What’s a Stablecoin? Main Types and Tips for Newbies
Stablecoins stand out as a special class of digital assets. Unlike volatile cryptocurrencies like Bitcoin (BTC), Ethereum (ETH), or Solana (SOL), stablecoins retain a consistent value. They help investors minimise price fluctuations and maintain stability while still enjoying the benefits of the crypto world. Therefore, in this article, we will cover everything about stablecoins, their functions, types, potential risks, and whether you should consider buying them.
How Do Stablecoins Work
Stablecoins use different mechanisms to tie their value to specific standards. This could be fiat money, commodities, or other assets. Among the top stablecoins in 2024, you can find USDT, USDC, TUSD, and DAI including many others.
Stablecoins linked to fiat money like the USD or EUR often act as crucial tools in bridging the traditional and decentralized finance sectors (DeFi). Such connections are usually achieved through smooth, fast, and dependable transactions worldwide.
Every stablecoin attempts to track the price of another asset. There are various methods to achieve this depending on the currency or commodity they are pegged to. For example, Paxos Gold (PAXG) is backed by gold, where each token represents one fine troy ounce of gold held in reserve. Consequently, certain stablecoins might present risks that others do not, based on their underlying assets. As their name suggests, stablecoins seek to mitigate this volatility.
Generally, traders leverage stablecoins in order to reduce the impact of price fluctuation. This helps eliminate the need to convert their digital assets into traditional cash. Currently, many stablecoin initiatives are in operation, however, only a select few still control the majority of stablecoin trading activity.
Types of Stablecoins
You might be wondering what type of stablecoin USDT is. Before diving into specifics, it’s important to understand the different categories and their mechanisms. Generally speaking, there are three types of stablecoins in the world:
- Cash-collateralized stablecoins
- Crypto-collateralized stablecoins
- Algorithmic stablecoins
Each of them has unique features and approaches to maintain its value. They are all available through various cryptocurrency exchanges, such as Binance or Coinbase, offering a diverse range of options for traders.
So, to fully grasp their nature and functionality, let’s delve deeper into each type of stablecoin, and discuss their benefits, and potential risks.
1. Fiat-collateralized Stablecoins
Fiat-collateralized stablecoins (or cash-collateralized stablecoins) are digital currencies backed on a 1:1 basis by a government currency such as USD or EUR. The so-called ‘cash equivalents,’ like treasury bills, can also serve as backup. These reserves are held in a financial institution like a bank. Every unit of a stablecoin is supported by an equal amount of fiat currency, which is held in reserve. This is how they maintain a consistent value. Examples include USDT (Tether) and USD (USD Coin).
2. Crypto-collateralized Stablecoins
Crypto-collateralized stablecoins are backed by other cryptocurrencies. They secure their value based on one or more crypto assets. They often leverage open-source software to authorise traders to lock crypto assets as collateral. This process yields new stablecoins through loans.
These stablecoins are frequently over-collateralized to counteract the high volatility of their reserve cryptocurrencies. This ends up being beneficial for traders and investors. If that turns out to be the case, the value of the cryptocurrency supporting such coins exceeds the value of the issued stablecoins.
3. Algorithmic Stablecoins
Algorithmic stablecoins are basically digital assets that rely on smart contracts to uphold their price pegs. Some of them use a secondary native token which helps them maintain price stability. Others, on the other hand, are known as rebase tokens which automatically adjust their supply in order to maintain pegs.
If these prices exceed the peg, the algorithm launches new tokens to be minted, which are then distributed among existing holders. This helps ensure market price stability. Conversely, if prices fall below the limit mentioned earlier, the algorithm removes tokens in circulation until the prices eventually stabilise. This system enables holders to exchange tokens for stablecoins and profit from price fluctuations until stability is restored.
Are Stablecoins… Stable?
Stablecoins aim to be stable by being pegged to traditional assets. However, you must understand that their stability can vary on their type. In general, fiat-collateralized stablecoins like USDT and USDC have been reliable and consistent in value for years now due to their reserves of traditional currency.
Algorithmic stablecoins, in contrast, carry a lot of risks due to their higher vulnerability to manipulation and attacks. In 2022, Terra Luna, a leading algorithmic stablecoin project, collapsed within a few days. This event came to be known as a ‘death spiral’ in the world of cryptocurrencies. It was the result of multiple large investors and traders offloading a huge amount of the platform’s algorithmic stablecoin TerraUSD on the market. This move caused its price to detach from the US dollar, triggering a series of troubles.
