WTF is stablecoin?

WTF is stablecoin?

Stablecoin is a kind of cryptocurrency that gets its value from an external asset. Companies that issue stablecoins will set up a secure ‘reserve’ of the asset backing the stablecoin, typically in a one-to-one ratio. The reserve can be centralized with a central issuer or financial institution, as is the case with fiat or commodity-based assets, or it can be decentralized.

Users can theoretically redeem one unit of stablecoin for one unit of the asset that backs it. This tie-in helps stablecoins maintain their value -- the asset in the reserve serves as collateral for the stablecoin.

Types of stablecoin collateral

There are different types of assets that can be used to act as security or “collateral” against stablecoins. 

Fiat-collateralized stablecoin

Fiat-collateralized stablecoin refers to stablecoin that’s tied to fiat money, which is a government-issued currency like the U.S. dollar. Fiat is the most common collateral for stablecoins and the U.S. dollar is the most popular among fiat currencies, but other currencies have been used like the euro and the Chinese yuan. 

Commodity-collateralized stablecoin

Some cryptocurrencies are tied to the value of commodities, like precious metals such as gold or silver -- sometimes even oil or real estate. Commodity-backed stablecoins have the potential to offer more lucrative incentives since the assets can appreciate in value over time. The coin can be backed by one or more commodities. 

Crypto-collateralized stablecoin

Some stablecoins even use other cryptocurrencies as collateral. This process occurs on the blockchain technology that powers crypto and it uses ‘smart contracts’ (programs stored on a blockchain that run when predetermined conditions are met) instead of a central issuer. Because the asset that backs the stablecoin is on the blockchain, this kind of stablecoin is considered decentralized, with no central authority. 

Since the tied asset is also a cryptocurrency, it may also be highly volatile -- depending on the stablecoin. To reduce volatility, crypto-collateralized stablecoins can be over-collateralized so they can absorb price fluctuations in the collateral. For example $500 of a crypto-collateralized stablecoin might be backed by $1000 of another cryptocurrency -- if that cryptocurrency’s value dropped but remained above a set threshold, the excess collateral would buffer the stablecoin’s price to maintain stability. 

In the event of a price crash, crypto-backed coins are auto-liquidated into the underlying crypto asset. To distribute and mitigate risk, crypto-backed stablecoins are sometimes backed by multiple cryptocurrencies. They can be quickly and cheaply converted into their underlying asset as well.

Non-collateralized (algorithmic) stablecoin

Non-collateralized -- algorithmic -- stablecoins don’t use any assets. Instead, they use specialized algorithms and smart contracts to maintain a stable price and manage the supply of coins in circulation. The algorithm issues more coins when the price increases and buys them off the market when the price falls. 

However, there’s an added risk -- because there’s no attached collateral that users can liquidate their coin into, users risk losing all their money in the event of a crash.

Popular stablecoins

Tether

Tether is a stablecoin and it’s the most widely used blockchain digital currency in terms of sheer trading volume. Tether issues digital tokens and each token is tied to a different fiat currency. Currently, there are four Tether tokens: USDT (tied to the U.S. dollar), EURT (tied to the euro), CNHT (tied to the Chinese yuan) and XAUT (tied to one ounce of gold per token).

Tether’s endured some scandal in recent years -- the company that issues Tether is under investigation by the New York Attorney General, whose office determined that crypto exchange Bitfinex allegedly used funds from Tether to secretly cover an $850 million loss in customer and corporate funds. Neither the loss nor Tether’s fund movements were disclosed to customers.

It also claimed to have a real dollar in the bank for every USDT token in circulation but in 2019, following the Attorney General’s interest in Tether, the company was forced to reveal that the reality was closer to $0.75. 

USD Coin (USDC)

USD Coin is a stablecoin that claims to have a one-to-one value with the U.S. dollar. That means one USDC should equal one real U.S. dollar. It was created by fintech Circle and crypto exchange Coinbase.

Initially launched as an Ethereum-based token, USDC has since expanded beyond Ethereum to other blockchains, including Algorand, Stellar and Solana. As such, USDC is also available as Algorand ASA and Solana SPL tokens that can be purchased using U.S. dollars on major exchanges.

Like some other U.S. dollar-backed stablecoins, USDC has a more transparent auditing process, which means it’s a lot more secure than some other coins on the market. It’s fully regulated by the Financial Crimes Enforcement Network (FinCEN), which combats money laundering. It’s also attested by Grant Thornton, one of the world’s top 10 accounting firms.

There is currently a total supply of 23 billion USD Coins in circulation right now.

Dai

Dai is a stablecoin that runs on the Ethereum blockchain. While Dai is backed by Ether, a cryptocurrency, it aims to maintain a one-to-one ratio with the U.S. dollar. 

Dai, like most crypto-backed stablecoins, is decentralized, so no single entity controls its issuance nor is there a central authority that’s trusted to oversee the whole system. It’s also over-collateralized to help maintain a stable value. 

