Why Over-Collateral Puts the Stability Back Into Stablecoins

Those that were hoping the global economy would finally return to normal in 2022 have been forced to rethink their optimism. Supply chain disruptions, the war in Eastern Europe, inflation, and higher interest rates are indications that we are on the edge of falling into a deep recession or even depression.

Stablecoins, considered the answer to secure money’s value and hedge against inflation while maintaining liquidity, have shown some alarming “instability” with the recent collapse of Terra Luna.

However, reports of an impending depression and the death of stablecoins are still premature.

How Stablecoins Help Overcome Inflation and Recession

A recession is a downtrend in the economy measured by negative gross domestic product growth. While a recession can be uncomfortable for our finances and savings, they are a normal part of the economic cycle. The US has already experienced 14 recessions in the last 100 years, and a vast majority of consumers haven’t even noticed.

Despite all the warning signs, experts say the economy won’t fall into another Great Depression. However, something we can all agree on is the fact that fiat currencies are designed to lose value over time.

On the other hand, stablecoins may be the answer to preserving the value of money without sacrificing the ability to make transactions, as opposed to traditional long-term investments. Stablecoins are pegged to other real fiat currencies or assets like gold. Unlike BTC or ETH, which are good for long-term investments, stablecoins can be used as a credible medium of exchange.

Reasons to use stablecoins as an anti-inflation measure:

• Lower transaction costs for international trade and faster processing speeds than the traditional banking system.
• If you mint them as a debt to yourself, inflation then pays off your debt.
• Ease of access — stablecoins are bought and sold through an app.
• Resistant to the ill effects of inflation, especially in developing countries.
• Bigger collateral yields — by putting stablecoins into yield farming, it is possible to offset inflation.

There are four primary stablecoin collateral types: fiat-backed, crypto-backed, commodity-backed, and algorithmic.

The best way for people to use inflation in their favor is to mint or borrow stablecoins within DeFi protocols at fixed interest or even at zero interest. Stablecoins can then deliver returns through DeFi lending while inflation devalues the debt you took out to mint them in the first place.

When used for minting within DeFi protocols like TheStandard.io, stablecoins can help offset inflation’s negative effects as the debt balance is also devalued by inflation. However, by their nature, stablecoins are prone to inflation, just like fiat money.

The Risks of “Instability”

It seems strange even to discuss the stability of stablecoins. However, as with any financial venture, risks do exist. Thus, users must question how the stablecoin’s peg is maintained to understand the possibilities and limitations of managing and ensuring the stability of a stablecoin.

In market volatility periods, the pegging methodology's robustness can be compromised. Correspondingly, this affects the collateral crypto value of a stablecoin and the consumers and investors who are actively using it to make payments. So the extent to which the peg can be maintained is crucial for the stability of a stablecoin.

In May 2022, TerraUSD (UST) dropped to $0.05. How was it possible for the third-largest stablecoin by market cap to lose around 95 percent of its value within a matter of days?

To briefly sum up the event, Terra Luna’s collapse was linked to the value of the collateralization (which determined the coin’s value). However, the true base of a stablecoin has to be above suspicion and beyond questioning. In the case of Terra Luna, its value was not ensured by a proper peg, leading to doubts piling up over investor confidence in the coin.

How can Over-collateralization Help?

The over-collateralization of stablecoins is a provision of collateral assets worth more than enough to cover potential losses in case of default. It involves having an asset as collateral on a loan where the asset’s value exceeds the loan’s value.

An over-collateralized stablecoin will have a large number of cryptocurrency tokens that act as a reserve for issuing a lower number of stablecoins. This creates something like a buffer against price fluctuations.

TheStandard.io, for example, allows users to take out a fixed 0% interest loan in sEURO. Anyone can put ETH, Bitcoin, or tokenized gold into a smart vault, borrow money for what they need at 0% interest, and in the event of inflation devaluing the loan — they’ll have less to pay back. Since a smart contract validates the loan, no government or bank can adjust the debt to match inflation.

Remember, a real stablecoin needs real value backing it. TheStandard.io provides this backing along with all the anti-inflation benefits that stablecoins offer.