Understanding Stablecoins: Stability in an Unstable Market

In the stormy waters of crypto, prices are highly volatile, and this is considered a norm in this space. But despite the price swings, how do some cryptos manage to stay stable. Well, let’s explore how stability is achieved in the world of crypto.

What Are Stablecoins?

Stablecoin is a type of cryptocurrency designed to maintain a stable value by being pegged to a stable asset such as a national currency like the U.S. dollar or a commodity like gold. 

Pegging means tying the value or fixing the value of the stablecoin to a more stable asset, like the U.S. dollar. Most stablecoins are blockchain-based versions of fiat currencies. 

Dollar-Pegged or Currency-Pegged Stablecoins

Dollar-pegged stablecoins like USDT, USDC, and DAI, all designed to maintain a 1:1 peg with the U.S. dollar, meaning 1 USDT, 1 USDC, or 1 DAI equals 1 USD.

If a stablecoin is pegged to the U.S. dollar or if its value is fixed to the U.S. dollar, this means that stablecoin value is kept as close to $1 as possible, even if the broader cryptocurrency market fluctuates.

Other Types of Stable Coins

Stable coins can be also pegged to stable assets like gold as well. For example, PAX Gold (PAXG) is designed to be equal to the value of gold. Meaning 1 PAXG equals 1 troy ounce of gold. Therefore, the value of a PAXG token will fluctuate based on the market price of gold.

In this blog, I will only focus on dollar pegged stablecoins backed by fiat currencies and cryptocurrencies to keep things straight forward and to avoid complexity. As you read on, you will learn how stablecoins derive their value and how that value is maintained. 

Centralized vs. Decentralized Stablecoins

Centralized Stablecoins

Centralized stablecoins are issued and managed by a central organization.  For example, USDT is a centralized stablecoin issued by a company called Tether. USDC is issued by Circle in partnership with Coinbase. 

For a company to offer stable coins pegged to the U.S.dollar in the blockchain, they have to back the amount of stable coin value they mint or create with reserve currencies. For example, if Tether wants to mint 1 million of USDT, they need to have 1 million worth of dollars in their reserves. They simply cannot mint stable coins as much as they like.

How Centralized Stablecoins Sustain Their Pegged Value and Are Released into the Market

Let’s see a simple example of how a company like Tether, maintains the value of its stable coin USDT to U.S. dollar with a 1:1 ratio. 

Step 1 - A user (A crypto exchange or financial institution) deposits fiat currency to Tethers bank account.

Step 2 - Tether mint or create USDT equivalent to that amount deposited. For example, a $100,000 deposit results in the issuance of 100,000 USDT.

Step 3 - Users then can use their USDT for transactions, transfers or store USDT in a blockchain based platform. 

Step 4 - When users want to convert USDT back to fiat, they can deposit their USDT with Tether Limited. 

Step 5 - Tether Limited then destroys the returned USDT and transfers the equivalent fiat currency back to the user’s bank account. 

For example, if a user sends $10,000 USDT to Tether in exchange for cash, then Tether will destroy the returned USDT and send $10,000 U.S. dollars to that user from Tethers cash reserves. In this way, Centralized stable coin issuers can always maintain the one-to-one ratio.

However, if Tether fails to transfer that required amount of cash, this will mean Tether does not have an equivalent amount of cash reserves in their bank account. This will threaten to break the pegged value, leading to a decline in the value of USDT.

Perfect! now you have a solid understanding of how the pegged value is maintained in centralized stable coins. The process is the same for other centralized stable coins like USDC. Next, let's explore the pros and cons of using centralized stablecoins to gain a deeper perspective on their impact.

Pros of Centralized Stable Coins

Direct Fiat Conversion: Centralized stable coins issuers like Tether gives the opportunity for crypto individuals to redeem USDT for fiat with them, directly bypassing middlemen like crypto exchanges. 