Dai can also use different cryptocurrencies as collateral unlike other stablecoins. This is intended to diminish user risk and increase Dai’s stability. 

Honorable Mention

Diem

Diem is a Facebook-backed digital currency that’s been through hell and back.

Founded with the name Libra in 2014, the token was initially intended to be a universal currency tied to ‘a basket’ of currencies, including the U.S. dollar and the euro. However, because of Facebook’s reach, critics feared Diem’s unregulated emergence could encourage financial instability and money laundering. Many also had privacy concerns -- an issue that often props up when Facebook’s involved. 

With strong opposition from regulators, bankers and politicians over the last two years, the Diem project has lost major backers, including Visa, Mastercard and Stripe. The Diem Association, which oversees Diem’s development, backed off its original plans and decided to go the traditional stablecoin route -- a Diem lite of sorts. The group will now develop multiple stablecoins, each backed by a separate national currency.

The Diem dollar is expected to launch later this year.

Use cases

In 2019, the European Central Bank (ECB) conducted a study that compared the volatility of several popular stablecoins with a few top cryptocurrencies. The study found that the average volatility of USDT was 10 percent. Similarly, it was 27 percent for Dai. For comparison, Bitcoin averaged around 69 percent. Stablecoins are likelier to be used in commercial transactions because they aren’t as volatile as traditional cryptocurrencies. 

Stablecoins can also be utilized within remittance and cross-border payments since they offer faster and cheaper payments. Some incumbent financial institutions have already begun to work on their own stablecoins. In February 2019, JPMorgan Chase launched JPM Coin, which was initially used for internal transactions. Late last year, it announced that the JPM Coin was being used in commercial transactions. It’s also no secret that Goldman Sachs and Bank of America have been looking to hire experts in blockchain and digital assets.

Countries with weak local currencies are also capitalizing on stablecoins pegged to stronger foreign currencies. For example, economic collapse and hyperinflation in Venezuela have cost the Venezuelan bolivar 95 percent of its value. Venezuela’s acting president Juan Guaidó rallied Circle to deliver aid to the country’s medical workers via USDC. In November 2020, Circle worked with the U.S. government to disburse USDC through a payment platform that allows healthcare workers to withdraw funds from the platform into their local bank accounts as bolivars. 

Limitations

Because stablecoins are tied to existing, external assets, they’re only as stable as the asset itself. For example, if the price of the asset fell, it would affect the value of the attached stablecoin. While some assets like the U.S. dollar are not expected to experience wild crashes in their values but rather gradual changes over time, it is possible for government-issued currencies to lose their values in the blink of an eye. It happened with Russia’s ruble in 1998 and the Lebanese pound in 2019. 

Some stablecoins may also have less liquidity -- for example, it could be a time-consuming and costly process for someone to trade in their gold-backed stablecoins for their actual gold. 

Crypto-backed stablecoins aren’t the most secure or stable of available options. If the underlying cryptocurrency loses its value, the stablecoin might follow suit -- and if it crashes completely, the stablecoin auto-liquidates into the crashing currency and that doesn’t help anyone.

Additionally, many stablecoin issuers aren’t very transparent about where their reserves are held so investors may not have the full scoop on risk assessment before they buy in. For example, if stablecoin operators are holding their reserves in a region where they don’t have a license, a regulator could potentially freeze the stablecoin’s underlying funds and users wouldn’t know until after they were affected.

Moreover, without audits and other regulatory processes, it’s hard to know whether stablecoins actually have the collateral they claim to have -- case in point, Tether. It’s also possible that its reserves are insufficient to redeem every unit. Again, without regulation, it’s hard to know.

Regulation

Last year, nearly 30 blockchain and crypto bills were proposed or debated by Congress but nothing has passed so far and been made law. 

While fiat-backed stablecoins are subject to the same regulations as fiat currency, under current regulation in the U.S., stablecoin issuing organizations operate as trust companies or fiduciaries and agents. This means they’re not required to obtain banking charters or deposit dollar funds with the Federal Reserve. If passed, the Stablecoin Tethering and Bank Licensing Enforcement (STABLE) Act, introduced in December 2020, would change all of that, requiring stablecoin issuers to comply on both fronts. Issuers would also be required to abide by traditional banking regulations, and as such, be subject to regular audits to ensure compliance. 

Stablecoin issuers would need to get the approval of both the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC) six months before issuance. 

There’s a serious concern among critics that the act will stifle stablecoin’s development. They feel the act will broadly affect non-incumbent and start-up institutions more than bigger players, even though the latter have already begun accepting and using stablecoins. For example, non-incumbents just may not have the resources or expertise required to navigate these rules and be in full compliance. 

Speaking broadly about cryptocurrency regulation, a few different regulatory bodies have weighed in. Most significantly, the Office of the Comptroller of the Currency announced that the office, the Federal Reserve and the FDIC were discussing the possibility of an interagency group to look at crypto policy. 

The Treasury Department also announced that it will require crypto transactions worth $10,000 or more to be reported to the IRS.