A Beginner's Guide To Stablecoins

May 19, 2021
Stablecoins are cryptocurrency tokens designed to hold a specific value without volatility. Most stablecoins are backed by reserve assets like US dollars, gold, or other cryptocurrencies.

Back in Bitcoin's early days, people envisioned using cryptocurrency to pay for things — like pizza. In 2010, Laszlo Hanyecz infamously paid 10,000 BTC for two Papa John's pizzas. Bitcoin was worth less than a cent at the time, but in today's appreciated BTC prices, Hanyecz spent roughly $450 million.

Hanyecz learned the hard way that when you pay for something, the money used should hold a stable, predictable value. Fiat currencies like the dollar, euro, and yen are pretty good at doing so. But they're centralized, inflationary, and require you to trust an authority.

The blockchain technology underlying volatile cryptocurrencies offers a platform for creating decentralized digital money called stablecoins. Unlike perpetually fluctuating cryptocurrencies, stablecoins hold a steady value that enables you to use them for digital payments reliably.

Stablecoins explained

Like the dollar in your wallet or bank account, stablecoins keep a value that doesn't fluctuate much. Look at the US dollar on a forex market. You’ll find its value does experience volatility — but usually not enough to be noticeable on a day-to-day level.

Stability is a crucial characteristic of useful money. For cryptocurrencies to achieve similar stability, they must anchor themselves to another stable asset. In most cases, the pegged asset ends up being USD because of its global reserve currency status. That's why you find so many USD stablecoins like USDT, USDC, BUSD, and so on.

Stablecoins tie themselves to stable assets by a few simple mechanisms. The most basic and popular way to protect a stablecoin from price fluctuations is to back them 1:1 with assets in reserve. For stablecoins like USDC, this means keeping $1 in reserve for every 1 USDC issued.

However, you don't have to peg stablecoins to dollars. As DAI, TerraSDR, and sUSD stablecoins have shown, you can collateralize stables with baskets of assets including cryptocurrencies. Some, like Meter, are tied to the global market for electricity, citing its stability over fiat.

Some stablecoins aren't collateralized at all. Such stablecoins, called algorithmic stablecoins, use elastic supplies that expand and contract token supply to maintain a peg with a targeted asset.

Types of stablecoins

Today, stablecoins have a total market cap of $100 billion. More people than ever are using them to trade crypto, earn interest in DeFi applications, and protect wealth against local currency volatility, as many Latin Americans currently do.

As the demand for digital currency grows, the types of stablecoins available do too.

Digital dollar stablecoins

Dollar-pegged stablecoins are by far the most popular stable digital currencies right now. Their 1:1 backing with dollars in reserve makes them digital representations of physical dollars.

Tether (USDT) was the first digital dollar stablecoin to gain wide acceptance and is now ubiquitous across crypto exchanges. Using Tether and other popular digital dollars like USDC, traders can quickly shuffle funds between digital wallets, keep them on hand for market buying opportunities, or cash out to USD.

Crypto-collateralized stablecoins

Cryptocurrency usage and adoption are increasing, which means there are more crypto asset holders than ever. Because so many people are invested long term, using crypto to collateralize and issue stablecoins makes sense since it unlocks the collateral's liquidity without forcing the holder to sell.

The way collateralizing and issuing stablecoins with crypto collateral happens is straightforward. You deposit crypto in a stablecoin vault like Maker DAO, then mint stablecoins (in Maker's case, DAI) against your collateral. When you repay your loan and withdraw the collateral, DAI is removed from the supply.

Image courtesy of Dragonfly Research

Additionally, the programmable nature of blockchains like Ethereum opens up an entire realm of stable synthetic assets, i.e., assets that mimic others. Think of a plastic banana — it looks like a real banana, but isn't one. So it goes with stablecoin synthetic assets like Synthetix sUSD. Synthetix mints sUSD from a vault collateralized with SNX tokens.

