Caleb & Brown

April 28, 2022  ·  5 min read

Stablecoins Explained: Reaching for Stability in a Volatile Market

Stablecoins Explained: Reaching for Stability in a Volatile Market

Stablecoins are some of the most highly traded coins on the market. In some weeks, Tether outpaces Bitcoin in trading volume.

Why are so many flocking to a coin that rarely changes in value? 

Are some stablecoins really backed by gold?

Keep scrolling to learn more about these very unique “stablecoins” and how they might be of use to you in the world of cryptocurrency.

What Are Stablecoins?

Stablecoins are a class of alternative cryptocurrencies (altcoin) that attempt to offer relative price stability. Their market value is usually pegged to the value of a stable asset, like USD or gold.

Stablecoins are designed to be somewhat resistant to volatility, so you won’t see significant price changes.

Stablecoin projects claim to be backed by a reserve asset (e.g. US dollar), another cryptocurrency (e.g DAI), or a precious metal. Some stablecoins use algorithms to continually adjust their price to account for demand and supply dynamics.

Through the use of algorithms, or through pegging their value on a different asset, stablecoins function more like a fiat currency within a crypto space. They are often traded at high volumes; similar to cash in a traditional market.

Tether (USDT) is the stablecoin with the highest market cap. Image: Shuttertsock
Tether (USDT) is the stablecoin with the highest market cap. Image: Shuttertsock

How Do Stablecoins Work?

Stablecoins achieve their price stability via collateralisation (backing) or through algorithmic mechanisms of buying and selling the reference asset or its derivatives. 

A company, like Tether (USDT), can claim that every coin they create is backed by a reserve asset in their possession. Traders trust that the company is solvent and does have the actual assets it claims to have. 

As long as the company has the assets (crypto, fiat, or precious metals), the price should reflect the value of the pegged asset.

Most Common Stablecoin Use Cases

  • Gateway to DeFi: For traders, stablecoins are often a gateway into decentralised finance (DeFi). They are by far the most traded coins across decentralised and centralised exchanges (DEX/CEX) due to their ability to function as currency in the DeFi space.
  • As Everyday Currency: A majority of large stablecoins are pegged to USD, so they are meant to be $1 today, tomorrow, and so on. Less volatility makes stablecoins a reasonable alternative for facilitating DeFi transactions for goods, services, and more.
  • As a Trading Pair: Stablecoins will often pair with the most popular cryptocurrencies, making for simplified trades between different types of coins. They help facilitate the most liquid transactions due to their popularity (USDT in particular). 
  • Lending & Borrowing: Stablecoins can also be used for lending and borrowing. Traders can lend a portion of their assets to a borrower, in hopes of a yield after the borrowing period has ended.
Stablecoins are the most traded coins across decentralised and centralised exchanges (DEX/CEX). Image: Shutterstock
Stablecoins are the most traded coins across decentralised and centralised exchanges (DEX/CEX). Image: Shutterstock

Types of Stablecoins

The 4 common types of stablecoins are listed as follows:

Fiat-Backed

These cryptocurrencies claim to be pegged to a legal tender of a particular country. Common examples include Tether (USDT), USD Coin(USDC), and True USD (TUSD).

The majority of these coins are created and managed by a central authority, but not the same authority as the fiat currency they are pegged to. Rather, the company issues tokens equivalent to the amount of fiat currency in their reserves. Traders trust that the company’s ledger and reporting are true.

Crypto-Backed

We know what you’re thinking, crypto backed by more crypto? How does this work? 

Crypto-backed stablecoins are often overcollateralised to account for potential fluctuations within the market. A prime example of this would be the ‘on-chain’ cryptocurrency, Dai (DAI).

Let’s say a crypto-backed stablecoin is worth $1. This $1 will be tied to another cryptocurrency worth $2 or more. If the backing currency loses value, the stablecoin could still be worth $1. There is a built-in buffer to account for price changes.

This class of coins often utilises smart contracts, removing the need for third parties to validate transactions on the network. This decentralised approach to management differentiates crypto-backed stablecoins from many fiat-backed ones.

Commodity-Backed

These types of stablecoins use a precious metal, like gold, to affirm their value.

Centralisation could be seen as a disadvantage by some investors. The trade-off is that you get a level of stability backed by an asset that has a proven track record in traditional markets. 

