In this guide, we will examine Stablecoins, seeing what they are, how they function, and how cryptocurrency traders utilize these digital assets in the market.
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What are stablecoins?
Volatility and the cryptocurrency market are natural bedfellows, with the price of various digital assets going to the moon one day before plummeting back down to Earth the next.
Many fortunes have been won and lost navigating the tumultuous world of crypto. Trading cryptocurrencies can be incredibly stressful, although the rewards that some have reaped make it a very worthwhile endeavor.
That said, even the most dedicated traders sometimes need to step back and catch their breath, particularly when the markets turn negative. Stablecoins are considered by many as ideal for this situation.
In this way, traders can take advantage of speedy transactions and low fees and not worry about Know your customer (KYC) concerns while avoiding the volatility associated with the likes of Bitcoin (BTC), Ethereum (ETH), and other digital assets.
Why use stablecoins?
Despite some crypto crashes such as those that happened in January 2022, when the overall cryptocurrency market cap dropped to around $2 trillion, stablecoins, with a value pegged to another asset, such as the U.S. dollar, are starting to prove a good alternative.
Amid the 2023 banking crisis and the collapse of Silvergate Bank, Silicon Valley Bank, and Signature Bank, investment bank JP Morgan Chase stated a new opportunity in their research, with investors becoming increasingly more reliant on stablecoins to move money around.
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How do stablecoins work?
Stablecoins, as the name suggests, are digital assets whose value is designed to remain stable amid the ups and downs of the crypto market. Stablecoins are popular because they act as a kind of intermediary for traders, allowing them to exit a market position and capitalize on their profits.
Swapping Bitcoin for USD Coin (USDC), for instance, can be seen as preferable to cashing out into fiat dollars, as it can be done more or less instantly and without fees. Stablecoins are generally widely accepted across multiple exchanges, making it easier to move funds across them.
Given the role they play, stablecoins have emerged as a critical pillar of the crypto economy. According to data from Statista, for example, stablecoins have increased their market capitalization from just $27.52 billion in December 2020 to $152.1 billion on June 19, 2022.
The growth of stablecoins suggests that they’re likely here to stay. However, recent events have shown us that not even stablecoins are immune to price volatility and that the potential exists for things to quickly turn sour.
With that in mind, traders need to understand the inner workings of the various stablecoins on offer, especially regarding how they maintain their value.
Recommended video: What are Stablecoins? (via 99Bitcoin YouTube)
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What are stablecoins used for?
Traders like stablecoins because the cryptocurrency market fluctuates wildly, with its market capitalization rising and falling by billions of dollars daily. Bitcoin is generally viewed as one of the safest and most stable digital assets, but it can still see significant fluctuations in its value.
Traditional fiat currencies, such as the U.S. dollar, don’t experience anything like this kind of volatility. Although the dollar’s value changes over time, it is far more stable and reliable than any cryptocurrency – hence it is considered a safe haven for investors when they need to exit an investment and take stock of their holdings.
For crypto investors, it’s important to realize that not every stablecoin is made the same. They can be pegged to various different assets, including other currencies like the British pound or Japanese yen, or even a commodity such as gold. They also use different mechanisms to maintain their 1:1 peg to the underlying asset.
Fiat-Backed Stablecoins
The most common kind of stablecoin is the fiat-collateralized token. These coins are the simplest to understand, as they maintain their price peg simply by holding a pool of reserve assets equal to their market cap.
A prime example is USD Coin, the parent company that holds U.S. dollar cash reserves equivalent to the total number of USD Coins in circulation. If it needs to mint another 1 million USDC, it will add $1 million to its cash holdings. In this way, it has the money on hand required to reimburse every USDC holder, should they so desire.
USDC’s reserves combine cash and other liquid assets such as U.S. Treasury notes. The company behind it is considered one of the most reliable and undergoes regular audits by third parties to verify its assets exist.
The most prominent fiat-collateralized stablecoin is Tether (USDT) though it’s a bit more controversial. At the time of writing, USDT is the third biggest cryptocurrency by market capitalization, behind just Bitcoin and Ethereum. However, Tether has been plagued by doubts due to a lack of transparency around its actual reserve holdings.
Back in October 2021, Tether was ordered by the Commodity Futures Trading Commission (CFTC) to pay a civil penalty of $41 million for “untrue and misleading statements” regarding its reserves. The CFTC said Tether “misrepresented to customers and the market… that it maintained sufficient U.S. dollar reserves to pay back every USDT in circulation.”
