Stablecoin: All About this Type of Cryptocurrency

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Stablecoin: All About this Type of Cryptocurrency
Stablecoin: All About this Type of Cryptocurrency

Stablecoins are a type of cryptocurrency whose purpose is to follow the price of an asset such as a fiat currency like the dollar and euro or other tangible assets. Their aim is to bring stability and confidence to the market. Stablecoins have managed to establish themselves as a major pillar of the industry over the years, so let’s discover together the ins and outs as well as the different approaches that stablecoins take.

What is a Stablecoin?

One of the biggest impediments to the adoption of cryptocurrencies has always been the high volatility of this market. This is where stablecoins come in.

A stablecoin is a type of cryptocurrency that tries to bring stability to this very volatile market. It combines the advantages of a cryptocurrency with the price stability of traditional fiat currencies.

It does this by following the course of a traditional finance asset. In the majority of cases, this asset is a fiat currency, the dollar, but there are some that follow the rate of the euro, the Japanese yen or even the pound sterling.

It can also follow the price of various more tangible assets such as gold, oil or even a real estate portfolio.

Many stablecoins exist, and we can classify them into three main categories, which will be detailed in this article:

  • Centralized stablecoins (off-chain);
  • Decentralized stablecoins backed by other cryptocurrencies (on-chain);
  • Algorithmic decentralized stablecoins.

The value of a stablecoin is supposed to remain constantly equal to the asset it is backed by. In principle, a stablecoin following the price of the dollar should always be worth 1 dollar, regardless of the value of Bitcoin or the state of the market as a whole.

What are the Most Famous Stablecoins?

Many stablecoins have become staples in the cryptocurrency ecosystem, occupying many places in the ranking of the most capitalized crypto assets.

Here are the main ones at the time of writing these lines (April 2022), along with their capitalisation:

  • Tether (USDT), the best known and most used stablecoin: 66 billion dollars;
  • USD Coin (USDC): $55.8 billion;
  • Binance USD (BUSD), the stablecoin of the Binance platform: 17.5 billion dollars;
  • Dai (DAI): $6.9 billion;
  • TrueUSD (TUSD): $1.2 billion;
  • Neutrino USD (USDN): $760 million;
  • Pax Dollar (USDP): $944 million.

The ranking is largely dominated by USDT, USDC and BUSD, which are all 3 centralized stablecoins. The BUSD is, however, closely followed by the UST of the Terra blockchain, a decentralized stablecoin which could catch up with its centralized competitors in the near future.

Why were Stablecoins Created?

You know that originally, to own cryptocurrency, you first had to get Bitcoin or Ethereum from sites like Coinbase. It was then necessary to transfer these cryptocurrencies to exchanges such as Binance.

When you wanted to recover your profits (if you have any), you had to convert those cryptocurrencies back to BTC  before you could finally secure the fiat currency profits in your bank account.

In the same way, it was impossible to keep fiat on the exchanges to take advantage of an opportunity that could arise since it would have been necessary to make transfers to sites that allow the fiat/crypto conversion.

This was very tedious since it involved several transactions and intermediaries, with the fees that are associated with such actions.

This is how the cryptocurrency industry worked before the appearance of the first stablecoin in 2014, Tether (USDT). Gradually, other stablecoins appeared on the market, and exchanges listed more and more pairs, including stablecoins, as they watched the demand for them increase.

Since then, all exchanges have at least one stablecoin that can play the role of money (fiat). So, if you want to have some of your money in dollars, you can buy a stablecoin that will always (in theory!) want 1 dollar.

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Figure 1: Stablecoin, 1 token = 1 dollar (USDC)

Thanks to this system, no more laborious and expensive transfers between exchanges. You can convert part of your cryptocurrencies instantly and inexpensively into an asset that will “always” keep a fixed value in relation to the dollar.

What can be done more concretely with a stablecoin?

  • Escape the volatility of the cryptocurrency market;
  • Take direct advantage of investment opportunities  when they arise;
  • Allows you to transfer assets anywhere in the world, without loss of value, quickly and inexpensively, all without having a bank account;
  • It is one of the entry points into the world of decentralized finance (DeFi);
  • Generate interest by staking it, as most DeFi platforms offer a higher return than banks.

