Stablecoin: All you need to know about it

Familiar cryptocurrencies, such as Ethereum and Bitcoin, do not need intermediaries to make payments. This is a huge plus for them. However, their Achilles’ heel is that cryptocurrency prices are unpredictable and can fluctuate drastically (volatility). That is, while you were sending or receiving coins for a certain amount, when you receive it, it may be a completely different amount. This is one of the reasons why there is still no widespread acceptance of cryptocurrencies in society.

After all, it’s unclear how much your crypto will be worth next week. Consequently, it is not the best way to save money. Even though the price of fiat currencies fluctuates, these changes are not as significant as in crypto.

What is a stablecoin?

Stablecoin is a type of cryptocurrency. However, its main difference is that its main task is to keep a fixed value. This is done by pegging it to one of the existing fiat currencies or gold (usually the US dollar or euro). Usually, after that, the value of stablecoin is typically equal to 1 dollar or 1 euro.

However, a loud and unfortunate event in the currency market – the collapse of the TerraUSD to zero – has forced federal officials to pay close attention to this area. Treasury Secretary Janet Yellen noted the risks to overall financial stability posed by stablecoins. The Federal Reserve issued a report discussing the uncertainty of what underpins stable coins and the lack of oversight in this area.

Usually, the makers of stablecoin make the “reserve” necessary to make their coin stable. These gold, oil, or fiat reserves are held in banks and bases.

So every time stablecoins are cashed in, an equal amount of the supporting asset is withdrawn from the reserve.

But there are more sophisticated types of stablecoins backed by other cryptocurrencies rather than fiat, but they still follow assets like the dollar.

Why are stablecoins important?

In recent years, the use of stablecoins in the crypto-asset EMIR has increased. Initially, stablecoins were used primarily as a relatively safe island in the world for cryptocurrency volatility and as a bridge for digital asset trading.

With the development of decentralized financial applications (DeFi), stablecoins began to gain popularity. However, it is less than 10 percent of the total crypto-asset market, with market capitalization rising from €23 billion in early 2021 to almost less than €150 billion in the first quarter of 2022.

It is stablecoins that are often used as liquidity providers in DeFi. Tether, USD Coin and Binance USD dominate the market, accounting for about 90% of the stablecoin market.

They are followed by algorithmic stablecoins DAI (a decentralized stable currency based on Ethereum).

The most significant stablecoin, Tether, has already begun to play a crucial role in crypto-asset trading. It (like other stablecoins) serves as a bridge between official currencies and crypto assets. Thanks to Tether, stablecoin trading volume exceeded unsecured crypto-assets trading volume in 2021, reaching 2.96 trillion euros in the quarter. This amount almost equaled the trading volume of US stocks on the New York Stock Exchange (3.12 trillion euros).

Tether is also involved in every second bitcoin and ether transaction, and in March of this year, it accounted for about 65% of all transactions on crypto-asset trading platforms.

Stablecoins generate the majority of the liquidity in DeFi applications, which is critical for decentralized exchanges and credit protocols. Stablecoins accounted for about 45% of decentralized exchanges (DEXs) liquidity in May.

Types of stablecoins

Fiat-collateralized stablecoins

Fiat is the most common asset to support stablecoins. The US dollar comes first, although other currencies are also used.

Commodity-backed stablecoins

Some cryptocurrencies are tied to the value of black gold (oil), gold, silver, and other precious metals.

Crypto-collateralized stablecoins

There are stablecoins whose value is tied to another cryptocurrency, such as Ether or Bitcoin.

Other investments

Tether’s Stablockin USDT was once supposed to be backed by US dollars, but almost half of its reserves are in commercial paper in the form of short-term corporate debt. The company has not given an exact list but assures their rating is A-2 or higher. Also, other unnamed “approved investments” appear in various USDC documents, along with accounts at federally insured banks (but it is unknown if the accounts are insured too).

Algorithmic stablecoins

Their price stability is due to specialized algorithms and smart contracts that manage the supply of tokens in circulation. For example, when the market price falls below the cost of fiat currency, which the system automatically monitors, it will reduce the number of tokens in circulation. In another case, more tokens will go into circulation.