Tether still maintains that it does have sufficient reserves, and the crypto community seems to agree as USDT has, aside from a few temporary blips, always managed to maintain its 1:1 peg with the U.S. dollar. Furthermore, the company has never defaulted on any redemption request.
Crypto-Backed Stablecoins
In an effort to be more transparent, some stablecoins instead choose to collateralize not with fiat but with crypto itself. Such an idea might seem nonsensical, given that crypto is incredibly volatile. Still, these kinds of coins get around it by significantly over-collateralizing to ensure that they can absorb the wild price fluctuations of the underlying asset.
A good example is MakerDAO’s DAI, which is collateralized using Ethereum. DAI is created when users spend a specified amount of ETH to mint new tokens. It relies on an algorithm that ensures users always over-collateralize.
So, depending on the current market price, a user might pay $1,000 worth of ETH to obtain $500 worth of DAI. In this way, the DAI is 200% collateralized, which means it can endure a price drop of 50% without any worries. However, if the underlying asset’s price drops considerably, the DAI will be liquidated automatically to prevent its collapse.
One of the most popular crypto-collateralized stablecoins is dUSD, minted by Ardana through its Ardana Vaults service. Ardana created dUSD to serve as the native stablecoin of the Cardano (ADA) blockchain, with the idea being to inject more liquidity into its growing decentralized finance (DeFi) ecosystem.
To mint dUSD, users can lock Cardano’s native ADA token as collateral inside Ardana Vaults, a non-custodial and permissionless protocol that ensures the stablecoins are backed by excess collateral.
Ardana uses unique smart contracts known as Collateralized Debt Positions to create new tokens. Once minted, dUSD can be sold on the open market, giving other users access through brokers and crypto exchanges, or used as a means of payment.
In this way, every single dUSD token is directly backed by excess collateral. The process is transparent, with all dUSD transactions publicly viewable on the Cardano blockchain.
Another promising example of a crypto-collateralized stablecoin is GC Dollar (GDC), designed to play a key role in GTON Capital’s ecosystem of Ethereum scaling solutions. GCD is a stablecoin that’s uniquely designed to be used to pay ‘gas’ transaction fees within GTON’s ecosystem. It’s also unique in that it can be collateralized in multiple different cryptocurrencies despite sharing the same design principles as DAI.
GCD is minted using the GTON Capital Dollar protocol and has a real use case as it can be used to pay fees by users looking to take advantage of GTON’s rollup-based Ethereum scaling solution. New GDCs can be minted using ETH, BTC, PAXG, and many other liquid cryptocurrency tokens, including the platform’s native GTON governance token, as collateral.
Commodity-Backed Stablecoins
The third kind of stablecoin that’s been growing in popularity lately is backed by real-world assets such as precious metals and oil. By holding a commodity-collateralized stablecoin, the owner is, in effect, holding a share of a tangible asset in the physical world, providing a tonic to the often-repeated argument that crypto has no intrinsic value.
Commodity-backed stablecoins are quite unique in that, while they’re designed to be stable, they can appreciate over time. It’s similar to someone who buys gold, hoping its value will increase later. Due to this, such stablecoins provide an incentive for long-term holders and users. They also provide an easier way for some people to invest in the commodities that back them. Rather than buying physical gold, one can simply purchase PAX Gold (PAXG) tokens that are pegged to their real-world price.
PAXOS, the company behind PAXG, says that each of the tokens it issues is backed by one fine troy ounce of a 400 oz London Good Delivery gold bar, stored in Brink’s vaults for security purposes. Because it is backed up by these physical assets, PAXG is less vulnerable than some other stablecoins to de-pegging instances, and users can even benefit from a positive value change.
A second commodity-backed token is Digix Gold (DGX), which offers holders the chance to visit its head offices in Singapore and redeem their tokens for physical gold. Tiberius Coin, meanwhile, is backed not only by gold but also by a basket of six other precious metals – copper, tin, platinum, cobalt, nickel, and aluminum – which all have industrial applications. Meanwhile, SwissRealCoin is a unique stablecoin backed by a portfolio of Swiss real estate.
Algorithmic Stablecoins
The final primary type of stablecoin, which has attracted a lot of negative publicity lately, is the algorithmic stablecoin. These kinds of tokens are unique in that they’re not collateralized. Rather, they are designed to maintain their peg to an asset through complex algorithms that automatically control the token supply.
This kind of approach is also known as “seignorage shares,” and they’re generally joined at the hip to a more traditional kind of cryptocurrency. Whenever demand for the algorithmic stablecoin rises, new tokens will be minted to reduce the price to its target peg. Should demand for the coin decrease, tokens are purchased and burned to reduce the circulating supply and increase its price.
