What are Stable Coins?
The functionality of stable coins has been questioned since the demise of UST and LUNA. People are losing faith in cryptocurrencies, and officials are attempting to seize control. Such events will form a better and more robust environment in the future for Crypto, which is still in its infancy!
Let’s start with an explanation of what Stablecoins are.
Stablecoin is a type of cryptocurrency that is used to minimize volatility in pricing by pegging its value to a more stable US Dollar. Digital Assets of Fiat Currency (like USD, EURO, British Pound) is the most popular use case for Stablecoins.
There are several benefits of using Stablecoins, which include taking advantage of blockchain technology and peer-to-peer value transfer, while not being exposed to high volatility in the prices of Bitcoin, Ethereum, or other cryptos.
Understanding this by an example:
Suppose you want to send Rs. 10,00,000 on bank holiday. You may use blockchain technology for instant money transfers. But due to price fluctuations in BTC, ETH, may receive Rs. 9,99,900 or Rs. 10,00,500. Either case is not fair. So to deal with such issues, within minutes you can send Stablecoin whose value remains constant most of the time!
With all the transactions recorded in Public Ledger!!
Can you now imagine the big picture of companies paying out using this, worldwide?! 🤔
As of writing this, the Market Capitalisation of Stable Coins is $160 Billion. With a daily trading volume of $60 Billion.
What are the types of Stablecoins?
- Fiat Collateralised Stablecoin
- Crypto Collateralised Stablecoin
- Non-Collaterised or Algorithmic Stablecoin
- Central Bank Digital Currency (CBDC)
Let’s understand one by one
Fiat Collateralised Stablecoins
The tokenization of the US Dollar into USD Coin happens in a three-step process:
- A user sends US dollars to the coin issuer’s bank account.
- The issuer uses a USD Coin smart contract to create the equivalent amount of USD Coin.
- The newly minted USD Coins are sent to the user and the substituted US dollars are held in reserve.
These cryptocurrencies maintain a reserve of fiat currency such as the US Dollar, as collateral assuring Stablecoin value.
Such reserves are maintained by an independent custodian and are regularly audited.
Risks: Fiat Collateralised Stablecoin
•Counterparty Risk (fraud, theft, govt seizure, etc.)
•Censorship Risk (operations blocked by regulators, etc.)
•Economic Risk (off-chain assets go down in value)
Each can result in the stablecoin value going to zero.
There are 3 major Fiat Backed Crypto Stablecoins: USDT, USDC & BUSD.
The Biggest Market Capitalised USDT (Tether) has a large reserve of US dollars, that is regularly audited by an independent group of people.
Here’s the breakdown of USDT Reserves:
Red Box alert! Commercial paper is a commonly used type of unsecured, short-term debt instrument issued by corporations, typically used for the financing of payroll, accounts payable and inventories, and meeting other short-term liabilities.
Commercial paper is not usually backed by collateral, making it a form of unsecured debt. It differs from asset-backed commercial paper (ABCP), a class of debt instrument backed by assets selected by the issuer.
USDC
Fintech company Circle is looking to make a better, faster, digital version by launching USDC backed by Coinbase and Goldman Sachs.
It is also backed by a large reserve of US Dollars that are held in accounts at regulated US Financial Institutions and attested (Not audited) by a large accounting firm named Grant Thornton LLP
BUSD
Binance USD (BUSD) is a new stable coin developed in partnership between Binance and Paxos. It is backed 1:1 by U.S. dollars.
Crypto Collateralised Stablecoin
These cryptocurrencies also maintain reserves but instead of Fiat Currency, they hold another cryptocurrency in the reserve.
Risks: Crypto Collateralised Stablecoin
•It’s not the most capital efficient because it requires over-collateralization.
• Smart Contract risks
• Asset collateral depreciation
Example: DAI
Dai is pegged to the value US Dollar, but it is backed by Ethereum as collateral.
So, the model works like this: 1 Eth=2000 DAI, 2000 DAI=2000 USD
To safeguard reserves, sometimes such transactions often take place in an over-collateralized manner.
Non-Collaterised or Algorithmic Stablecoin
Algorithmic stable coins keep their value stable by using algorithmic formulas. They are not backed by any hard cash or currency, they work on the basis of demand and supply.
Risks: Non-Collaterised or Algorithmic Stablecoin
- Collateral (issuance>value)
- Data Feed (system can’t price itself)
- Governance (parameter failure)
- Base Layer (chain fails)
- Smart Contract (hack leads to insolvency)
Example: Luna and UST, value of UST was backed by Luna. That means the circulating supply of Luna keeps on changing based on the demand of UST in order to maintain the value of UST at 1 US Dollar.
However, in the event of a crisis, algorithms can fail and lead to tragic losses and this is what happened.
Central Bank Digital Currency (CBDC)
A CBDC is a virtual money backed and issued by a central bank.
- A central bank's digital currency is the digital form of a country’s fiat currency.
- A CBDC is issued and regulated by a nation’s monetary authority or central bank.
- CBDCs promote financial inclusion and simplify the implementation of monetary and fiscal policy.
Risks: Central Bank Digital Currency
China has been experimenting with CBDCs for quite a long time and rolling out CBDCs that are now being used in public transport like buses, trains, and metros.
Fractional-algorithmic stablecoin
A new type of stablecoin is also coming up these days in the crypto space. It is being partially backed by collateral and partially stabilized algorithmically. Frax Protocol is one such protocol.
Emerging Stablecoins:
USN- Near Blockchain’s Stablecoin. Algorithmic and Doble Collateralised by Near and USDT
USDD- Tron Blockchain Stable Coin offering High yield like anchor protocol (Similar to Luna Death Spiral utility protocol) (Just launched more details awaited)
CMST- Cosmos Blockchain StableCoin building and about to launch.
Final Thoughts:
Stablecoins have many utilities in terms of fast transactions, blockchain security, public ledger support and many more. However, there are many risks involved when it comes to stable coins and events like UST, where we witnessed stablecoins losing their 1:1 peg against US Dollar.
Published By
Aishray Suryawanshi
For more such content, follow me on Twitter: https://twitter.com/AishrayS
Risk Disclosure: Trading in cryptocurrencies involves high risks including the risk of losing some, or all, of your investment amount, and may not be suitable for all investors. Prices of cryptocurrencies are extremely volatile and may be affected by external factors such as financial, regulatory, or political events. Author or the organisations he is associated cannot be held responsible for any losses.