Stablecoins have established themselves very quickly in the industry, as evidenced in particular by the transaction volume they generate: they represent 80% of all transaction volume carried out in spot trading. By far, the most volume-generating cryptocurrency on the market is the stablecoin Tether (USDT).

This highlights the success and weight of this type of cryptocurrency in the industry.

The Different Types of Stablecoins

There are many cryptocurrencies that claim to be stablecoins. However, given the capitalization of some of them, we can retain a few that we classify in mainly three categories, with different types of stablecoins in their approaches that we will detail here.

Before going into the technical details of how the 3 types of stablecoins work, here is a summary of their main differences:

Centralized stablecoin   Decentralized stablecoin   Algorithmic decentralized stablecoin
Collateralization           fiat currencyCryptocurrenciesAlgorithm and cryptocurrencies
Main riskNo real collateralizationRisk of instabilityRisk of instability
TransparencyAt the discretion of the companyTotalTotal
TechnologySimplisticComplexVery complex
Censorship ResistanceNoneGovernance decisionGovernance decision

Centralized Stablecoins (off-chain)

This type of stablecoin has always been the industry standard, and it continues as of this writing.

These are, therefore, stablecoins whose value of the tokens is collateralized by off-chain assets, whether by the issuing company’s dollar reserves, bonds or commercial paper. That is, for 1 token of a centralized stablecoin, the issuing company is supposed to hold the equivalent in fiat. It will be mostly dollars that we will talk about since the majority of stablecoins follow the price of the dollar.

The stability and value of these stablecoins are therefore guaranteed by a rate of 1 token for 1 dollar, the tokens being the debts and the dollars being the assets.

The circulating supply of centralized stablecoins works through a mint and buyback mechanism. To create a new token, the dollar equivalent is theoretically deposited in the bank to guarantee its value. Conversely, a burn of the token is carried out when one recovers the equivalent in dollars from the bank account.

These fiat currencies are then used by the company behind the centralized stablecoin to generate interest and cover the charges necessary to operate the stablecoin, as well as earn profits from it.

The Strong Points

  • It is the first model of stablecoin introduced on the market, benefiting from the advantage of the first mover;
  • Proven rugged design;
  • Guaranteed by assets themselves relatively stable and guaranteed by governments;
  • Relatively simple to understand.

The Weak Spots

  • High costs to comply with financial regulations;
  • Sensitive to censorship due to their centralized nature, they are an easy target for financial regulators;
  • A lack of transparency on reserves, particularly in terms of the composition of the underlying assets;
  • High audit costs;
  • Strong trust is required on the part of the user in a centralized private entity, which contradicts the very nature of cryptocurrencies.

Here are some of the highest valued centralized stablecoins in the market in detail.

Tether (USDT)

This stablecoin is the first introduced on the market and is the most used to date; in other words, it is the one that generates the most transaction volume on the market. This partly explains the constant pressure on this stablecoin to audit the company’s reserves and the various controversies associated with it. Available on the vast majority of exchanges, this stablecoin is backed by Tether Limited, which is a company controlled by the owners of the Bitfinex exchange.

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USDT Logo

The USD Coin (USDC)

The Center Consortium, founded by Coinbase and Circle, is behind this centralized stablecoin. USDC is notably the dominant stablecoin in decenttralized finance (DeFi) in terms of total value locked (TVL).

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USDC Logo

Binance USD (BUSD)

This stablecoin is founded by Binance and Paxos. It is approved by the New York State Department of Financial Services (NYDFS), something rare enough to be underlined. Paxos is the custodian, which means that the company takes care of guaranteeing the value of the BUSD with reserves in dollars and treasury bills.

These stablecoins are all dollar-backed. By visiting their sites, it is possible to follow the reports (usually monthly) of the reserves they have.

There are many other such stablecoins like TrueUSD (TUSD) or Pax Dollar (USDP). However, there are also stablecoins backed by physical assets such as gold with PAX Gold (PAXG) or Tether Gold (XAUt).

