All You Need to Know About Stablecoins: Cryptocurrency’s Gold Standard
Key Questions Answered
The concept underlying stablecoins is a breath of fresh air to those interested in decentralized finance (DeFi). Cryptocurrencies present a fascinating opportunity for investors, but the inherent volatility can be enough to dissuade all but the more knowledgeable from getting involved. However, certain ideas are popping up around the industry, like lightbulbs lighting up a darkened space; ideas that help to mitigate or even solve the issue of volatility entirely. One such idea is that of stablecoins, and the potential they present has set the cryptocurrency world ablaze, with many different platforms competing to see who can offer the most “stable” stablecoin.
What Are Stablecoins?
A stablecoin is a digital token pegged to the value of a stable asset, most commonly a fiat currency, like the US dollar. Designed to overcome the volatility of cryptocurrencies, stablecoins provide a reliable medium of exchange/store of value for crypto users. However, they don’t all work the same way.
Here are the different types of stablecoin available, and how the underlying mechanisms that allow them to operate:
Types of Stablecoins
Stablecoins fall into three broad categories:
- Collateralized stablecoins are backed by an asset of value to help them maintain their stability.
- Uncollateralized stablecoins aren’t backed by any asset of value, but their stability is maintained using an algorithmic model of issuance to control inflation.
- Hybrid stablecoins use a combination of the two methods above. There are some assets held in reserve, but an algorithm also helps to control the value.
By far, collateralized stablecoins are the most popular, well-used, and widely circulated – accounting for the lion’s share of the combined total market cap. So far, none of the projects in the other two categories have achieved any meaningful success by comparison.
Fiat-Collateralized Stablecoins
Fiat-backed stablecoins were the first kind of stablecoin to arrive on the market, with Tether having launched the first USD stablecoin, USDT, in 2014. The idea behind a fiat-collateralized stablecoin is as follows – $1 worth of stablecoin is backed by $1 of “real” currency held in reserve. Essentially, it’s a cryptocurrency tied to the dollar; or perhaps a form of cryptocurrency federal reserve, if you will.
While still by far the largest stablecoin by market cap, Tether has come under fire over recent years, mainly due to doubts around the quantity of reserves it holds to back up its coin issuance. In 2019, the New York Attorney General’s (NYAG’s) office brought a lawsuit against Tether’s parent company. The NYAG alleges that Tether had gambled with user’s funds after giving a $1 billion loan to sibling company, Bitfinex, which had subsequently lost the money. To date, Tether has declined to undergo an independent audit that would prove the level of funds it holds in reserve.
The case is still ongoing, but it hasn’t affected Tether’s popularity, as USDT has maintained its position in the top five cryptocurrencies.
Stablecoin supply statistics as of early-2022, showing massively increased adoption (source: Cointelegraph)
Nevertheless, USDT is no longer the only fish swimming in the fiat-backed stablecoin sea. Since 2018, competitor stablecoins have flooded the market, including USDC, GUSD, and BUSD. Most likely as a way of distancing themselves from the tribulations of Tether, the issuers mentioned here have all undertaken regular audits of their reserves.
Crypto-Collateralized Stablecoins
Crypto-collateralized stablecoins are backed by cryptocurrencies. However, due to the volatility inherent in cryptocurrencies, they generally use some kind of price stability protocol to adjust the required collateral, ensuring the price remains pegged to a stable value.
The oldest and best-known crypto-backed stablecoin is Maker’s DAI. The underlying mechanism is technically complex. However, in summary, users can deposit ETH and other cryptocurrencies into smart contracts known as Collateralized Debt Positions. The deposit will result in the issuance of the DAI stablecoin, which is pegged to the value of the US dollar.
Maker is a project based on Ethereum, meaning that it can only support the creation of DAI using Ethereum-based tokens. A newer project, Kava, is based on the interoperable Cosmos platform. Therefore, Kava aims to be a version of Maker that can ultimately allow the issuance of crypto-backed stablecoins based on assets from any blockchain.
Additionally, the more recent release of the crypto-backed British stablecoin jFIATs by the Jarvis Network represents an interesting and localized version of the same concept. jFIATs track the price of their representative currency – in this case the UK’s pound – against the US dollar, and are collateralized using USDC (another, US dollar-backed stablecoin).
