Stablecoins are cryptocurrencies that have their price pegged to some other asset. This can be a fiat currency such as the U.S. dollar or a commodity such as gold. There are two main ways the issuer can maintain this peg: via a known ratio of circulating supply to reserve assets, or by using crypto-native smart contracts.
Overview for Fast Readers
- Stablecoins offer price stability in an often volatile market
- Centralized and decentralized stablecoins exist, each with their own unique benefits and risks
- Despite efforts from legislators to regulate stablecoins, there are exciting new developments bringing more transparency to the space
Understanding Different Types of Stablecoins
There are two major types of stablecoins:
- Those collateralized by 1:1 reserves of assets held by a centralized issuer
- Those that maintain this peg by using decentralized smart contracts
Fiat-backed stablecoins such as Tether (USDT), USD Coin (USDC), and True USD (TUSD), as well as commodity-backed stablecoins such as PAX Gold (PAXG) and Tether Gold (XAUT) are examples of the former. Each USDT token is redeemable for a US dollar, and each PAXG or XAUT token is redeemable for an ounce of gold.
For new stablecoins of this type to be minted the issuer must put into reserve an equal amount of the asset to which the stablecoin’s price is pegged.
(Minting is the creation of new money, just like a government mints new fiat currency).
For example, if you want to create 100,000 new USDC stablecoins you have to send $100,000 to Circle, the stablecoin’s issuer. Circle then locks up the U.S. dollars in a bank account and mints a corresponding amount of USDC.
To redeem your 100,000 USDC for $100,000, you send the USDC tokens to Circle who then burns (i.e. destroys) them and returns your $100,000.
Maker’s Dai – which maintains a dynamic peg to the value of the U.S. dollar – is the main example of the second type of decentralized, crypto-backed stablecoin. Instead of sending U.S. dollars to Maker in order to mint more Dai, users lock up crypto in what’s called a collateralized debt position (CDP).
This CDP must be over-collateralized, meaning you have to deposit collateral worth at least 150% of the Dai you wish to mint and withdraw.
This is necessary because the price of the collateral is unrelated to the price of the target asset, meaning large fluctuations between the two could occur. Over-collateralization ensures that the value of the collateral is enough to cover the value of the loan drawn while taking into account the natural volatility of cryptocurrency markets.
In the event of a large enough price movement that ends up sinking the value of the collateral below that of the loan, there is a liquidation mechanism to ensure that each Dai in circulation is sufficiently backed.
A much smaller third category of stablecoins includes non-collateralized or algorithmic stablecoins. These coins use techniques such as rebalancing the circulating supply in order to keep price steady.
What are the Use-Cases for Stablecoins?
The price stability of stablecoins allows traders and investors to weather market volatility, benefit from increased liquidity, and cash out of positions while keeping their capital within the crypto ecosystem.
Stablecoins came about due to a number of features of cryptocurrency markets in their early days:
- Lack of fiat on/off-ramps
Early Bitcoin exchanges had nowhere near the liquidity of today, where a slow day sees multiple billions of dollars’ worth of Bitcoin traded. This resulted in large bid-ask spreads, with customers paying the price.
Illiquid markets are also more subject to manipulation and extreme volatility.
One reason for this illiquidity was the lack of fiat on-ramps. It was often very difficult to convert your fiat currency to cryptocurrency. Unbanked exchanges were unable to offer crypto/fiat pairs, leaving stablecoin issuers as some of the most convenient on-ramps.
Stablecoins also allow traders to exit positions much more quickly. Before the advent of stablecoins, a trader would have to sell to fiat – often a cumbersome and time consuming process – or convert to another crypto-asset which may have only slightly lower volatility, if any at all.
Commodity-backed stablecoins allow users to maintain their purchasing power with regard to gold, silver, or some other asset, without having to cash out of cryptocurrency as a whole and lose access to the asset class’s many benefits.
Disadvantages of Stablecoins
The disadvantages of stablecoins are not unique to their purpose, but rather to the centralized or decentralized model by which they are issued.
Censorship of centralized stablecoins is one major disadvantage. Since 2017, Tether has blacklisted over 37 addresses after requests from U.S. law enforcement. The largest address held $4.56 million, all of which is now unspendable.
The issuer of USDC – Circle – has also blacklisted addresses. Circle also states in their terms of service that they will not serve residents of nations under U.S. economic sanctions.
Another disadvantage to the centralized model is its lack of trustlessness. While some stablecoin issuers are more transparent than others, users are still often left to trust that the issuer does in fact hold sufficient reserves for each stablecoin in circulation.
Circle and Gemini release audits of their reserve bank accounts, though there are ongoing concerns about the degree to which Tether is actually backed by U.S. dollars.
However, there are alternatives to this problem that utilize open-source smart contracts. TrustToken – the issuer of True USD (TUSD) – recently unveiled an innovative and trustless solution to the proof of reserve problem.
In partnership with Chainlink’s on-chain decentralized oracles and the major U.S. accounting firm Armanino, TrueToken allows anyone to verify the U.S. dollar reserves it holds and compare this to the circulating supply of TUSD.
Decentralized stablecoins avoid proof of reserve transparency issues and are censorship-resistant. Yet the smart contract technology that underpins these stablecoins is still relatively new. Although Dai has not suffered any issues so far, contract bugs are the main attack vector for decentralized stablecoins.
One thing to keep in mind when holding stablecoins is the real likelihood of their regulation by the U.S. or other governments. Legislation was recently introduced into Congress that aims to strictly regulate the stablecoin industry.
The Stablecoin Tethering and Bank Licensing Enforcement (STABLE) Act would require issuers to obtain a bank charter, obtain approval from the Federal Reserve, FDIC, and state authorities six months before issuance, and maintain reserves at the Federal Reserve to ensure that all stablecoins can be readily converted into United States dollars on demand.
Any stablecoins that cannot or do not comply would likely be banned in the U.S. if this bill were to pass.
There are more than 200 different stablecoin projects out there, with 147 released in 2018 alone.
Issuers can keep stablecoins stable by maintaining a 1:1 reserve of the asset to which the stablecoin is pegged, or via over-collateralization and liquidation of unrelated assets.
Bitcoin is not a stablecoin. It is not pegged to any other asset; it is completely independent. The price of Bitcoin is the price that the market values it at.
The best stablecoin depends on your needs. With so many on the market, you can pick out the features that are important to you.
If you’re looking for liquidity above all else, Tether is at the top of the list.
If you’re happy to compromise a little on liquidity for the benefit of transparently-audited reserves, USDC may be the coin for you. True USD is also notable for its trustless proof of reserves.
Dai is unique in its decentralized model and has a market capitalization of over $1 billion, making it an attractive option for crypto-purists or those who want to benefit from posting collateral in crypto, rather than dollars.
Reminder: This is not financial advice. Always do your own due diligence before investing.
Dai and TUSD both can lay claim to being the safest stablecoin. The choice boils down to whether you prefer to trust decentralized smart contracts with cryptocurrency as collateral or real-time audited USD reserves.
Stablecoins offer many benefits to traders and investors looking to beat short-term volatility. They have helped to greatly increase liquidity in crypto markets, and there are a range of centralized and decentralized stablecoins out there to suit different needs.