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BUSD logo, by Cryptoast

Decentralized Stablecoins Backed by Other Cryptocurrencies (on-chain)

This type of stablecoin is backed by other cryptocurrencies, which means that the value of the tokens is collateralized by on-chain assets instead of being backed by off-chain fiat currencies.

These stablecoins can therefore be guaranteed by assets that are themselves decentralized, which is a major difference from centralized stablecoins. Another major difference is at the governance level since no centralized entity manages the stablecoin.

The highest valued stablecoin in this category is DAI.

Dai (DAI)

A Decentralized Autonomous Organization (DAO) named MakerDAO governs this stablecoin. DAI is fully backed by other cryptocurrencies, namely USDC (57%), Ether (19%), Wrapped Bitcoin (6%) and many others (data as of March 2022).

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Figure 2: DAI Reserves (March 2022)

It is worth noting that the DAI, although having the characteristics of a decentralized stablecoin, is notably guaranteed at 57% by the USDC, which is itself a centralized stablecoin.

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DAI Logo

Over-collateralization

The principle of guaranteeing value also works differently from a centralized stablecoin.

Indeed, to mint a token, it is often necessary to allocate as collateral a value greater than the equivalent in another cryptocurrency. This is called over-collateralization. This is to protect the value of the stablecoin in the event of a sudden drop in the assets it is backed by since cryptocurrencies are much more volatile than fiat currencies.

Let’s take the  DAI example again. It is necessary to allocate as collateral 150% of the desired mint value of this stablecoin. That is to say; if you want to mint 1,000 DAI tokens, you need to put 1,500 dollars in Ether, USDC or other equivalent as collateral. What is called the collateralization ratio is 150% for the case of DAI.

Each stablecoin has its own rules regarding this ratio, and it can be modified by governance votes.

There are other such stablecoins, which are mostly popping up in decentralized finance (DeFi) protocols.

For example, the fUSD of the Fantom protocol provides access to Fantom Finance, and it has a collateralization ratio of 500%.

Algorithmic Decentralized Stablecoins

The algorithmic decentralized stablecoin uses complicated and highly sophisticated mechanisms by manipulating the circulating supply to achieve stability. This one is not backed by an asset like the other two types of stablecoins are. This is a crucial difference, and that is why it is very complicated to manage to create one that is reliable.

Concretely, the protocol of an algorithmic stablecoin acts as a central bank since it increases or decreases the supply in circulation by issuing tokens on the market or buying them back to burn them.

These mint and burn actions are defined by rules previously written into smart contracts that can be audited anytime since they are open source. Generally, these rules can only be changed by governance, i.e. through the votes of network participants, which makes it the most decentralized type of stablecoin in existence.

Typically, an algorithmic stablecoin has a structure with a two-cryptocurrency system. One maintains the exchange rate to the dollar (the stablecoin), and the other is used to absorb market volatility.

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Figure 3: Dual cryptocurrency system with UST (stablecoin) and LUNA (absorbs volatility)

This is the case, for example, of TerraUSD (UST) and LUNA, which images this relationship between the two currencies with the Moon (LUNA), which stabilizes the rotation of the Earth (UST).

Finally, an oracle like Chainlink (LINK) is usually used by the algorithmic stablecoin to allow the protocol to understand what exchange rate it should be pegged to. Some can also use a decentralized oracle: the validators of the network vote for what they consider to be the true exchange rate every X blocks.

The algorithmic stablecoin is therefore completely apart since it works in a radically different way from other stablecoins, relying solely on its algorithm, making it completely decentralized.

The most popular successful example of this type of stablecoin comes from the Terra protocol and its stablecoin TerraUSD (UST).

UST being a  decentralized algorithmic stablecoin, it is stabilized by another cryptocurrency native to the Terra protocol, LUNA, which adjusts its circulating supply in order to increase or decrease that of UST and thus guarantee the stability of its price.

