What is the one thing crypto is most accused of? Of course, by the people who are yet to step into the market.
High volatility
To solve this accusation, the first stable coin, USDT, was introduced back in 2014. As the name suggests, remaining stable is its number one priority. Now we have a dozen of stablecoins in the market.
In this article, we have cleared all the myths and explained stable coins in depth. How it works, its types and utilities can be expected in the following paragraphs.
Understanding Stablecoins
Cryptocurrency is often accused of being a highly volatile asset. And it’s true when the market is in turmoil, even the bigger market cap coins like Bitcoin and Ethereum have experienced a 10-15% swing or dip.
To minimize volatility, stablecoins were brought to attention for the very first time in 2014. USDT was the first stable coin to set its foot in the crypto market. Developed by Bitfinex, it remains the largest and most used stable coin.
The value of any stable coins remains fixed, and this is achieved via various pegging methods, some are pegged to fiat like USD, EURO, or Japanese Yen or real-world commodities like gold or oil, while others are backed by computer algorithms. For all, the goal remains the same, to achieve stability.
For example- Coins like USDT or USDC are pegged to a US dollar in a 1:1 ratio, meaning either coin is exchangeable with one US dollar or vice versa. For every one circulation of USDT, one dollar or cash equivalent is kept in its central reserve.
Still, most of the/largest of the stablecoins are centralized, meaning controlled by a single authority. In recent years, we had seen the development of other stablecoins that are decentralized like FRAX, UST, or Dai.
Use of Stablecoins
Stablecoins are the representation of fiat currencies on the blockchain, making it intractable on numerous dApps. It’s known for stability, and alone it’s should be enough. But it doesn’t stop there; DeFi and Crypto exchanges heavily rely on stablecoins for their daily trades.
On every crypto exchange, a huge chunk of their trading volume happens with the likes of stablecoins, making it a highly liquid asset. The users can opt for these trading pairs like BTC/USDT, ETH/USDT, ATOM/USDT, BnB/USDT, AVAX/USDT, LUNA/USDT, and more.
To make trades even smoother, numerous crypto exchanges have come up with their stablecoins. For Example- USDT is owned by Bitfinex, Coinbase has shares in USDC, BUSD is developed by Binance, and GUSD is owned by Gemini crypto exchange.
Stablecoins is one of the pillars on which DeFi has expanded in recent years. With about 200+ billion assets locked in various decentralized applications, DeFi would have been an unimaginable place without stablecoins.
The loans taken out on decentralized applications are finalized in Stablecoins after borrowers lock their crypto in collateralization.
For instance, Banks in America give only 0.5% annual returns. While Users enjoy a staggering 19.66% APY on UST on Anchor protocol— a DeFi lending platform built on Terra layer 1 blockchain.
Users who want to trade anonymously have an option as well, trades on decentralized exchanges allow users to swap, the network-supported token into stablecoins. Every layer 1 and layer 2 chain has a decentralized exchange and automation market maker to its community needs.
Active Web 3 users, builders, and enthusiasts prefer taking their salaries in crypto, and stablecoins have made the process smoother.
Before stablecoins, Cross border transactions were a hassle. Now with stablecoins, any amount can be sent with a very minuscule fee that would reach its desired destination within a few seconds to a maximum of an hour depending on network congestion.
How do Stablecoins remain stable?
Fiat does a very good job at being stable; however, over a longer period, it depreciates its value. In this example- 15 dollars was more than enough to purchase a regular pizza, ten years ago, now the same thing demands 30 dollars. Meaning, that the fiat value has decreased by over 50% in this particular case (Fictional case). We all have experienced something similar to it, with inflation or sometimes hyperinflation.
Stablecoins achieve stability by various pegging methods. Most are pegged to fiat currencies like USD while others achieve the same with the help of algorithms.
Coins like USDT or USDC are pegged to USD in a 1:1 ratio. For every of its circulation, a dollar or cash equivalent is kept in the central reserve. While Coins like UST or Frax use complex computer algorithms to keep their price in check.
Fiat backed, Algorithm backed, Crypto backed, Commodity backed stablecoins are explained in the following paragraphs.
Fiat Backed Stablecoins
Stablecoins backed by fiat like USD has a reserve maintained by a central entity. For every Stable coin in circulation, 1 dollar is kept in the reserve or cash equivalent.
For the issuance of coins, users must submit Know Your Customers documents and comply with anti-money laundering regulations.
Once in the market, stablecoins can be traded with anyone, however, these central bodies possess the power to freeze the assets. And we have seen USDT doing in the past.
