Glossary

What are Stablecoins? what are different types of it and its benefits

what are stablecoins

Cryptocurrencies are notoriously volatile. Quite often, the prices of some cryptocurrencies can fluctuate by more than 50% in a day owing to some positive or negative events around that cryptocurrency. But what if we told you that there was a specific type of cryptocurrency that is stable? Stable cryptocurrency. Sounds like an oxymoron, right? Well, pinch yourself because this isn’t a dream. Stablecoins are not only ‘stable’ by nature but also form a huge part of the total industry market capitalization.

But what are they? How do they work? Why would someone want to buy a cryptocurrency that is stable? That is exactly what we are going to talk about today. Read on! 

What are Stablecoins?

Simply put, a stablecoin is a type of cryptocurrency that is pegged to a ‘stable’ asset like USD, Gold, Euro etc. Pegging is essentially mimicking the price of the underlying asset. In other words, it is a digital counterpart of a real-world asset. For e.g. USDT, a stablecoin pegged to a dollar, will always mimic the actual price of a dollar in the real world. 

Stablecoins act as a gateway from centralized finance to the decentralized world. Anyone can get exposure to cryptocurrencies without worrying about their volatility just by holding stablecoins. 

Stablecoins hit the sweet spot between a real-world asset’s stability and a digital currency’s flexibility. Imagine if you were to pay someone $1000 who lives in a remote country where dollars aren’t acceptable. Traditionally, you would go to a bank/money exchange agency. They would take their own sweet time to convert that money and share it with the intended recipient. Plus, it would cost you a percentage of the total money and a lot of time. 

Now compare that with sharing some USDC with the receiver. It would take less than 5 minutes to set up a wallet (in case they don’t have it already) and share the amount with them. Once received, they can sell it on a centralized exchange for the currency of their choice within minutes. 

Therefore, digital versions of real-life assets simply turbocharge their functionality. But is remittance the only use case of a stablecoin? Turns out there’s a lot more left to explore. 

How Do Stablecoins Work?

From a functional perspective, stablecoins are quite simple to wrap your head around. The sole purpose of a stablecoin is to mimic the underlying asset’s price. Depending upon the type of stablecoin, there are multiple ways to achieve this. 

For example, fiat collateralized stablecoins like Tether (USDT) often set up a reserve where the conversion between physical and digital assets takes place. 

If you buy 1 USDT (which always must be equal to $1), Tether (the issuing company), mints a new USDT and gives it to you. In turn, they take your $1 and store it. 

Similarly, if you redeem 1USDT against a dollar, Tether would burn that token (or send it to an inaccessible address) and give you a dollar from its reserves. 

In a different example, $DAI, issued by Maker, maintains something called “Vault”. As a user, you can deposit your crypto (non-stablecoins) in the vault. Once the deposit is completed, you can use it as collateral to borrow $DAI, a stablecoin. Since $DAI is always backed by crypto, they can maintain the price to $1 and honor the redemption if need be. 

And then some stablecoins aren’t backed at all. They rely on the basics of supply and demand to maintain the price of the crypto equal to the underlying asset. 

For example, in the case of a stablecoin that mimics a dollar, the algorithm that manages the demand and supply would burn crypto if the price goes below $1. This would create scarcity and hence bring the price back up to $1.

On the flip side, if the price exceeds $1 (say $1.1), the algorithm will issue more stablecoins to boost the supply and bring the price down. 

While a lot of players are trying to achieve this, there has been little to no success. One failed cryptocurrency which tried achieving this is $LUNA from the Terra ecosystem. 

What are the Types of Stablecoins?

Among the several types of cryptocurrency, Stablecoins can be divided into subcategories based on the asset they are pegged to or the mechanism used to maintain the peg. Let us explore each one of them in detail:

A. Fiat-Collateralized Stablecoins

A fiat-backed stablecoin will always maintain its price equal to a fiat currency. For the uninitiated, fiat is the currency issued by the government of a country. So, a fiat-backed stablecoin might be following USD, EURO, YUAN or INR. 

This type of stablecoins is often centralized because a central authority periodically maintains the reserves and gets them audited from a third party. For example, Tether holds the right to issue or burn the USDT in the market. Similarly, in the case of USDC, ‘Circle’ operates it single-handedly. Most of the centralized fiat-backed stablecoins work through the model of maintaining a reserve. 