This option offers the assurance that holders can convert their crypto to fiat whenever they need. However, to qualify for direct redemption, individuals might need to meet specific requirements like minimum redemption amounts.

Regulatory Compliance and Institutional Trust: Companies like Circle who issue USDC, partner with financial institutions to ensure regulatory compliance. This increases trust among crypto individuals as well as institutional investors. 

For example, Circle teamed up with Visa to enable transactions on the VISA network. Circle launched a Visa corporate card that allows business account holders to spend USDC anywhere Visa is accepted.

Financial Audits and Reserve Transparency: Centralized stable coins undergo regular financial audits and reserve checks to verify their stable coins are backed by cash or cash equivalent assets. For example, Circle, the issuer of USDC, undergoes audits by Marcum LLP. These audits assure users that Circle holds the necessary assets in reserve to back the USDC issued.

Cons of Centralized Stable Coins

Centralized Control: Centralized Stable coins are managed by a single entity; this means the issuers have control over their centralized stablecoins. For example, if Tether or Circle identifies a wallet involved in illicit activities or receives a government request to restrict access, they can freeze the stablecoins in that wallet.

This act is not necessarily wrong, but this brings censorship and autonomy into the crypto space, which goes against the original purpose of cryptocurrencies: creating a decentralized, autonomous financial system.

Custodial Risk: If in any case the issuers of centralized stable coins go bankrupt, or their banks where issuers cash reserves are held, goes bankrupt, then users may not be able to redeem their stablecoins for fiat. 

Lack of Transparency: Although issuers of centralized stable coins claim that they are fully back their coins with cash reserves, this may not always be the case. Yes, we know that financial audits are done at regular intervals to assure users.

But we do have to keep in mind that issuers of centralized stablecoins are also investing their cash reserves in risky investments to make money just like crypto investors do. So, there is always room for mismanagement of funds leading to a limited transparency about the exact holdings of reserves. 

For example, Tether faced scrutiny in 2021 when reports indicated that a significant portion of Tether’s reserves included commercial paper - a type of unsecured, short-term debt, rather than just cash.

Decentralized Stablecoins

Decentralized stablecoins are not controlled by a central authority like a company or financial institution. Instead, the supply and stability or the one-to-one backing of these stable coins are managed by smart contracts and a community of users. For example, DAI is a decentralized stablecoin pegged to the U.S. dollar. 

This community of users can include any stakeholder who has a specific interest towards the project. For example, developers who contribute to the project, users who use the stable coin, liquidity providers to the project, investors who have invested in the stablecoin and researchers and analysts who study the impact of the project or the project performance.

The governance tokens are provided to stakeholder of the project accordingly and this empowers the community to vote on key decisions regarding the project. 

How Do Decentralized Stablecoins Sustain their Pegged Value and Are Released into the Market?

To put it simply, this is how a decentralized stable coin like DAI maintains its 1:1 ratio and is released into the market.

Step 1: To create DAI, a user (crypto exchange or individual) needs to lock up a cryptocurrency like Ethereum in a special contract called a Collateralized Debt Position (CDP).

Step 2: After you lock up your crypto, the smart contract will then mint or create DAI for you. You only receive DAI less than the value of your crypto you locked up. This is to maintain stability because cryptocurrency prices are volatile. 

Step 3: When you mint DAI, you should pay a small fee called a stability fee in DAI or any other token.

Step 4: You can then use your DAI for various financial activities within the crypto space, like trading, lending, providing liquidity to DeFi platforms etc.

It is important to know that if the value of your locked cryptocurrency drops too low, the smart contract will sell your locked crypto for another cryptocurrency or stablecoin to cover the DAI you obtained. This process helps maintain DAI's stability at $1.

Pros of Decentralized stable coins

Censorship Resistant: Decentralized stablecoins are not controlled by a single entity, therefore it provides users greater financial freedom and autonomy. 

Transparency: Most decentralized stablecoins operate on public blockchains, this allows users to verify all the transactions and collateral backing. 