Crypto-Backed Stablecoins
A popular example of crypto-backed stablecoins would be Wrapped Bitcoin. In this case, WBTC was issued on the Ethereum blockchain to get more into the DeFi ecosystem, as the Ethereum DeFi ecosystem is still the largest with a 200 billion worth of assets locked in.
However, to maintain its peg during the market’s extreme swings, the crypto is over collateralized. Meaning, that an extra amount is used more than what it would have been in the other case. So for example- an amount of 1000 worth Eth can be collateralized to back only 500 worth BTC.
Commodity Backed Stablecoins
Commodity-backed coins are a representation of that particular commodity on the blockchain network. Real-world assets such as Gold, other precious metals, real state, and oil can be backed, and have a representation of their own on the blockchain.
It has a few benefits: One it’s easier to carry trade, compared to owning and obtaining the physical commodity. Second, Commodity based stablecoins also allows convenient swapping, to other cryptocurrency or taking profit directly in fiat which saves a huge time and effort.
Algorithmic backed Stablecoins
To keep its peg, algorithms used are transcribed in smart contracts that stabilize the price via keeping supply and demand in check. The process is simple, when the price goes up, the algorithm sells to increase supply in the market and when the price is low, the algorithm buys back to decrease the supply. Example UST—developed by Terra Luna
Example of Stablecoins
1) UST
UST is a decentralized stable coin issued by Terra labs—the founders of Terra Luna crypto coin from South Korea. It’s an algorithm-backed stable coin. This means, its stability is maintained via complex computer algorithms. Luna, the native token of Terra is used to maintain the peg of UST and other stable coins in Terra’s suite.
Holders can mint an equal amount of UST after burning their LUNA or vice versa. For example- 10 dollars’ worth of LUNA can be burnt to mint 10 UST. And one UST can be burnt to mint 1 dollar worth of LUNA.
Say, the UST price is more than one dollar, LUNA users are incentivized to burn it to mint UST. Since UST is more than a dollar, users can sell it and take profits. This would overall increase the supply of UST, bringing its price back to 1 dollar.
Similarly, if the price of UST falls below a dollar, users can burn UST in return for LUNA. The users would get more LUNA worth in USD, decreasing the supply of UST and bringing the price up.
2) USDT
USDT is the first-ever stable coin developed in 2014 by Bitfinex Crypto exchange. It’s pegged to USD, meaning for every one USDT mint, one dollar is kept in central reserve or cash equivalent.
USDT is the most popular stable coin and ranks only 3rd in the crypto list with a market cap of $83 billion.
3) Dai
Dai is a crypto-backed, decentralized stable coin brought up by Maker DAO and Maker protocol. It’s soft pegged to the US dollar, and every time a Dai is minted, a mixture of cryptocurrencies is locked up in a Smart contract vault.
For issuance and other development of the software, it’s governed by Maker Protocol and Maker DAO.
Pros of Stablecoins
Any amount of stablecoins can be transferred cross border within seconds to a maximum of an hour with a very minimal transaction fee. It’s a highly liquid asset, and swapping into fiat via a crypto exchange is very smooth.
Stablecoins are based on blockchain, which provides first and foremost—stability, and can be transacted in various layer 1 and layer 2 DeFi ecosystem. For example, a user can take out loans, buy insurance, lend or trade NFTs with stablecoins. The lending dApps sometimes provide huge incentives to pool stablecoins in their liquidity pool.
Stablecoins represent fiat currencies on the blockchain, providing stability, however, stablecoins are more transparent than fiat. Any money laundering activity can be tracked and reported accordingly.
Cons of Stablecoins
Coins issued by central authority have the right to freeze assets, upon the request of the government, on charges such as money laundering or any other illicit activities.
A heavy amount of audits is required to maintain the peg, any day the probability of human errors is increased.
Most of the stablecoins issued are centralized, however, we have innovations, that abide by the decentralization, the very base of cryptocurrency, and have brought better options like Terra USD or Frax finance.
Final thoughts on Stablecoins
Stablecoins are more than just minimizing the high volatility of the crypto market, moreover, they contribute a huge chunk of daily trades on exchanges and the DeFi sector. It’s a faster and cheaper way to move funds across borders than traditional financial systems.
And all the major trades happening on crypto exchanges like Binance, OKX, and KuCoin happens in trading pairs with stablecoins. Stablecoins are the backbone of the DeFi sector, had they stopped circulating, or working, things could go terribly wrong in the crypto space.