2022 is the year that stablecoins broke out of relative obscurity and had their time in the spotlight. Many of the top stablecoins’ market caps hit all-time-highs. More people used and held them than ever before. But then what looked like one of the industry’s most promising projects imploded overnight, dragging down the rest of the sector with it.
Despite the winds of the crypto winter still blowing strong, stablecoins have managed to overcome the pressure felt everywhere else in the industry. This is in part due to their core mission: price stability. When the rest of the market heads south, stablecoins are a safe option for investors looking for a store of value. But that’s not the only reason stablecoins are popular. There are many different types of stablecoin on the market, all of which have different characteristics, from how they hold their value, to their use cases and risk profile.
No matter what’s happened in the markets, stablecoins are now an important fixture of the digital asset industry and their prominence will likely only grow in the future. This is why it’s important for all investors to understand what they are, how they work and what the differences between them are. Let’s dive in.
What are stablecoins?
In case you didn’t already guess, stablecoins are digital assets that have a fixed price. This means they don’t yo-yo up and down like other cryptocurrencies. This is because their value is pegged to stable underlying assets such as fiat currencies. Many of the most prominent stablecoins, such as USDT and USDC are pegged to the price of the US Dollar. There is already a wide range of stablecoins available on the market pegged to USD, EUR, GBP or even commodities.
Stablecoins were created to bridge the gap between cryptocurrencies and fiat. For the first time, crypto enthusiasts and businesses alike were able to conduct payments using all the benefits of cryptocurrency, such as lightning fast transaction times, borderless payments and low fees, all with the stability of a traditional currency.
From the early adopters of digital assets that wanted to receive their salaries in cryptocurrency, to migrant works that need to send money home from abroad in the form of remittances, stablecoins have been a quiet revolution in finance. But it’s not just citizens turning to stablecoins to carry out their financial needs. The local government in the province of Mendoza, Argentina recently allowed residents to pay their taxes with stablecoins in a bid to tackle raging inflation.
Why is everyone talking about stablecoins?
Stablecoins have been around since 2014, but they owe much of their recent fame to one man: Do Kwon. Kwon is a South Korean developer and entrepreneur that earned a name for himself by developing the Terra blockchain, along with its native token, Luna. Unlike some of the other big founders in crypto that take the backseat and try to let the technology speak for itself, Kwon was a firebrand, often getting into altercations on Twitter with his critics.
Kwon’s brash style, along with the $40 billion ecosystem he managed to grow on the Terra blockchain, quickly earned him a place among the industry’s most prominent public figures. But it all came crashing down in May when Terra’s stablecoin UST lost its dollar price peg after large withdrawals were made on a Terra-based lending platform called Anchor.
In just a few days, Luna, the token backing UST and the rest of the Terra ecosystem plummeted from $64 to $0.004. Kwon and the rest of the Terra team failed to get UST back to its dollar peg, even after throwing $1.5 billion in Bitcoin at the problem. But that wasn’t the end of it. Some of the biggest companies in the business were heavily invested in UST and Luna. The collapse of Terra/Luna kickstarted a black hole of contagion risk that forced several prominent companies into bankruptcy.
Fortunately, not all stablecoins are made the same and the industry’s top stablecoins held their price pegs and continue to enjoy widespread usage. Let’s look into the different types of stablecoin and why their differences are important to understand.
Because stablecoins have so many use cases for so many people around the world, many of whom lack access to developed financial services infrastructure, adoption is increasing fast. In fact, according to analysis from The block, the total value of stablecoins rose by approximately 495% from 2020 – 2021. Currently, over 200 stablecoins exist globally.
Types of stablecoins
Even though most stablecoins appear similar, from the value they hold to the names they have, they are not necessarily the same. As it stands there are four types of stablecoins in the crypto space. Let’s dive in.
Fiat-backed
Fiat-backed stablecoins are the most common type of stablecoin. These assets are backed by fiat currency at a 1:1 ratio – 1 stablecoin equaling 1 unit of USD or EUR. This means that, for each stablecoin out there, a USD or EUR backs it up. These types of tokens are as stable as the fiat currency that they are pegged to. This means that a stablecoin pegged to a more volatile fiat currency would be riskier than one pegged to a relatively stable currency such as the U.S. dollar.
With USDC one of the largest stablecoins on the market, investors are able to deposit their funds onto an exchange and immediately exchange them for USDC, a tokenized form of the dollar whose reserves are held in segregated bank accounts in the United States.
USDC to USD – Market cap, all-time
Source: CoinMarketCap
USDC’s market cap peaked at over 50 billion this year and managed to recover fairly quickly from the impact of the Terra collapse. Despite the turbulent market conditions, the market cap is just short of 50 billion, with a 24 trading volume of $4 billion.
Other examples of fiat-backed stablecoins are Tether (USDT) and USD Coin (USDC), Gemini Dollar (GUSD), Pax Dollar (USDP) and Binance USD (BUSD).