These reserves are often audited by reputed firms; hence, people trust these companies. 

B. Commodity-Backed Stablecoins

As the name suggests, a commodity-backed stablecoin tries to maintain its peg to a commodity like gold instead of fiat. These stablecoins work on a very similar model wherein reserves of the underlying commodity are held by a centralized authority which is obligated to get its reserves audited regularly. 

These stablecoins are relatively riskier than their fiat counterparts. Why? Because the commodity itself is more volatile as compared to fiat currency. Secondly, it is easier to maintain reserves for money as compared to something physical and bulky as a precious metal. 

Some examples of commodity-backed stablecoins are Pax Gold ($PAXG) and Tether Gold ($XAUT).

C. Crypto-Backed Stablecoins

One may argue that what is the point of a crypto stablecoin if they are going to be pegged against a centralized inflationary asset like USD? After all, USD has lost 92% of its purchasing power since 1933. 

Well, to counter this problem, crypto-backed stablecoins maintain their price equivalent to USD with a subtle twist. Instead of holding USD reserves, they maintain crypto reserves. 

But cryptos are extremely volatile, how do they make sure that the value of their reserves always exceeds (or stays equal, at least) to the stablecoin floating in the market?

To answer that, we’ll quickly explain over-collateralization. If you wish to borrow $DAI (a crypto-backed stablecoin) worth $100, you need to deposit $ETH worth $200 or more. This gives $DAI a cushion from a crash to the tune of 50% in the price of Ethereum. Therefore, whenever you borrow in a decentralized protocol, more often than not, your loans are over-collateralized. 

This means for every new $DAI minted or issued, there’s a 200% collateral in a blue-chip cryptocurrency reserved with Maker. Speaking of blue-chip, we have a Crypto Blue Chip Coin Set for you to invest in. It includes the top 5 cryptos by market cap, rebalanced monthly to offer you the best risk-adjusted returns. Download Mudrex and explore now!

D. Decentralized Algorithmic Stablecoins

Maintaining the reserves may sound like an easy job, but it is a big responsibility. Also, the cost of auditing is often very high. And even if you manage to pull this off, garnering the trust of people is a challenge for a non-government authority. 

So how about we do away with the reserves completely? Well, that is pretty much the idea behind an algorithmic stablecoin. Instead of relying on the reserves, it uses an algorithm to burn or issue the tokens to maintain the price equivalent to a dollar. 

While working an algorithm-based stablecoin is fairly complex, there has been little success in making them mainstream. Given the last experiment of Terra-Luna that led to wealth destruction of $50B, the future looks bleak for them. 

Other examples of algorithmic-stablecoins are FRAX, Magic Internet Money (MIM) etc. 

Are Stablecoins Really Safe?

Safety is a very subjective term. Are fixed deposits with banks safe? Are mutual funds safe? In the past, a lot of banks have defaulted on user deposits. There have been bank runs on some of the most famous fund houses like Franklin Templeton

That said, stablecoins are relatively safer compared to the rest of the crypto market. In principle, they are as safe as the fiat currency itself. 

However, this needs to be taken with a pinch of salt. Stablecoins are unregulated and while governments can rescue banks and force the mutual fund houses to pay back the customers, stablecoins don’t come under that purview. 

To sum it up, stablecoins offer stability against the ups and downs of the crypto market, often at the cost of compromising with decentralization. But comparing it with the rest of the crypto market, they are considered much safer as their price does not depend on supply and demand. 

With that being said, stablecoins issued by Circle (USDC) are least likely to default as they are a publicly listed entity ($COIN). Since SEC watches over its holdings, it could be considered as the safest coin within the stablecoin realm. 

What are some Benefits and Drawbacks of Stablecoins? 

We have already established that stablecoins are an essential gateway to crypto. But is it all they have to offer? Turns out they could solve multiple problems at once. With that being said, there are some problems as well that need to be addressed before we see the light of the day. Let us discuss each of these aspects.

Advantages of stablecoins

First, let’s look at the convenience that stablecoins offer.

A. Blockchain store of value

Do you want to park some funds in a completely decentralized and secure fashion? You already know that crypto could do it but quite often you cannot stomach the volatility. Well, stablecoins are a perfect blend. They offer you to hold relatively safer assets on a blockchain-based platform. Some of the protocols also offer interest to deposit your stablecoins with them. 