Commodity-backed stablecoins also facilitate investments in assets that may otherwise be out of reach locally. For instance, in many regions, obtaining a gold bar and finding a secure storage location is complex and expensive. Gold is seen as a hedge against stock market volatility. Precious metal-backed stablecoins are introducing this concept of ownership to the world of cryptocurrency.

Algorithmic

Considering most stables are backed to another asset, algorithmic coins go against the grain; they aren’t backed at all.

This type of stablecoin does not rely on fiat or crypto as collateral. Instead, it has a smart contract set up that attempts to adjust its market cap based on price fluctuations.

Let’s say an algorithmic coin is pegged to the US dollar. Some market activity causes the price of the stablecoin to rise above the 1:1 peg. More of the stablecoin will release, increasing the supply and thus reducing the price, matching the 1:1 peg. If the price falls, the coin supply is automatically cut off. This creates scarcity, which causes the price to rise again.

The most well-known example is TerraUSD (UST), but that has since proven to be a failed attempt. There are, however, several other successful algorithmic stablecoins, such as Ampleforth (AMPL) and the Tron network’s Decentralized USD (USDD).

Why Are Stablecoins Important?

Stablecoins fill a void in cryptocurrency that some of the major coins have a difficult time fulfilling. Some of the many reasons why stablecoins are important include:

  • A streamlined way to access the DeFi market.
  • A highly functional everyday cryptocurrency.
  • Potential to ‘firm-up’ smart contracts whose terms can be easily influenced by crypto market fluctuations.
  • Through the use of smart contracts, some stables are decentralised.

Possible Risks Associated With Stablecoins

As with any cryptocurrency, fiat currency, precious metal, or another asset, investing will always bring a level of risk to all parties involved. There are some disadvantages to having stablecoins:

  • Markets can be volatile. Just because a coin is considered “stable” it does not mean it is completely unaffected by market changes. 
  • Lack of government interference means there is no authority to regulate the validity of these projects.
  • Lending stablecoins can offer a yield to investors, but it is a very conservative way to invest in cryptocurrency.

While more regulations are being introduced by governments in the crypto space, stablecoins in particular have gone mostly unregulated. At present, there is no standard methodology to confirm whether a stablecoin project has the solvency needed to back its coin. Although most companies maintain transparency about the state of their reserves, there’s no central body to confirm or deny their reporting. 

Stablecoins are also a relatively new concept within cryptocurrency. Lack of time in the market could make some investors wary of their use cases.

Further reading: Blockchain and Cryptocurrency Laws and Regulations 2022

Current Regulations

With the current stablecoin market at $180 billion and growing exponentially over the last two years, policymakers are stepping in to regulate the space. In October 2021, the International Organization of Securities Commissions proposed that stablecoins be regulated in the same ways as payment systems and clearinghouses. The proposition would target specific coins (not every stablecoin) that it believes could impact these financial institutions.

On a national level, politicians like Representative Josh Gottheimer have drafted early legislation around the definition of stablecoins. We’ll continue to monitor this space for changes.

FAQs

Where can I buy stablecoins?

Through an exchange (centralised or decentralised), or through a broker like us

What is the top stablecoin by market cap today?

As of April 13, 2022 Tether is the top stablecoin with a market cap of $82,635,662,125.

Is Bitcoin a stablecoin?

Bitcoin does not include any of the common characteristics of a stablecoin (backing or steady price point) and is therefore not a stablecoin.

What does pegged mean in crypto?

A pegged cryptocurrency is a crypto whose value is tied to the value of another existing asset. Changes in the value of the original asset affect the pegged cryptocurrency accordingly.

What are stablecoins used for?

Stablecoins are used for everyday DeFi transactions, trading pairs, and for maintaining a highly liquid position on exchanges. They are also used for lending and borrowing.

Purchase Your First Stablecoin with Caleb & Brown

Stablecoins are considered to be the foundation of DeFi. Their ease of use and high liquidity could help any trader diversify their portfolio.

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Disclaimer: This assessment does not consider your personal circumstances, and should not be construed as financial, legal or investment advice. These thoughts are ours only and should only be taken as educational by the reader. Under no circumstances do we make recommendation or assurance towards the views expressed in the blog-post. The Company disclaims all duties and liabilities, including liability for negligence, for any loss or damage which is suffered or incurred by any person acting on any information provided.

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