There are several other companies whose business concepts model that of the Jarvis Network, each representing a currency in a localized area. Euros, Canadian dollars, Swiss francs, and others; all have been swept up in the emerging stablecoin craze, and each with their own corresponding cryptocurrency. Most of these currencies can be used, traded, and managed on Polygon, a protocol that lets DeFi developers build and connect Ethereum compatible networks.
Most Well-Known Stablecoin Market Information and Analysis
While certain pros and cons of different stablecoins themselves may be debatable, their rise has not. More than $180 billion dollars in coins have been issued worldwide, making stablecoins one of the fastest growing sectors in the cryptocurrency industry. In order to better understand the stablecoin market, here we shall examine several well-known stablecoins in brief:
- Tether (USDT): Tether is the third largest cryptocurrency in the world by some metrics. Tether’s increase in adoption over the years is hard to argue, as is its lack of transparency and the amount of controversy the company has been in of late. Some investors believe that a loss of confidence in this coin is inevitable, but this remains to be seen.
- US dollar coin (USDC): Released by the digital currency company Circle, USDC is very similar to Tether in that is backed by the US dollar at a 1:1 ratio. Where they differ somewhat however is in their behavior, USDC has been much more transparent, issuing audits regularly. Many analysts see this as a huge positive, and possibly one of the reasons why USDC has begun to catch up to the much older Tether in terms of market share.
- Paxos standard stablecoin – PAX (USDP): Another form of stablecoin backed by the US dollar, the PAX. Issued in the form of an ERC-20 token (the standard for the Ethereum blockchain network), the PAX is a popular choice for stablecoin users. With the way things are going for the coin, there is little reason to predict anything other than ongoing success.
- Terra USD: Again, Terra USD is a form of stablecoin that uses the Ethereum network for both security and stability. Many analysts have pegged this as one to watch in 2022/23.
- TrueUSD: Yet another stablecoin pegged to the value of the US dollar is True USD. The company has done an extremely good job of preventing inflation/deflation of their coin’s price, though they are not as heavily adopted as some of their competitors. Despite this they have managed to maintain an air of relative transparency, something that bodes well for the company’s future.
- MakerDAO (DAI): The final stablecoin on this list, and another that runs on Ethereum’s blockchain, DAI is one of the oldest stablecoins on the market. DAI maintains its value not by being backed by US dollars, but instead using collateralized debt denominated in Ether (ETH, the Ethereum network’s native currency). DAI has been a popular option for stablecoin investors for quite a number of years, and many see this trend continuing into the future.
How Are Stablecoins Used?
Fiat-backed stablecoins became popular among crypto traders as they provide a reliable means of denominating profits and losses. If a trader chooses to exit a position in BTC or ETH, they can hold their profits in a USD-backed stablecoin until they’re ready to enter a new position, without risking losses due to crypto’s volatility.
However, the decentralized finance (DeFi) movement has created entirely new use cases for stablecoins. This has come about mainly due to the unregulated status of stablecoins and DeFi – although some do require KYC for onboarding. Nevertheless, because there is a high demand for stablecoins from traders, users can lend them out using DeFi protocols such as Compound or AAVE and earn high yield.
Furthermore, the emergence of liquidity mining using stablecoins on protocols like Uniswap or Balancer has created new sources of revenue. When users contribute their stablecoins to a liquidity pool, they can now also earn governance tokens in DeFi protocols, which are often highly appreciative assets.
With over $9 billion staked in DeFi at the time of writing, it’s turning into a highly lucrative industry for those who understand how to play the system and are willing to accept any associated risks.
Whether or not the DeFi bubble continues to inflate, and stablecoins continue to remain unregulated is yet to be seen. However, in the meantime, stablecoins remain a hugely popular and ever-growing class of cryptocurrencies with many benefits for traders.
Are Stablecoins Securities?
Unfortunately, the answer to this question is not quite as clear cut as one might hope. The use of stablecoins presents a fair number of challenges with respect to public policy, whose main concern is to protect investors and financial security. A governmental report issued in November 2021 stated “stablecoins, or certain parts of stablecoin arrangements, may be securities, commodities and/or derivatives”.
It therefore stands to reason that stablecoins can be considered as securities. However, because of the lack of regulation that surrounds the trade of crypto as a whole, this term can only be used loosely. The simple fact is that, no matter how stable a cryptocurrency is, it is still a cryptocurrency; something which the traditional world of finance has been woefully slow to integrate into their pre-existing model. It’s hoped that regulation can help to provide that sorely needed integration.
How Should Stablecoins Be Regulated?
