Stablecoins are now known to be not-so-stable coins. They have been in news for all the wrong reasons for the last two weeks when the global cryptocurrency market crashed massively. Several top crypto prices, including that of Bitcoin, dropped to new lows in 2022.
Cryptocurrencies are known for their extreme volatility and we have been witness to such crashes since the inception of these digital currencies. But what certainly shocked everyone when stablecoins faced a massive drop in prices.
What are stablecoins?
Stablecoins, as the name implies, are crypto assets that have a fixed value and are usually pegged to an asset that has a stable price, such as leading fiat currency like the U.S. dollar or exchange-traded commodities such as precious metals, etc.
The first coin was issued in 2014. The purpose of these coins is to serve as an antidote to price volatility in the cryptocurrency markets.
Various types of stablecoins
There are primarily four kinds of stablecoins:
- Fiat-backed stablecoins
Such types of stablecoin are the most trustworthy since they are pegged against the fiat currencies such as the U.S. Dollar, Euro, or Chinese Yuan, which are kept as collateral. In other words, such stablecoins maintain reserves in fiat currencies. Fiat-backed stablecoins often have one dollar in reserve for every token in circulation — either in cash or cash equivalents.
The largest stablecoin, Tether (USDT), has a market cap of around $80 billion, having surged from just $4.1 billion in 2020. Tether tokens are assets that move across the blockchain just as quickly as other digital currencies. All Tether tokens are pegged at 1-to-1 with a matching fiat currency (e.g., 1 USD₮ = 1 USD) and are backed 100% by Tether’s reserves.
Another stablecoin, USD Coin, has the complete backing of the U.S. Dollar. As per its website, the total USDC in circulation is 53.2 Billion as of May 23, 2022. The particular highlight of the USD Coin is its identity as the official stablecoin for Coinbase. and has been verified by the founding company, Circle.
- Crypto assets – backed stablecoins
These kinds of stablecoins are backed by cryptocurrencies acting as collateral. As the crypto market is highly volatile, crypto-backed stablecoins usually over-collateralize the reserves as a measure against price swings.
There are two ways stablecoins are being managed:
– Use smart contracts to manage minting and burning. This makes the process transparent and reliable as users can independently audit the contracts.
– Run by Decentralized Autonomous Organizations (DAOs), where the community can vote for changes in the project. The users can directly participate or just trust the DAO to make the best decisions.
Since these are dependent on highly complex technological processes, they are very different from the fiat-collateralized kind and introduce more significant risks of exploits due to bugs in the smart contract code.
Dai stablecoin is an example of a cryptocurrency backed type. It is on the Ethereum blockchain, which aims to keep its value as close to one USD as possible through a system of smart contracts and the decentralized participants that those contracts incentivize to perform maintenance and governance.
Wrapped Bitcoin (WBTC) is an example. It is an ERC-20 token that represents Bitcoin (BTC) on the Ethereum blockchain. 1 Bitcoin can be converted to 1 Wrapped Bitcoin and vice-versa through a WBTC partner.
- Algorithmic stablecoins
Algorithmic stablecoins rely on complex algorithms to keep their prices stable, effectively balancing funds held on the blockchain via smart contracts with supply and demand to maintain price stability. Ideally, the algorithmic stablecoins function as real central banks, defending their currency’s peg in the market. The algorithmic stablecoin system reduces the token supply if the price falls below the fiat currency it tracks. It is done by locking staking, burning, or buy-backs. If the price surpasses the value of the fiat currency, new tokens enter into circulation to reduce the stablecoin’s value.
UST is an “algorithmic” stablecoin. It functions on a complex set of code, coupled with a supporting token called luna, to balance supply and demand and stabilize the price.
- Stablecoins backed by Commodity
There is another type of Stablecoins that is pegged against commodities. They have the backing of real-world assets that may include real estate or gold. That give these kinds of coin absolute stability. However, such commodities can fluctuate in price and therefore have the potential to lose value. There are other issues also with such kinds of coins. Holding physical commodities like gold and silver isn’t always a realistic proposition.
Two of the most liquid gold-backed stablecoins are Tether Gold (XAUT) and Paxos Gold (PAXG).
Use of Stablecoins
Stablecoins are used for day-to-day payments. Compared to cryptocurrencies, which are known for their volatility, businesses and online platforms accept them as a mode of payment. Stablecoins are the best digital currency for crypto exchanges and the most accepted ones. Stablecoins are on blockchain and hence are used for overseas payment without much transfer fees and much quicker. Additionally, traders and investors use them to hedge their portfolios by allocating a certain percentage of their portfolio to stablecoins to reduce overall risk.