Stablecoins are cryptocurrencies that maintain a stable value by pegging their worth to traditional assets. And they are tied to fiat currencies like the U.S. dollar or commodities such as gold.
Additionally, this pegging mechanism minimises volatility, making stablecoins more suitable for everyday transactions compared to more volatile cryptocurrencies like Bitcoin.
They serve as a bridge between the crypto and fiat worlds. Stablecoins facilitate easier trading, saving, and transfer of value without the unpredictability associated with other cryptocurrencies.
Types
Stablecoins are categorised into several types based on their collateralisation methods.
- Fiat-Collateralised Stablecoins: The U.S. dollar backs fiat-collateralised stablecoins. Examples include USDT (Tether) and USDC (Circle).
- Crypto-Collateralised Stablecoins: In crypto-collateralised stablecoins, other cryptocurrencies that are less prone to volatility back these assets. Examples include: DAI (MakerDAO), backed by ETH and other crypto assets, and LUSD (Liquity USD), backed by ETH.
- Algorithmic Stablecoins: These maintain their peg through algorithms and market mechanisms rather than direct collateral. For instance, FRAX, which is partially backed by USDC and its own token, FXS, and UST (Terra), which was previously backed by a combination of LUNA and BTC and has faced significant issues.
How Do Stablecoins Work?
Stablecoins maintain their value through different mechanisms depending on their type:
1. Fiat-Collateralised Stablecoins: These stablecoins are backed by reserves of fiat currency, typically held in a bank account. For instance, USDC (USD Coin) is pegged to the U.S. dollar and relies on regular audits to ensure that each coin is backed by an equivalent dollar in reserves.
2. Crypto-Collateralised Stablecoins: Backed by other cryptocurrencies, these stablecoins often require over-collateralisation to maintain their peg. DAI, for instance, uses a system where users lock up collateral like ETH to mint DAI, with mechanisms in place to liquidate collateral if its value falls too low.
3. Algorithmic Stablecoins: These use algorithms and smart contracts to manage supply and demand dynamically. They adjust the supply of the stablecoin based on market conditions. For example, UST (Terra) previously used a mint-and-burn mechanism with its governance token LUNA to stabilise its price.
Functions of Stablecoins
- Volatility Hedge: They allow users to secure profits from volatile assets without converting to fiat, thereby helping them avoid taxes.
- Liquidity Provision: Stablecoins facilitate trading on decentralised exchanges, acting as a bridge between cryptocurrencies and fiat.
- Decentralised Finance (DeFi): They enable lending, borrowing, and earning interest in DeFi platforms, enhancing the utility of blockchain technology.
Use Cases
Payments
Stablecoins enable instant and low-cost transactions across borders, allowing users to send money without relying on traditional banks. For example, using stablecoins for daily purchases via debit cards linked to crypto wallets simplifies spending.
DeFi Lending and Borrowing
Users can lend or borrow stablecoins on decentralized finance platforms, earning interest or accessing funds without selling volatile assets. This provides liquidity and financial flexibility.
Wealth Storage
Stablecoins serve as a safe haven during market volatility, allowing users to store value without the fluctuations seen in cryptocurrencies like Bitcoin or Ethereum.
Trading and Arbitrage
Traders use stablecoins for quick trades, taking advantage of price differences across exchanges without converting back to fiat, facilitating efficient market operations.
Earning Interest
Users can stake stablecoins on various DeFi platforms to periodically earn interest rates significantly higher than traditional banks, often ranging from 5% to 20% APY. This incentivizes users to hold stablecoins instead of fiat currency.
Cross-Border Transactions
Compared to traditional methods, stablecoins facilitate fast and cost-effective cross-border payments, removing the need for currency conversion and high transaction fees.
Trading and Liquidity
Traders use stablecoins as a medium for trading various cryptocurrencies, providing liquidity on exchanges and enabling quick entry and exit from positions without converting to fiat.
Accessing Financial Services
Stablecoins enable users in regions with limited banking access to participate in financial services, such as lending and savings, without relying on traditional banking systems.
Decentralised Applications (dApps)
Stablecoins are often used within dApps for transactions, governance, and other functionalities, making them integral to the operation of many blockchain projects.
Risks and Challenges of Stablecoins
- Regulatory Risks: Stablecoins like USDT may encounter regulatory scrutiny, particularly in regions implementing frameworks like MiCA, which could require compliance and capital reserves. Non-compliance could lead to removal from exchanges, affecting their market position.
- Redemption and Liquidity Issues: If a stablecoin claims to be redeemable for underlying assets, there is a risk that the redemption process may fail during market volatility, leading to liquidity problems for users.
- Centralisation Risks: Many stablecoins, such as USDT, are criticized for being overly centralised, which raises concerns about trust and the potential for manipulation by a small group of entities.
- Market Volatility: Algorithmic stablecoins can experience significant risks during market downturns, as seen with the collapse of TerraUSD (UST), which was unable to maintain its peg during extreme volatility.
- Smart Contract Vulnerabilities: Stablecoins like DAI are subject to smart contract risks, including bugs or governance issues that could compromise their stability or functionality.
Future of Stablecoins
Increased Adoption and Regulatory Oversight
As stablecoins gain popularity, regulatory bodies are likely to implement stricter guidelines to ensure transparency and consumer protection.
This could lead to more standardised practices across the industry, enhancing trust and stability in stablecoins.
Role of Central Bank Digital Currencies (CBDCs)
CBDCs can coexist with stablecoins, providing a government-backed alternative that could impact their usage.
In addition, CBDCs could offer similar benefits but with enhanced regulatory oversight, potentially leading to competition or collaboration between traditional finance and crypto.
Integration into Traditional Banking
Collectively, stablecoins are expected to integrate further into traditional banking systems, allowing for seamless transactions between crypto and fiat.
This integration could facilitate easier access to financial services for unbanked populations and enhance the efficiency of cross-border payments.