Crypto-backed
Some stablecoins are backed by other crypto assets. These are inherently more risky than fiat-backed stablecoins because the potential for the underlying asset to fluctuate is greater. Fiat pegged stablecoins are backed by the central issuer’s reserves, whereas crypto-backed stablecoins are backed by smart contracts and collateralization.
Because cryptocurrencies tend to fluctuate in price, these stablecoins are overcollateralized by around 200%. This means that every $100 of the stablecoin has to be backed by $200 of another cryptocurrency, such as ETH. This collateral is managed through smart contracts, coded agreements that control the stablecoin reserves by buying closing contracts and selling the collateral if reserves fall below a certain
The most prominent crypto-collateralized stablecoin is DAI, a medium of exchange for users of MakerDAO. This coin is backed by ETH and USDC and is locked in smart contracts. MakerDAO is one of the pillars of decentralized finance and enjoys widespread usage from borrowers and lenders. Like the rest of the crypto market, DAI’s market cap took a hit following the Terra crisis but managed to hold its peg and show signs of growth in the consequent months. The other token in the Maker ecosystem is the governance token MKR. It is tradable on the SMART VALOR exchange.
DAI to USD – Market cap, all-time
Source: CoinMarketCap
Other examples are the EOSDT token, Synth Dollar (sUSD), and Original Dollar (OUSD).
Commodity-backed
These types of stablecoin are backed by commodities such as gold, oil, and real estate. Holders of commodity-backed stablecoins have exposure to real-world assets, which have the potential to appreciate or depreciate over time. An example of this is PAX Gold (PAXG). PAXG is an asset that represents one fine troy ounce of a London Good Delivery gold bar, which is stored in a professional vault in London. When you buy PAXG, you own the underlying gold which is held under the custody of Paxos Trust Company.
Algorithmic
Algorithmic stablecoins are markedly different from other stablecoins because they do not have any collateral backing them. Instead, these stablecoins seek to maintain their value through algorithms that manage supply and demand.
Increased demand triggers the system to issue new coins and lower the price back to the peg. In the event of oversupply, tokens are removed from supply. These types of tokens are the most experimental on the market and the risk comes from the difficulty of manually expanding and contracting supply while promising growth.
These stablecoins have earned something of a bad name in the fallout of Terra’s UST collapse, which was among the most prominent algorithmic stablecoins. You can read more on the saga via our blog here.
What are the use cases for stablecoins?
Stablecoins were designed to supercharge the best aspects of fiat currency and combine them with the freedom of cryptocurrency. Beyond their most obvious role as a way for cryptocurrency traders and investors to keep their assets in a stable form without having to cash out into the traditional financial system, stablecoins have a whole host of other uses.
Remittances
There are hundreds of millions of migrant workers in the world. And almost every single one of them sends a portion of their funds home. This process is called remittance. Remittances are not just ways to support families, they are so widespread that they can count for a sizeable percentage of a developing nation’s economy. Remittances count for 24 percent and 9 percent of the economies of El Salvador and the Philippines respectively.
The mainstream financial system know that these remittances are something of a golden goose. That’s why banks charge an exorbitant fee for exchanging and transferring funds internationally, often at both ends of the transaction. Stablecoins are an enormous breakthrough for people that want the stability of a fiat currency but the cheap transactions costs and ability to send directly to anyone with a cryptocurrency wallet. Stablecoins transactions are settled in seconds, instead of days and months.
Currency for commerce
Early crypto enthusiasts that wanted to get paid in crypto faced a tricky problem: it was hard to charge consistently in crypto for products and services. This is because the price could vary so wildly from one day to the next.
Stablecoins are a great solution for companies and individuals that want the functionality of fiat currency without having to actually use it. People can now charge consistently and plan their finances entirely in crypto. Many employees around the world already receive part or all of their salaries in cryptocurrency. The government of El Salvador, which legalised Bitcoin as currency in 2021, announced that it would create a stablecoin version of its currency, the colon.
Earning yield
Stablecoins might stay the same price, but that doesn’t mean they can’t be used to earn yield. Because stablecoins are native digital assets, they can be put to work in ways that fiat currencies can’t, most notably in decentralized finance.
Decentralized finance is a revolutionary way of providing financial services without banks or financial institutions. Because there’s no middle man and everything is managed by protocols and smart contracts, the costs are lower and the yield percentage is consequently higher. Earning yield is possible due to the risk involved in lending, borrowing or acting as a liquidity provider.
Conclusion
Stablecoins are probably one of the most impactful creations in the digital asset space and we have only just begun to see what they are capable of. With these tokens, cryptocurrency has an option to satisfy people that desperately want a better system for daily financial services, as well as stable instruments to use across the digital asset industry. It's likely that we will continue to see an increase in stablecoin adoption over the coming years from a variety of investors that use them for payments, hedging and earning yield.
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