencies are highly speculative and extremely volatile. And that prices can fall just as quickly as they rise — even for the largest cryptocurrencies. Most recently, Bitcoin and Ethereum both dropped more than 75% from their 2021 peaks.
This is problematic.
Why would anyone want to transact or store their wealth in currencies that fluctuate so wildly in value? It’s this exact sentiment that’s preventing large-scale adoption of crypto from businesses and consumers like yourself. You might think — maybe that’s for the better. I’d rather rely on the cash in my wallet and bank account.
But there are a lot of benefits with crypto.
With crypto, we have an opportunity to create a cheaper and more efficient financial system that’s globally accessible. However, these benefits can only scale if we can remove crypto’s volatility problem and have a reliable, stable currency.
That’s where stablecoins come in.
What are stablecoins?
Stablecoins are a token whose value is pegged to another asset, most commonly the USD. It sounds obvious, but the whole point of a stablecoin is to maintain a stable price. By doing so, it becomes a more reliable store of value and medium of exchange, compared to other cryptocurrencies.
You can think of it as a digital-only form of cash which lets you leverage the benefits of crypto infrastructure. For example, with stablecoins:
- users can send money internationally, at any time, without needing to pay high fees or wait for banks to open
- businesses can receive payments from customers instantly, while avoiding transaction fees
- even those unbanked can participate in the financial system
The different types of stablecoins
While we use stablecoins as a blanket term, they’re not all the same. Different types have unique characteristics and their own sets of risk. They can be:
Firstly, fiat-backed stablecoins, such as USD Coin (USDC), Tether (USDT) and Euro Coin (EUROC), are backed by reserves of fiat currencies. This means that for each unit of a stablecoin that’s issued, some amount of cash or cash equivalent is stored away in a financial institution.
For example, there’s ~$55bn USDC in circulation and ~$55bn of reserves held as cash & short-term U.S. Treasuries. Since USDC is backed on a 1:1 basis, 1 USDC can always be redeemed for 1 USD. It’s fully collateralised.
The downside of fiat-backed stablecoins is a lack of transparency around these funds, and the risk that comes with relying on centralised entities. With USDC, these funds are held by Circle, the company which issues USDC. However, their bank balances aren’t publicly viewable.
So how do we verify that they actually have the full $55bn? Unfortunately we can’t know for sure. The best we can do is trust Circle’s monthly & annual reports, and their independent auditors.
As an alternative, crypto-backed stablecoins, such as Dai, are created by locking up crypto assets as collateral. Unlike fiat-backed stablecoins, this process happens through programs on the blockchain called smart contracts. This means it’s completely decentralised and transparent — anyone can verify the supply of Dai and the value of its collateral.
But as we know, crypto assets are volatile. How do we make sure stablecoins like Dai are dependable and sufficiently collateralised? One easy fix is to require them to be overcollateralised. For example, Dai’s smart contract requires each $1 of Dai to be backed by at least $1.70 of ETH.
The downside is that this isn’t capital efficient, since a large amount of crypto assets need to be locked away.
Algorithmic stablecoins such as TerraUSD (UST) have attempted to address this capital efficiency problem by either being undercollateralised or not collateralised at all. Instead, they’re designed to maintain a stable value by relying on the faith of the market, and demand/supply dynamics.
This is risky and hard to do which is why UST lost its peg to the USD in May 2022. At a high level, the idea behind UST was that whenever its value rose above or fell below $1, an arbitrage opportunity would be created. As the market exploited those opportunities for a profit, the shifts in demand and supply of UST would drive the price back to $1.
However, in May 2022, the market stopped believing that 1 UST could be redeemed for $1. Instead of taking advantage of the “arbitrage” opportunity, demand for UST fell, along with its price. With continually falling market confidence, UST spiralled down towards 0.
It’s important to recognise that the collapse of UST isn’t representative of all stablecoins. While UST relied on the faith and behaviours of the market to maintain its stable value, fiat and crypto-backed stablecoins are collateralised with real assets. Because of this, stablecoins like USDC, USDT and Dai have been able to maintain their peg to the USD over the years.
The future of stablecoins
Despite the collapse of UST, It’s likely we’ll continue to see new stablecoin experiments. For example, Frax has created a semi-algorithmic stablecoin that’s partially backed by crypto assets. It combines the capital efficiency of algorithmic stablecoins, with the security of crypto-based stablecoins.
More importantly, we’re starting to see stablecoins enter mainstream usage. For example, Stripe has enabled payments with USDC while Shopify lets their merchants accept crypto payments. By removing the volatility of crypto, stablecoins have an opportunity to unlock the benefits of blockchain technologies for our day-to-day lives, at scale.
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