A Beginners Guide To Stablecoins

First issued in 2014, and regularly issued on new blockchains in 2023, stablecoins are cryptocurrencies that are designed to prevent price fluctuations and volatility by maintaining a stable value pegged to the value of an underlying asset such as the Dollar or Euro.

They are typically backed by fiat currencies, such as the US dollar, or other assets such as the precious metal gold. This means that their price is matched to the value of the underlying asset and therefore should be less likely to experience volatility.

Stablecoins maintain their stability through “pegs” or pegging mechanisms. There are different types of pegging mechanisms and these affect the different types of stablecoins. Let’s take a look at some examples.

Collateralized

Collateralized stablecoins are fiat-backed assets such as Tether (USDT) or USDC and are backed on a 1:1 ratio of cash, cash equivalents or treasury notes held in a bank. Some stablecoins are collateralised with cryptocurrencies such as the DAI stablecoin, which is backed by Ethereum. 

Overcollateralized

An overcollateralized stablecoin is an asset backed by more than a  1:1 value. This means that the stablecoin is backed by more cash reserves or similar underlying assets than the market capitalization of the stablecoin.

Asset or commodity-backed: 

Asset or commodity-backed stablecoins include assets like Kinesis gold (KAU) and silver (KAG). These are both backed by physical gold and silver bullion on a 1:1 ratio. Kinesis Gold is backed by 1 gram of 9999 fineness, insured and vaulted gold whilst Kinesis Silver is backed by an ounce of 999 fineness, insured and vaulted physical silver bullion. 

Algorithmic
Rather than being backed by something, these coins use control pressures on their supply and demand to attempt to maintain a peg. Historically, this has sometimes been disastrous such as Terra Luna’s UST collapsing to 0. 

An evolution of algorithmic stablecoins sees “rebasing” coins emerge such as Ampleforth, which attempts to account for inflation, based on complicated supply and demand mechanics that see user’s volumes increase or decrease inside their wallet without buying or selling. 

Sometime’s stablecoins don’t just go below their peg, but above it too, as is currently the case with Cardano’s over collateralized asset-backed stablecoin Djed, which is over collateralized by about 400%:

Source: https://coinmarketcap.com/currencies/djed/

Stablecoins have several  important use cases in the cryptocurrency market, including but not limited to:

Liquidity & trading pairs

Assets listed on exchanges are tradable against a stablecoin such as USDT or USDC to ensure that there is sufficient liquidity for exchanging. 

Combatting volatility:
Outside of parameters like inflation and exchange rates, in theory stablecoins should be much less risky than cryptocurrencies and therefore useful for holding as a long-term store of value. 

Higher earning rates
Lending platforms, crypto bank accounts and other providers typically offer extremely high APYs for stablecoins – often in the double digits – because they are less risky and in such high demand that they can offer increased interest rates. 

Payments and purchasing power
Consider the purchase of an expensive NFT. The purchaser might want to pay in a stablecoin rather than Ethereum if the $ETH price is low. Similarly, companies may wish to pay international contractors quickly and affordably in a dollar-backed stablecoin.

In the interest of balance, it is important to address the numerous risks and concerns about stablecoins as well as the possible pros of using them. 

Low volatility – a dollar is a dollar, and fiat-backed stablecoins will benefit from this.

Speed & fees – compared to an international bank transfer, a stablecoin transfer, especially on a low-fee blockchain will be considerably quicker and cheaper.

Non-custodial – stablecoins can be held and owned solely by the purchaser.

Interest rates – as discussed above, major stablecoins offer a higher rate of return.

Transparency – all transactions are trackable on the blockchain.

For the unbanked – creating a receivable wallet requires only an internet connection, whereas a bank account needs much more data. 

Risks around regulation and deregulation – recent developments around Binance’s USD stablecoin $BUSD have seen many investors flee the coin as the SEC prepares to sue Binance.

Risk of depegging – how do you know which stablecoin is the safest? You don’t. Outside market factors could always influence a depeg or repeg. 

Proof of reserves or lack thereof – investors must trust that a company that may not have published its proof of reserves as having as much collateral as they say they will. 

Once implemented, CBDCs, or Central Bank Digital Currencies, will be digital versions of the fiat currencies that are issued by central banks. 

They aspire to offer the same benefits as physical cash, such as anonymity and convenience, but with the added security and efficiency of digital transactions. Despite being planned for deployment in most major countries, they are somewhat controversial as many individuals around the world associate cash with a free society, and do not want to see cash disappear.

It has been noted by some administrations, though, that CBDCs will operate alongside cash rather than replace it, and there might be both retail and banking versions. 

Stablecoins can provide a more stable and efficient way to store and transfer value, while CBDCs can offer a more secure and convenient alternative to physical cash, which is at the moment legal tender where crypto is not. 

Both technologies are still in their early stages of development, and it remains to be seen how widely they will be adopted. There are further differences worth noting, and that even amongst stablecoins, not many are decentralised, which is one of the most important ideologies of crypto and web3. 

• Stablecoins: Stablecoins are typically created by private companies, and they can be used to facilitate a variety of transactions, such as payments, trading, and lending. Some of the most popular stablecoins include Tether, USD Coin, and Binance USD. As such, they are not truly decentralised. 
• CBDCs: CBDCs are still in the early stages of development, but are close to being deployed by a number of central banks, including China, the Bahamas, and Sweden. These are centralised currencies too. 

As more companies around the world begin to accept cryptocurrencies as payments, and employees having the option to  take their salaries in crypto or stablecoins, it is likely we will end up with three choices as to how we manage our money:

• – Cash
• – Crypto
• – Other digital currencies like CBDCs

More work must be done to ensure that these currencies are without risk, and that decentralised alternatives exist. 

This publication is for informational purposes only and is not intended to be a solicitation, offering or recommendation of any security, commodity, derivative, investment management service or advisory service and is not digital asset or cryptocurrency trading advice. This publication does not intend to provide investment, tax or legal advice on either a general or specific basis.