Stablecoins are those cryptocurrencies whose value is fixed and are often pegged to a traditional asset such as the US Dollar, Euro, Gold, or even Crude Oil. These coins are mostly used as a reserve asset but are also widely used to settle transactions using blockchain technology.
Popular stablecoins include USDT, USDC, BUSD and the most recently launched PayPal’s PYUSD. These cryptocurrencies form the backbone of several activities such as store of value, trading and settlement of dues.
In this article we will discuss stablecoins, their types, usage, advantages, disadvantages, regulations around them and the technology behind them.
Table of Contents
Definition of a Stablecoin
Any cryptocurrency that has a stable value can be called as a stablecoin. Generally, these cryptocurrencies have their value pegged to a certain financial asset such as fiat currency(USD, GBP), commodity (Gold, Crude Oil), or any other asset.
However, despite being called stablecoins, their value might fluctuate if the value of pegged asset fluctuates too. For example, as the US Dollar depreciates, you would have to pay less when buying a USD based stablecoin like USDT.
Stablecoins are typically backed by currency or currency-equivalents. In the case of USDT, the largest stablecoin, it is backed by a mixture of US Treasury Bills, Loan Mortgages and cash (US Dollar).
The Need for a Stablecoin
The need for a stablecoin arises from the fact that most cryptocurrencies are highly volatile and cannot be used to store and preserve wealth. Stablecoins address this concern by providing almost zero volatility and helping in preserving asset value.
Types of Stablecoins
There are several types of stablecoins depending upon what backs them or how they maintain their value.
1. Collateralized Stablecoins
Collateralized stablecoins are backed by some type of collateral such as US Dollar, Gold or Euro. These collaterals make the cryptocurrency valuable because each coin can be redeemed for some backed asset or an equivalent amount of money.
The stablecoins which are backed by fiat money or fiat equivalents such as government bonds, treasury bills, etc., are called as fiat-backed stablecoins. A few examples of such stablecoins are:
- USDT by Tether
- USDC by Circle
- BUSD by Binance
Stablecoins can also be backed with collateral that contain a basket of other cryptocurrencies such as Bitcoin, Ethereum, or even stablecoins are called as Crypto-backed stablecoins. An example is:
- DAI, a stablecoin by MakerDAO.
2. Algorithmic Stablecoins
Algorithmic stablecoins are those which use some trading mechanism to balance their value. For example in Terra’s UST stablecoin, an excess of demand(which increases its value) would be countered by burning LUNA (Terra’s native crypto) and minting new UST that would absorb excess demand. Similarly, the fall in price of UST was countered by burning UST to gain LUNA. Therefore making the stablecoin balanced.
However, this delicate balance could go horribly wrong when there is an overwhelming amount of demand or supply.
A similar situation caused the collapse of UST and LUNA.
3. Rebase Stablecoins
Rebase stablecoins increase or decrease their supply using a reserve pool. When there is an excess demand, more stablecoins are released in the market and when there is a excess supply, they are bought back using the reserve or treasury funds of the maker.
Example of rebase stablecoin:
- Ampleforth (AMPL)
Usage and Their Advantages
The following usage and advantages are my personal experiences. There are other usages and advantages such as liquidity pools but I have left them out of this article because they are not used in our daily life.
1. Store of Value
Stablecoins are used to store value. Since their volatility is almost zero, they can be used to preserve your capital during a turbulent market. They also act as reserve currencies for providing collateral for crypto loans.
2. Settlement of Transactions
Many freelancers including me depend on stablecoins for faster and secure international payments. The reason to use stablecoins is that they are easy to transact, have a faster transaction time and have very less transaction costs as compared to fiat money.
I use PayPal for international billing which often takes 2 days for settlement of dues. Further, these transaction costs a high amount of fees. When I receive $265 for my content writing services, I only end up with $250, with $15 as transaction and forex costs.
The same transaction in stablecoins gets me $262 or more even on Ethereum blockchain. If I use the Tron or Solana blockchain, I pay less than $1 in fees. That’s a 15x reduction in charges.
3. Cryptocurrency Trading
Traders like me who often engage in crypto trading, need a base cryptocurrency as a stablecoin in a trading pair. This makes it easier for us to calculate and keep track of profits. If the base crypto in a trading pair is not a stablecoin it would be a nightmare to calculate profits and let alone do taxes on them. This is because both of them would change value from time to time.
Disadvantages, Risk, Controversies and Challenges
Every technology has its downsides. Here are a few downsides associated with Stablecoins and a few technological developments that pose challenged to a normal crypto user like you and me.
1. Risks in Stablecoins
Stablecoins can only save you from volatility risk. They themselves suffer from financial risk of collapse lie what happened with Terra’s UST.
There is also a risk of being undercollateralized where sufficient reserves are not maintained for each stablecoin. Such risks could trigger a sell-off like in the case of USDD and plummet the coin’s value. A de-peg resulting from such plummet could cause a further selloff and spiraling a fall in price.
2. PayPal’s PYUSD and its Controversy
On August 07, 2023, PayPal launched its stablecoin PYUSD on Ethereum. It immediately came under criticism for being able to freeze and erase funds from someone’s wallet.
However, to PayPal’s defense, it can be said that reversible transactions have been a core feature of PayPal and it is not surprising that it made its way into the PYUSD.
However, we feel that such reversible transactions could have been better implemented with technology. Forcing such technology on a stablecoins seems excessive.
1. The US Federal Reserve’s Notes on Stablecoins
On Dec 16, 2022, the US Federal Reserve published a note on Stablecoins and their stability authored by Garth Baughman, Francesca Carapella, Jacob Gerszten, and David Mills.
2. UK’s Crypto Laws
The United Kingdom recently made a law that governs cryptocurrencies. Names as the “Financial Services and Markets Act”, the law would serve to make U.K.’s Treasury, Financial Conduct Authority, Bank of England, and the Payments Systems Regulator as the regulators for cryptocurrencies in the country.