Image courtesy of Dragonfly Research

Algorithmic stablecoins

Digital dollar stablecoins and crypto-collateralized stablecoins are 1:1 backed or over-collateralized by other assets. This makes them secure against price volatility and black swan events but comes at the cost of sourcing, securing, and warehousing collateral.

Algorithmic stablecoins are different from the reserve bank style of Tether, Maker, and Synthetix. Instead of relying on a reserve full of collateralizing assets, algorithmic stablecoin protocols are active open market participants buying and selling their own coins. Their market-making activities drive the stablecoin closer or further away from the intended peg.

Terra's UST, an algorithmic dollar stablecoin, works by incentivizing arbitrage opportunities between UST and Terra's LUNA token. When UST goes over the $1 peg, the protocol's stabilizing mechanism swaps $1 worth of LUNA for $1 of UST. This process allows you to sell each UST on the market for more than $1 and dilutes the UST supply — thus lowering UST back to its USD peg.

Image courtesy of Dragonfly Research


Advantages of using stablecoins

Stablecoins remain stable even in the face of volatility. Their value-securing superpower makes them your best friend when you need to do things like move money around or take profits on crypto trades.

Ultimately, stablecoins are an advantageous digital currency in a variety of situations. Let's unpack a few of the scenarios in which they thrive best.

Safe haven currency

In the time before stablecoins, if you wanted to protect your hard-earned gains from crypto market downturns, you had no choice but to sell to fiat currency.

Cashing out your crypto meant creating a taxable event and leaving the crypto ecosystem. The latter was a major headache before fiat to crypto onramps became as fast and efficient as today. As such, traders were left in a bind when reducing risk exposure. 

Stablecoins give traders a safe place to preserve capital. Because of them, you can keep your gains all in crypto while simultaneously reducing your exposure to price volatility in assets like BTC, ETH, DOGE, and LTC.

After weathering the latest storm, you can easily deploy your stablecoins back into the market across the myriad USDT, USDC, and DAI trading pairs available on exchanges like Coinbase, Binance, Kraken, Gemini, and Huobi.

Borderless payments

Let's suppose you need to move funds between Coinbase and Binance. Transferring BTC or ETH is problematic because they fluctuate in value and face network congestion. Instead, convert your funds into stablecoins, then send them. This way, you know how much money you're receiving no matter how much time passes in transit.

Additionally, you can send stablecoins like USDT using different blockchains like Polygon, Tron, Avalanche, and Solana. These chains are all much faster than Ethereum and cost far less per transaction to boot.

An equally compelling use case for stablecoins is sending them anywhere without geographic restrictions. Have you ever tried sending money between different geo-located PayPal accounts? It's a hassle and expensive when it works and frustrating when it doesn't. 

In contrast, there are no restrictions when sending stablecoins between crypto wallets. Someone in Canada can send stablecoins to a friend in India within minutes and pay minimal fees. The friend in India can cash out to rupees at the best exchange rate available to them.

Use DeFi, play crypto games, and buy NFTs

Stablecoins help ease the adoption of cryptocurrency applications. For instance, by converting cash to stablecoins on Coinbase, you can load your stablecoins into a MetaMask crypto wallet, then deposit them in a high-yield crypto savings account like Compound.

The same goes for buying NFTs. Gone are the days when you could only pay for NFTs with volatile ETH tokens. On NFT platforms like Zora, you can bid on artworks and pay for NFTs using stablecoins like USDC. This way, you gauge what you're spending in a directly correlated dollar amount.

Price stability is also key for in-game payments. Gaming is now a global, massively multiplayer sport. Players need frictionless money that can handle multitudinous micro payments in real-time. Blockchain gaming platforms are already using Circle’s USD Coin as they push stablecoin features toward the mainstream.

The best stablecoins

New stablecoins are popping up in the crypto market every day. Which stablecoins are safe, trustworthy, and popular? Here's a rundown of the best stablecoins available these days.

DAI

DAI is a decentralized stablecoin issued by the Maker DAO protocol on Ethereum. To mint DAI, you deposit ETH in Maker's reserve vault. The price of DAI is pegged to the US dollar.