There are few such stablecoins, and many of them have failed in the past. It should be noted that there are also algorithmic stablecoins that could be described as hybrid since they are partly collateralized by other assets. This is notably the case of the  FRAX.

We have grouped the strengths and weaknesses of the last two types of stablecoins together.

The Strong Points

  • Total transparency since it is possible to consult in real-time all the operations in the ledger of the blockchain, as well as the value of the assets which guarantee or stabilize the price of the stablecoin;
  • Much more resistant to censorship due to its decentralized nature, which is much more in harmony with the original philosophy of cryptocurrencies;
  • No need to trust a centralized private entity.

The Weak Spots

  • Risk of increased instability since decentralized stablecoins are generally backed or stabilized by cryptocurrencies themselves which may be subject to high volatility;
  • Extremely complicated to set up and requires high adoption to fully function, more so for algorithmic stablecoins;
  • More sophisticated technology is, therefore, complicated to assimilate for most neophytes, especially for algorithmic stablecoins.

The Stability of Stablecoins

All stablecoins following the price of the dollar have a theoretical value of 1 dollar each; however, by analyzing the price curve of these different tokens, we realize that the prices are not always equal to 1 dollar. These slight upward and downward variations have a negligible impact, which is completely normal.

To explain very simply this difference in price compared to the theoretical price, we can say that it is mainly due to an adjustment effect when there is a strong demand or a strong supply. Put, if the price is too high, people will sell, if the price is too low, people will buy.

But there are many cases in which stablecoins have lost this stability with worrying magnitude—some examples of the best-known cases in the industry.

In October 2018, Tether (USDT) fell to $0.92. This was due to a lack of investor confidence following a controversy over the lack of transparency on USDT reserves. The direct consequence of this fall was a general rise in other assets as investors traded their USDT for BTC or other stablecoins.

In May 2021, the Terra USD (UST) fell to $0.90 mainly due to the fall in the price of LUNA and cascading liquidations on the Anchor protocol, a decentralized application (dApp) of the Terra network.

Almost all stablecoins have suffered a momentary drop in price at one time or another following an incident; however, like the two examples above, these have recovered their exchange rates very quickly. Others had much more dramatic consequences, like the hybrid algorithmic stablecoin named IRON in June 2021.

The latter had 75% of its value guaranteed by the USDC and 25% by TITAN, a token supposed to adjust its supply in circulation to stabilize the value of IRON. The problem with this stablecoin lay in its Tokenomics and, therefore, the economic incentives necessary for the proper functioning of IRON. Indeed, the price of TITAN was excessively high due to speculation. Investors began to take their profits which triggered very high volatility due to the lack of liquidity, which caused a cascade of panic selling and, therefore, a lot of arbitrage opportunities.

A sudden fall in the price of the TITAN directly affects the exchange rate of the IRON since it is stabilized at 25% by the TITAN. To solve this, it took mint more TITAN, which led to inflation and further accelerated the fall in the price of TITAN. IRON’s price could not be sustained, and TITAN eventually fell to 0.

An algorithmic stablecoin survives solely on its code, so there was no way to stop this downward spiral that led to the failure of a previously $2 billion stablecoin. The very design of the IRON is in question.

We see here that it happens that a stablecoin fails to maintain its parity with the dollar, whether it is due to a lack of confidence on the part of investors, because of the high volatility of the market or because of errors in the design of the stablecoin itself.

This is why it is necessary to take precautions and preferably to trust more stablecoins that have been able to prove themselves.

Conclusion on Stablecoins

So here we are at the end of our article on the famous stablecoins. We hope this will help you better understand what it is and the logic behind such a crypto-asset that has proven to be a major pillar of the cryptocurrency industry.

Stablecoins offer many advantages in the cryptocurrency industry, as we have seen. The most obvious is to use it as a safe haven. This can be very useful if you feel prices are falling and want to exit the market for a few hours or days.

Finally, a small aside on central bank digital currencies (CBDCs), which should not be confused with stablecoins. Indeed, although potentially using blockchain technology, CBDCs are just digital versions of fiat currencies, backed by countries’ reserve assets and completely regulated and controlled by central banks.