Stablecoin regulation has been a topic of growing concern for some years now. This is because, as things currently stand, stablecoins are completely unregulated by any major sanctioning body. Some watchdog agencies fancy themselves for the job, and have seemed keen to offer their independent services in the advent of regulation. Whether they’re actually best suited for the job, however, is another matter entirely.
It’s the opinion of many in the industry that the only way that stablecoins can achieve true stability is through proper governmental regulation. If federal safety and soundness regulations can be successfully implemented, they reason, there is no telling the heights that stablecoin popularity could reach. This is because various publications have suggested that one of the major roadblocks impeding the rise of stablecoins has been the worry from potential investors over a lack of regulation. If this roadblock can be removed, it’s safe to say that the future for stablecoins, and their holders, will look bright indeed.
How Will The U.S. Government Regulate Stablecoins?
The U.S. Federal Reserve and digital currency have had, at best, a rocky start to their relationship. In fact, a Federal Reserve Board financial stability report published in 2021 cited stablecoins as a “growing financial stability risk” for the very economy of currency trade itself. However, with the market cap of several major stablecoin issuers totaling around $150 billion, it’s safe to say that a proactive step towards proper regulation is probably in everyone’s best interest at this point. Stablecoins look to be here to stay for the foreseeable future.
The President’s Working Group (PWG) has argued that stablecoins be treated like bank deposits. By this argument, stablecoin issuers would have to comply with all the same laws, rules, and regulations that apply to the modern banking system. The PWG have also made the comparison between exchange-traded stable value funds (ETSVFs) and stablecoins, stating that this could present another road to regulation. However, as things stand this is all entirely theoretical. It’s important to remember that stablecoins are currently still unregulated, and there have been no immediate moves to undo this considerable oversight as of yet.
Congressional speaker awaiting stablecoin ruling (source: Quartz)
What Are The Effects of Cryptocurrency on Government Monetary Policy?
While some try to deny it, cryptocurrencies do effect the standard economy of international currency trade. Similar to lowered interest rates or eased regulations for banks, stablecoins and crypto represent a loosening of the general money supply. The same would be true of any asset that was used en masse as a representation of value, as it replaces the need for traditional money. At least in some small, but not insignificant way.
While the effect on U.S. monetary policy has been negligible to date, this seems unlikely to last, particularly with the growth crypto and stablecoins have experienced in recent years. As things currently stand, the U.S. dollar supply is still 50X that of the entire value of cryptocurrency combined. Additionally, much of that could only be loosely defined as money, as it’s not held in liquid form. Liquidity refers to the ease with which something can be traded for another asset of agreed upon and equal value.
The effect has, as expected, been more pronounced in countries that have smaller economies – especially those with weaker-than-usual national currencies. However, as monetary policy has typically been difficult to ascertain in any clearly defined way in such jurisdictions, the effect on it has been hard to measure.
In the future, if cryptocurrencies and stablecoins continue to see increased adoption across the board, it seems reasonable to speculate that central banks will begin to have an increasingly difficult time when attempting to tighten monetary policy. Combined with the fact that the same monetary policy will also be hard to loosen, because of increased competition brought about by crypto’s proliferation, this could make tackling these issues a real problem. If banks and other forms of central authority can perhaps do a better job of integrating cryptocurrency into the traditional world of finance, at least to some degree, then it’s hoped these issues can be mitigated.
How Can Stablecoin Issuers Tackle These Issues?
For the time being, all that stablecoin issuers, and altcoin issuers as a whole, can really do is continue what they have already been doing. Continue petitioning their local financial and governmental authorities, continue streamlining their platforms, and continue putting out the word about the potential crypto offers. The whole world of finance can rather obviously benefit from a stable and secure online barter system. Cryptocurrency clearly facilitates this system; now all the world of centralized finance (CeFi) has to do is wake up to this idea, and help increase the levels of security and transparency clearly needed to make this system function properly.
Conclusion
To conclude, it’s very clear that stablecoins present an extremely useful and necessary function for the world of cryptocurrency, and perhaps even the financial industry as a whole. However, this can only be achieved through proper regulation, which in turn can only be achieved if certain sanctioning bodies will do their part to enable that regulation. As with any form of trade, some type of security is essential if two parties that are previously unknown to one another are to trade with one another with maximum confidence. Stablecoins can help to provide that much needed security and confidence for the financial industry, confidence it has lost steadily throughout the years. Now all it needs is for the financial industry to provide it with some much needed security of its own. Security in the form of proper, institutional regulation.