In its 5+ years of running, DAI has faithfully kept its price peg and has grown to become one of crypto's most liquid stablecoins.

USDT

Tether (USDT) has a long and controversial history within the crypto space, but that hasn't stopped it from becoming the most popular stablecoin. Anywhere you look, USDT is a dominant trading pair.

On some exchanges, USDT trading volumes exceed those of BTC pairs, leading to a diminished BTC market dominance and a potential decoupling of the market from Bitcoin.

After years of speculation whether USDT was backed 1:1 with dollars in reserve, several audits have confirmed Tether is over-collateralized and secure. Perhaps the most significant confirmation of USDT's legitimacy was Coinbase's recent decision to finally list USDT on its exchange.

USDC

USDC is a stablecoin built by Circle, a payments company backed by Goldman Sachs. At its core, USDC is meant to be an institution-grade digital currency with a robust, regulated infrastructure and 1:1 dollar reserve.

Because of its compliant nature and institutional backing, USDC has found quick adoption and is a widely accepted stablecoin across crypto exchanges and merchants. So far, around $750 billion USDC has been transferred on the Ethereum, Algorand, and Solana blockchains.

BUSD

Whereas USDC has become Coinbase's unofficial stablecoin, rival exchange Binance created Binance USD (BUSD), a very official stablecoin.

Binance is the world's most popular crypto exchange, so creating BUSD was a natural progression for the company. To create BUSD, Binance partnered with Paxos. Together, they've built a vast reserve of audited US dollars held in FDIC-insured banks.

BUSD isn't very popular outside of Binance, but considering the extent of Binance's user base, the stablecoin reaches a large audience by default.

UST

UST is an algorithmic stablecoin on the Terra blockchain. You can buy UST directly on KuCoin, TerraSwap, Mirror Protocol, or mint it with LUNA tokens.

UST is hard to find outside of the Terra DeFi ecosystem. However, the sheer volume of Terra apps and their popularity in South Korea have made UST the largest algo stablecoin by market cap.

Diem

Diem is a global digital currency being developed by Facebook. It's meant to compete with impending central bank digital currencies (CBDC) and uses a blockchain-based payment system.

While Diem hasn't been released yet, we can only assume that Facebook's stablecoin will immediately become one of the world's most used digital currencies. Why? Because Facebook has nearly three billion users.

Problems with stablecoins

Stablecoins are a relatable way for people used to regular cash to start using digital currencies. However, stablecoins aren't without their drawbacks.

  • Centralization: Dollar-backed stablecoins like USDT and USDC are managed, audited, and issued by centralized reserve bank entities. As we've seen with Tether, if the parent company comes under fire, the entire crypto ecosystem is at risk by correlation.
  • Unsecure: Collateralized stablecoins rely on the custodians to reliably warehouse the collateral assets. This centralizes risk, which gives algo stablecoins an advantage. However, algo stablecoins are under-collateralized, leaving them exposed during black swan events.
  • Non-transparent: Because centralized entities operate most stablecoins, much of the activity related to them, including their backing, occurs off-chain. Determining whether a stablecoin is fully backed can get tricky, and answers can remain elusive.

The cryptocurrency ethos dictates that when problems with one model arise, the solution is to innovate rather than rely on incumbent frameworks. As such, even though some of today's most popular stablecoins are centralized and deeply embedded in the overall market, decentralized versions are quickly gaining steam.

Additionally, the increased regulatory scrutiny on the entire market has led stablecoins to come clean if they wish to survive. Tether's battle and subsequent settlement with the New York Attorney General is a prime example. 

In a landscape increasingly dominated by digital currency, the importance of stablecoins within financial infrastructures will significantly increase. So too will regulation. Early in 2021, US regulators cleared the way for banks to settle stablecoin payments. While the ruling was a win for digital currency, it also means stablecoins will likely be heavily regulated, as is traditional money.

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