What Is A Stablecoin?

A stablecoin is a digital currency that is pegged to another asset that has a "stable" value, for example the U.S. dollar (USD).^[1]

According to crypto website Coinmarketcap, "Stablecoins are cryptocurrencies with a fixed value that are usually pegged to leading fiat currency, currency basket or exchange-traded commodities."^[17] Behind the concept of stability, many central banks are researching creating their own stablecoins. Known as a "central bank digital currency (CBDC)," this asset class may be the future of stablecoins.

Stablecoins benefit from low volatility, which makes it easier for people to leverage them as a medium of exchange. This functionality affords the user an array of benefits. First and foremost, the enhanced price action of traditional cryptos such as Bitcoin (BTC) and more obscure altcoins may be avoided.

These innovative digital currencies have attracted significant demand, and as of March 2019, the top five fiat-collateralised stablecoins had drawn more than US$2.5 billion worth of deposits.^[2] Stablecoins may be bought, sold, and traded on many platforms. Prominent examples are crypto exchanges such as Binance or Coinbase.

Background On Stablecoins

Many digital currencies are highly volatile. While this can create significant opportunities for traders, it also undermines the conventional use of these digital assets.^[3] A person will be unlikely to use Bitcoin to make a simple purchase if they believe the digital currency's value will double in the coming months. Alternatively, an investor may be hard-pressed to hold on to Bitcoin if they think its value will decline significantly in the near future.

There are additional drawbacks to high volatility, as long-term price stability can prove integral to holding a digital currency over time as opposed to trading it actively.^[1] Fiat currencies such as the USD and British pound are not without volatility, as they experience changing foreign exchange rates. However, these fluctuations are not significant enough to detract from fiat currencies' regular use.

The pricing volatility of crypto assets is one reason that backed stablecoins have risen in popularity. Products such as stabilised Ethereum tokens (TrueUSD) and Dai (DAI) are attractive to those in the digital currency ecosystem that aren't fond of large swings in price. In this way, a stablecoin's valuation model is similar to that of precious metals and FX currencies.

How Are Stablecoins Used?

In addition to being used for everyday transactions, stablecoins could enjoy widespread use in remittances.^[2]

Remittance

The total USD value of remittances going to low-income and middle-income countries reached approximately US$529 million in 2018, according to the World Bank.^[4] This figure represented a new record and a 9.6% increase over the previous high reached in 2017.

Also, an industry report predicted that the global market for digital remittances would experience a compound annual growth rate of 25.1% between 2019 and 2024.^[5] According to these estimates, the market was projected to more than triple in size between these years.

During the COVID-19 pandemic, the remittance market to developing nations remained strong. According to World Bank estimates, such transfers totalled US$540 billion for 2020, only a modest 1.6% decrease from the previous year.^[18] Given the size of this financial sector, the Defi space and crypto market as a whole stands to benefit from the remittance environment.

Digital Currency Trading

Investors can leverage stablecoins to enter and exit digital currency trading positions in the most efficient possible manner, as these digital currencies can provide settlements that are almost instantaneous.^[6] Another way investors can harness stablecoins is by using them to hedge against market volatility.^[2]

For instance, individuals could buy and sell the TrueUSD coin to capitalise on volatility facing the forex majors. This type of strategy may prove ideal for anyone looking to profit from central bank policy shifts and their impacts on the global financial system. Also, long-term investors are able to use the TrueUSD to hedge the negative effects of deflation on the pricing of goods and services.

Challenges Of Stablecoins

A handful of major difficulties have hindered stablecoins, according to an industry report written by prime dealer SFOX.^[6]

One major obstacle is trust. Some market observers are skeptical of stablecoins because they are issued by centralised entities, which is different from major digital currencies like Bitcoin and Ether, which are decentralised. While they're technically digital currencies, these assets may be easier for regulators to target, which raises questions about future tax liabilities and governing regulatory framework. Still, others are reluctant to use a stablecoin backed by a fiat currency like the USD when they could simply use the USD instead.

Until stablecoins enjoy greater adoption, their utility will be limited, claimed SFOX.^[6] One way that individual stablecoins can achieve this widespread use is by showing that their issuing financial institutions are trustworthy. Unfortunately, significant concerns have been voiced about the trustworthiness of the organisations behind Tether, one of the best-known stablecoins.

Collateralisation Types

Issuers of stablecoins have different methods of collateralising, or backing up, units of their digital currency. In most cases, the entities issuing stablecoins use one of three methods for collateralising their cryptocurrency, and they're outlined below.^[7]

1. Fiat-collateralised Stablecoins

These digital currencies are backed up by fiat currencies, or traditional money, on a one-for-one basis.^[8] A centralised entity is responsible for the supply of all units of these stablecoins, issuing and destroying them as needed. The management process is much like the oversight of national currencies. For instance, the U.S. Treasury is in charge of the circulation, minting and destruction of paper notes and coinage.

There are numerous benefits to fiat-collateralised stablecoins. Using fiat currencies like the USD to back up digital currencies can help keep their volatility at a reasonable level.^[7] Further, the entities responsible for issuing these stablecoins can take part in active measures to maintain their value.

One major drawback of this approach is that centralisation requires trust in an entity like a bank, and the faith that market participants have in such institutions can certainly waver.^[7] Without confidence in management, the demand for even the largest stablecoin is positioned to waver.