The most famous, or infamous example of an algorithmic stablecoin was TerraUSD (UST). As the foundation of the Terra blockchain ecosystem, it became incredibly popular, reaching a market cap of $18.7 billion at its peak in early May. UST maintained its peg to the U.S. dollar through a process of minting and burning its sister coin, LUNA, each time a UST coin was bought or sold.
Unfortunately, though the model worked for some time, UST ultimately failed to hold its peg. The exact circumstances of the Terra USD crash are still unknown, but in mid-May, it suddenly entered into a “death spiral” as UST lost its peg and its value crashed. The algorithm desperately minted billions of LUNA in an effort to maintain the peg, but it was unable to keep up. Within a couple of days, the value of UST fell to just a few cents, while LUNA crashed to zero.
Terra has since relaunched without its stablecoin and TerraUSD now trades under the TerraClassicUSD tag.
A somewhat more successful algorithmic stablecoin is Frax (FRAX), which boasts a market cap of around $1.4 billion and has, until now, managed to maintain its peg. FRAX is based on an open-source protocol that lives on the Ethereum blockchain, and it uses a combination of collateral and algorithms. When it launched, it was originally fully backed by a combination of USDC and USDT as collateral, but over time this supply has diminished, to be replaced by an algorithm.
FRAX’s algorithm works by using ChainLink (LINK) price oracles that provide price data from the ETH/USD trading pair on UniSwap (UNI) to obtain the most accurate USD price.
It employs a burn mechanism, similar to UST and LUNA, with its native governance token FXS, which helps to ensure the peg is maintained. However, many believe that as FRAX moves further away from its collateral backing, it will become much more susceptible to losing its peg, similar to what happened to UST.
Which stablecoin is best for me?
With so many different stablecoins available to choose from, new investors can have a tough time settling on which one to use. For many users, the choice of stablecoin is all a matter of balance, keeping in mind aspects such as decentralization, stability, permissionless-ness, and freedom from rules and regulations.
For example, many believe that USDC is one of the most stable of stablecoins because of its transparent accounting and the fact that its parent company, Circle, is an established financial services provider.
However, critics of USDC say that it is highly centralized and therefore not free from regulatory control by the government or another entity. Indeed, USDC is one of the few stablecoins that can also blacklist wallets – meaning that the government could potentially suspend your tokens if it has reasons to suspect you’re up to no good.
Fiat-collateralized stablecoins aren’t always the most transparent either, as the ongoing uncertainty over Tether’s accounts has proven. Tether has in the past briefly lost its peg due to speculation that it might not have enough in the bank to reimburse all of its holders, though to date it has always returned to its 1:1 peg. Another stablecoin, Binance USD (BUSD), does not strictly hold an equivalent amount of U.S. dollars in its accounts either, instead using assets like bonds and cash equivalents.
For this reason, many investors prefer the transparency of crypto-collateralized tokens such as Ardana’s dUSD and GTON Capital’s GDC tokens. The advantage of these tokens is that their smart contracts are fully transparent and can be reviewed by users to ensure they are sufficiently over-collateralized by other cryptocurrencies. In this way, they can be thought of as the most reassuring of stablecoins.
Commodity-backed stablecoins do not have the same level of transparency, because just like fiat-backed tokens, we must trust their backer’s claims that they do indeed have the physical assets stored safely in a vault somewhere. That said, they do provide the aforementioned advantage of increasing their value steadily over time, similar to real-world assets like gold, while remaining relatively stable in terms of their price.
For those who believe in the dream of decentralization, algorithmic coins – which are governed by their communities – are the purest type of stablecoin, though it’s probably not a wise move to hold substantial amounts of value in such tokens, given their perceived vulnerabilities.
Final thoughts
There are other considerations when it comes to choosing a stablecoin, the main one being availability. The likes of USDC and USDT are widely accepted and can be bought and sold on most cryptocurrency exchanges.
That’s not true for other stablecoin assets, such as FRAX. Availability can be an issue depending on the specific blockchain too. For instance, dUSD is one of the few available stablecoin options within the Cardano ecosystem. In any case, the bottom line is that stablecoins will continue to play a dominant role in the cryptocurrency markets.
With the U.S. government looking to tighten its monetary policy in light of rising inflation, the strength of the U.S. dollar is likely to increase. Precious metals too, are seen as a safe haven during times of economic uncertainty. Thus, stablecoins pegged to these assets are likely to remain in strong demand, serving as a reliable store of value.
Disclaimer: The content on this site should not be considered investment advice. Investing is speculative. When investing, your capital is at risk.
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