Stablecoin regulation

European payment service providers (PSPs) are reluctant to accept payments in stablecoins, and most are pegged to the US dollar or euro. The reason is regulatory uncertainty pending adopting the Markets in Crypto Assets Regulation (MiCA). Most of the service providers in the EU stablecoin markets are registered in the EU, with only some of them authorized as PSPs. Still, most are listed as virtual asset service providers (under the current AML/CFT framework). 

Activities vary considerably from member state to member state. Such services related to stablecoins mainly consist of acquiring, storing, or selling.

In August 2022, the International Organization of Securities Commissions (IOSCO) and the Committee on Payments and Market Infrastructures of the Bank for International Settlements (CPMI) issued detailed guidance on using stablecoins. 

It says that if stablecoins act as a transfer means and are considered “systemically important,” they must follow traditional international standards (PFMI). This also applies to payment systems, central securities depositories, securities settlement systems, and counterparties.

US regulators are also not napping. They called on the federal government to cooperate with other countries in the field of cryptocurrency policy, in particular concerning cryptocurrencies following fiat.

What are the risks of stablecoins?

• Stablecoins work differently than other cryptocurrencies, so their vulnerabilities are different. 
• If a third party holds reserves, there is counterparty risk. Does the organization have the collateral it’s talking about? 
• There is a risk that reserves may not be enough to ensure the stability of a coin in a certain situation.
• Cryptocurrencies were created to eliminate intermediary companies from the chain because they have some control over the money. They can, for example, stop a transaction. Some stablecoins can also prevent transactions.
• Coin USD has a similar mechanism in case of illegal use. Circle, one of the companies behind USDC, froze $100,000 of USD in July 2020 at the request of law enforcement.

How safe are stablecoins?

To begin with, you have to read the statements of the issuers in detail. Check the reserve statements. If there are none, you should be wary. The stable cryptocurrency Tether has been under the gun for failing to disclose its reserves. The March 31, 2021 report showed that less than 4% is real cash, most of which is short-term corporate debt. These commercial papers could decrease value quickly if the markets go down. And that would make the stablecoin Tether less than fully committed just when it might be most needed.

Unless stablecoin commits to holding all of its reserves in cash, there is no guarantee that money will be available for coin redemptions. 

In 2021, the US Commodity Futures Trading Commission fined Tether $41 million because its stablecoin was not 100 percent backed by real currency (though it said otherwise). 

Since then, Tether has begun cutting back on non-cash assets. And at the end of last year, it was only 30 percent.

So the best guarantee for the security of such a currency would be widespread adoption and use to pay for goods and services.

How are stablecoins different from traditional cryptocurrencies?

Cryptocurrencies are a form of digital tokens that exist on the blockchain, a distributed and decentralized ledger. In addition to bitcoin, there are thousands of altcoins, including Ethereum, Terra, Litecoin, and Dogecoin. Many cryptocurrencies are incredibly volatile, which has led to the emergence of stablecoins.

Stablecoins differ from bitcoin and altcoins in that they peg their value to an asset – this can mean pegging to a fiat currency (like the US dollar), another more well-known cryptocurrency, or a valuable commodity like gold or oil to stabilize the price.

Algorithmic stablecoins are backed by an on-chain algorithm that facilitates changes in supply and demand between the stablecoin and the other cryptocurrency being tracked.

Advantages and disadvantages of stablecoin

The main advantage of stablecoins is that they are supported by blockchain technology. They can be used to conduct international transactions faster and at a lower cost than using fiat. They are easy to use because they can be handled through wallets, similar to traditional cryptocurrencies.

Because they are tied to a fiat currency or commodity, stablecoins have virtually no periods of high volatility, making them a more reliable currency with the benefits of blockchain technology. 

Stablecoins are popular for traders to hedge against other cryptocurrencies when markets see a drop in prices. They can be used to liquidate their digital assets quickly and easily return to the market when the price stabilizes. 

But stablecoins are more centralized because each coin in circulation is backed by an equal reserve value of active or fiat.

Some stablecoins don’t boast transparency, as was the case with Tether.

What are the most popular stablecoins?

As of May 2022, by market capitalization, these were:

1. Tether (USDT): $82 billion.
2. USD Coin (USDC): $49 billion
3. Binance USD (BUSD): $17 billion