2. Crypto-collateralised Stablecoins

These stablecoins are backed by digital currency and account for the volatility of the cryptocurrencies by over collateralising, which means providing more digital assets than needed.^[9]

In other words, if a person wanted US$500 worth of a stablecoin, they could provide US$1,000 worth of the cryptocurrency Ether. This would make the resulting stablecoins 200% collateralised.^[9] If the value of Ether fell by 20%, for example, the stablecoin in question could maintain price stability.

One major benefit of crypto-collateralised stablecoins is they are issued on-chain, meaning that collateral is bound by a smart contract. The only way a person can get it back is by paying their debt.^[7] Alternatively, if excess collateral declines below acceptable levels, the collateral can be sold and the contract can be closed. When stablecoins are issued on a blockchain, interested parties can both view and audit reserves.

There are also downsides. Severe fluctuations in the price of cryptocurrencies used as collateral can result in under-collateralisation, which could potentially result in the liquidation of stablecoins that were issued.^[7]

3. Non-collateralised Stablecoins

These stablecoins are not backed by fiat or digital currency, and their supply is governed by an algorithm.^[10] This is why they're sometimes referred to as algorithmic stablecoins.

The system behind an algorithmic stablecoin will issue new units of the digital currency in response to rising demand. It will reduce the stablecoin's money supply if the cryptocurrency's value starts declining below its peg.^[11]

One popular stablecoin based on an algorithm is Terra. Terra is a blockchain protocol that services an array of decentralised stablecoins.^[19] This group of stablecoins pegs their value to the protocol via the LUNA coin. To maintain pricing equilibrium, Terra mints and burns tokens, ensuring market stability. As of this writing, Terra (LUNA) held a value north of US$80.00 and a market capitalization upwards of US$27.7 billion.^[20]

Algorithmic stablecoin models frequently harness two kinds of digital tokens.^[10] The first is a stablecoin and the second is similar to a bond, in that it promises to provide income if the stablecoin's value increases. This approach certainly has its risks because it depends upon the expectation that these stablecoins will enjoy a certain amount of future upside.^[10]

What Are Some Examples Of Stablecoins?

Entrepreneurs have worked on several projects designed to create an ideal digital currency that would address these problems by having, among other qualities, price stability.^[1] This section will delve into some of these stablecoins, as well as their shortfalls.

1. Tether

Tether is a well-known stablecoin that was designed to be backed by the USD one-for-one.^[12]

Units of Tether trade under the ticker symbol USDT, and many investors are apparently interested in it, according to cryptocurrency analyst Mati Greenspan. "Anybody who's trading on some of the major exchanges [holds Tethers]," he said.^[12] "What exchanges like Bitfinex do is, rather than having a client's balance held in dollars, they hold them in USDT. So if somebody's got their money on an exchange such as Bitfinex and they don't have any current open positions, they're actually probably in Tether."

While Tether has achieved notable adoption, some industry participants have voiced concerns that Tether Limited, the company responsible for issuing Tether, does not have the USD reserves needed to back up the stablecoin.^[12] New York Attorney General Letitia James alleged in April 2019 that "the operators of the 'Bitfinex' trading platform, who also control the 'tether' virtual currency, have engaged in a cover-up to hide the apparent loss of $850 million dollars of co-mingled client and corporate funds."^[13]

According to this announcement, the operators of Bitfinex lost these funds by providing them to Panama-based Crypto Capital Corp. without securing a written agreement or other guarantee. These parties also did not disclose the loss to investors, James wrote in the report.^[13]

2. USD Coin

USD Coin, a stablecoin that trades under the ticker symbol USDC, was also designed to be fully backed by the USD on a one-for-one basis.^[14] The USD Coin was created to be decentralised, as it is issued by financial institutions that are regulated and hold enough USD reserves to back up any USDC they issue.^[15]

This stablecoin was originally released by crypto startup Circle and CENTRE, the latter being a consortium designed to help create standards and policies for stablecoins.^[16] Because financial institutions must adhere to the guidelines set forth by CENTRE to issue USDC, they must meet several minimum requirements, such as being licensed and regulated.^[15] To issue USDC, financial institutions must keep full reserves of fiat currency and report any holdings of the U.S. dollar.^[15]

Another example of a USD-based coin is the TrueUSD (TUSD). The TrueUSD is touted as being "money built for the new global financial system" and "the first regulated stablecoin fully backed by the US dollar."^[21] Owning the TUSD is viewed as being a viable hedge of crypto market tumult by many traders and investors in digital currencies.

Summary

Stablecoins are digital currencies that are pegged to an asset with relative stability, such as the USD. Cryptocurrencies that have benefited from minimised volatility can be used more easily as a medium of exchange.

These digital currencies, which have drawn significant interest from investors, can be used for many different applications including day-to-day transactions and remittances. Also, investors can potentially leverage stablecoins to hedge against sharp market volatility, and they can harness them to open and close positions.

However, stablecoins face numerous obstacles, specifically a lack of widespread adoption and trust. Fortunately, there is a clear way to establish this trust, as centralised entities, which issue stablecoins, can make efforts to ensure their reputations.

Leverage is a double-edged sword and can dramatically amplify your profits. It can also just as dramatically amplify your losses. Trading foreign exchange/CFDs with any level of leverage may not be suitable for all investors.