Risks and Considerations
Centralized Control and Transparency
Centralized stablecoins are not without their difficulties and threats. For example, in early 2022, the value of the US dollar-pegged stablecoin UST de-pegged from the dollar and plunged in value. Consequently, it ended up causing significant losses for investors. Due to a lack of transparency and accountability on the part of the central authority, trust in the stablecoin ultimately eroded. This is one of many examples of the potential risks associated with these coins.
Additionally, centralized stablecoins are vulnerable to external factors such as government intervention or market manipulation. If the central authority controlling a stablecoin is subject to sanctions or other regulatory measures, this could have a damaging impact on its strength. Similarly, if the central authority is susceptible to market manipulation, this could lead to instability in the value of the stablecoin.
Algorithmic Risks and Market Manipulation
The stability of algorithmic stablecoins is heavily conditional upon market demand, and general conditions. If demand decreases below a certain threshold, the entire system can stutter. Similarly, these stablecoins rely on independent investors, who can perform price-stabilizing arbitrage which ends up introducing significant risk.
Nonetheless, despite these potential downsides, the transparency and decentralization offered by algorithmic stablecoins can be attractive to some users. This is so because their operations are governed entirely by auditable code and are not subject to regulatory oversight.
It’s important to note, however, that the stability of algorithmic stablecoins can be severely impacted in times of crisis. This, for instance, includes times when traders acting on unclear information cause the stablecoin to lose value. Such market conditions could trigger a herd mentality, resulting in a significant drop in the stablecoin’s price.
Let us take the example of TerraUSD stablecoin experiencing a significant de-pegging event in May 2022. It led to a massive sell-off and a consequent drop in the price of Luna, the governance token of the Terra blockchain system. More recently, Binance’s removal of TrueUSD (TUSD) from its Launchpool in May 2023 marked another de-pegging event, highlighting how a single exchange’s actions can influence the market.
Regulatory Landscape and Uncertainty
Throughout 2024, new regulatory and legal requirements for stablecoin issuers are expected to come into force in major financial centres. From July 2024, stablecoin issuers in the EU, or those issuing stablecoins linked to a currency of an EU member state, will be captured by the Markets in Crypto Assets (MiCA) regulation. This move is bound to offer a lot of depth to regulations regarding stablecoins in general and also protect investors from systemic risks that they may encounter.
MiCA is a comprehensive framework that requires stablecoin issuers to maintain adequate reserves. It also ensures the redemption rights of token holders and protects and segregates assets. Of course, these are just among a few of its many obligations. Similarly, several other jurisdictions are also moving ahead with similar measures to crack the whip, so to speak.
Singapore has already set out a regulatory framework for stablecoin issuers. The framework will apply to single-currency stablecoins pegged to the Singapore Dollar or any G10 currency.
The UK and Hong Kong are also keen on pushing for legislative updates. In the UK, the Bank of England is expected to continue its progress work on addressing the risks of systemic payment stablecoins. These can have wider implications for financial markets given their size and scale.
However, a notable exception to this picture of clarifying rules and regulations is the USA. In October 2024, the US Congress made significant progress on stablecoin laws. Senator Bill Hagerty released a draft for a clear regulatory framework. Other representatives also proposed a deal to advance stablecoin legislation. Nonetheless, the timeline for approval is still uncertain due to the election season. Optimistically, though, there are still chances that the legislation could be passed by the end of 2024 or early 2025.
To Buy Or Not to Buy?
Just like other cryptocurrencies, stablecoins operate smoothly across international borders. Transactions take place seamlessly at minimal expenses or commissions. These tangible advantages make stablecoins a valuable option to traditional banking and an attractive option to investors.
Stablecoins offer the benefits of traditional cryptocurrencies, with transparency being the most important. At the same time, they also protect holders from price volatility. It is entirely up to you to try your luck with stablecoins. However, if you decide to invest in them, we can confidently say that cash-collateralized stablecoins remain one the most dependable solutions among other investing options.
FAQ
How do stablecoins maintain stability?
Are stablecoins volatile like other cryptocurrencies?
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