B. Switching

Say market conditions are getting worse and you want to sell your holdings. At the same time, you don’t want to be taxed yet as you plan to get back in once the storm settles. Stablecoins enable just that for you. Instead of cashing all your crypto into fiat and paying exchange fees and taxes in the process, you can simply convert your crypto into a stablecoin, wait and then decide to switch back whenever required. 

C. Entry to exchanges

Cryptocurrencies are always amidst legal uncertainty. Due to this, a lot of banks often, intermittently, disable the payments to fund your crypto wallet. In such a case, some exchanges resort to P2P or peer-to-peer exchange. 

Idea is to connect two individuals, a buyer of crypto and a seller of crypto. These two individuals transact outside exchange to deposit money into the seller’s account. In return, the seller deposits a stablecoin in the exchange wallet of the buyer. 

While this can be done for other cryptocurrencies as well, stablecoins often offer a simpler transaction that is unlikely to fluctuate while you are completing the process. Secondly, it offers greater flexibility to buy other cryptos as most trading pairs are available with stablecoins. 

Disadvantages of stablecoin

Because we are a prudent set of investors, it is time to explore the other side of the coin. Some of the disadvantages of stablecoins include:

A. Trust

While the ethos of crypto revolves around trustlessness, most of the stablecoins are based on trusting a central authority like Tether or Circle. What if the audit reports are manipulated and they do not have enough reserves to cater to the redemptions? In fact, Tether has had a couple of close encounters with de-pegging (or losing its value from $1) in the past. 

B. Store of value without store of value

This is specific to fiat-backed stablecoins. What is the point of holding value in a devaluing currency like fiat? So if you are not deploying your stablecoin to earn some yield, there is no point. It is similar to keeping your cash in the bank to lose its value over a period. 

C. Regulation

Lack of regulation also scares a lot of individuals who are on the fence about jumping into crypto. As we write this, the top two stablecoins USDT and USDC have a combined market cap of $120B. This is more than the GDP of Bangalore, a city in India.

Stablecoins need a consumer protection clause implemented by a government agency to make sure that the interests of the retail investors are protected. 

What’s Next For Stablecoins?

Governments across the globe have become wary of the size of the stablecoin market. Therefore, a unanimous opinion is to regulate them. 

Jerome Powell, chair of the Federal Reserve, issued an urgent call for regulation of stablecoins — cryptocurrencies that are pegged to a reference asset such as the U.S. dollar — and Federal Reserve Governor Lael Brainard signalled that the case for the Federal Reserve exploring a central bank digital currency (CBDC) in response to stablecoins seems to be getting stronger.

Apart from the regulation, we may see a government version of a stablecoin or CBDCs. Central Bank Digital Currency is a blockchain counterpart of the fiat. They don’t have to peg to any asset as the supply and demand are directly controlled by the central bank of the country such as Federal Bank or RBI. 

Will it replace the stablecoins and the narrative of state-free money? Only time will tell. 

If CBDCs or regulations, in general, see the light of the day, we could observe a dramatic shift in the way businesses operate. Remittances would be faster, we could now bank the unbanked (all you need is a smartphone/internet to send or receive money). 

No matter what happens, stablecoins are simply money 2.0. Some version of it is definitely here to stay. 

FAQs

1. What’s the point of a stablecoin?

The main idea of stablecoins is to leverage the benefits of blockchain without the volatility of crypto. Other use cases include easy back and forth between crypto and stablecoins, easy entry to exchanges etc. 

2. Can you make money from stablecoins?

Yes. A lot of platforms offer yield if you deposit your stablecoins with them. However, risk needs to be evaluated before lending your stablecoin to any platform. 

3. Is Bitcoin a stablecoin?

No, Bitcoin is not a stablecoin since its value is not pegged to any physical asset like gold or fiat currency. Rather, its value is determined by short-term demand supply and its fundamentals. Whereas stablecoins mimic the price of the underlying asset by which they are backed.

4. Is Ethereum a stablecoin?

No. Ethereum is not a stablecoin since its value is not pegged to any fiat or commodity. Ethereum’s price is defined by its fundamentals and short-term supply and demand. Stablecoins’ value however is tied to an underlying asset like the US dollar or gold.

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