Users can check amounts of collateral locked, types of collaterals like which cryptocurrencies are locked up, and how the smart contracts handle one-to-one backing during times of price volatilities. This gives users confidence and trust in the system. 

Permissionless Access: Anyone can participate in the decentralized stable coin ecosystem without needing permission from any central authority. This strengthens the resilience of the system.

Smart Contract Automation: Decentralized stable coins are managed by smart contracts, this means the contract handles everything automatically from creating stable coins (minting) to selling off the collaterals (Liquidation) to maintain its stablecoin value at $1. This automation does the job it was created for pretty well, therefore reducing human errors and mistakes.

Cons of Decentralized stable coins

Over-Collateralization and Lower Liquidity: Most of the decentralized stablecoins require users to lock up significantly more collateral than the stablecoin's value to deal with volatility, for example, a user might have to lock up $7500 of ETH to get $5000 DAI. 

This 150% of collateralization ratio leads to lower liquidity because users lock up a significant amount of capital in collateral, rather than making it available for trading within the crypto space. 

Smart Contract Risks: Smart contracts are not 100% security guaranteed. While the code written into the contract cannot be changed, hackers can still explore the flaws in the code and exploit these vulnerabilities, leading to substantial losses. 

Governance issues: When decentralized stable coins projects are driven by a community, the decision-making process when it comes to addressing critical issues can be slower and disagreements can happen within the community, impacting the stablecoin’s stability and direction.

In summary, most centralized stablecoins in the crypto space are backed by cash and cash equivalents, while decentralized stablecoins are usually backed by cryptocurrencies to maintain its stability.  

Why Stablecoins are important in the Crypto Space

Stablecoins pegged to the U.S dollar provides stability making it more suitable for everyday transactions. For example, by using stablecoins, users can buy any type of cryptocurrency whenever they need without having to worry about the price of the stablecoins.

Since the value of your stablecoin is stable, you can maintain your purchasing power and make transactions with confidence.

Stablecoins also allow crypto users to exit the market quickly and avoid any potential losses. For example, if you find out that the prices of bitcoin and other crypto is about to drop very sharply, you can easily sell your crypto in exchange for stablecoins like USDT or USDC. By doing so, you protect your investments! 

Stablecoins is also actually a blessing in disguise for countries that do not have the opportunity to buy cryptocurrencies through exchanges using fiat money due to a lack of legal frameworks.

For example, in a country like Sri Lanka, there are many people who are genuinely working in the crypto space, for them, the option to convert their fiat to stablecoins is not available due to regulations. 

Therefore, the most common and easiest way for them to buy crypto is through exchanges that provide peer to peer trading. And almost 99% of peer-to-peer transactions are done using stablecoins. 

Stablecoins are also widely used in DeFi activities as well, they provide liquidity for exchanges making it easier for users to trade without having to worry about price volatility. Stablecoins also enable secure lending and borrowing by offering a stable asset for collaterals. 

To wrap things up, the supply of stablecoins increases the speed of money coming into the crypto space improving liquidity in the whole crypto ecosystem. Stablecoins facilitate the ease of doing transactions and also act as a bridge for countries to easily get into this space. 

Final Thoughts

Stablecoins are a gem in the crypto ecosystem, but it’s really important to keep in mind that no one should overly rely on a single type of stablecoin to store their wealth. 

It's usually better to convert your realized profits in crypto into cash or to spread your profits on multiple stablecoins, both centralized and decentralized. This way, you are spreading your risk and not putting all your eggs in one basket. 

Keep in mind, there is always a chance that something could go wrong in this space, so don't be surprised if a stablecoin fails to maintain its peg and collapses. For example, when UST (a dollar-pegged stablecoin) collapsed, millions of people lost their money. So, remember anything can happen in crypto.

Disclaimer: The contents of this article are for informational purposes only and are not financial advice. The views here are just the author’s opinions. The crypto market is volatile, so be sure to do your own research before investing.