What Is a Stablecoin?

A stablecoin is a type of cryptocurrency whose value is pegged to an external asset, such as the US dollar or gold. It is a price-stable digital asset that behaves similarly to FIAT but retains the mobility and utility of cryptocurrency. Let’s look at what stablecoins are, why they are important, and which are the most popular ones.

What are Stablecoins?

First things first, let’s talk about why stablecoins even exist. If you’ve been in the crypto game for a while, you know that volatility is both a blessing and a curse. One minute, you’re on cloud nine as your portfolio skyrockets, and the next, you’re plummeting back to Earth. This volatility can be a trader’s dream but a nightmare for someone who wants to use cryptocurrency for everyday transactions. The unpredictability of cryptocurrencies is in contrast to the usually stable prices of FIAT money, such as the US dollar, or other assets, such as gold. The values of currencies, such as the dollar, change gradually over time. But the day-to-day changes in cryptocurrencies are much more drastic.

So we created stablecoins, the yin to crypto’s volatile yang. These digital assets are designed to offer the best of both worlds: the technological advantages of cryptocurrencies and the stability of traditional fiat currencies. Billions of dollars have flowed into stablecoins like Tether (USDT). Also, they have become one of the most popular ways to store and trade value in the crypto ecosystem.

Main Features:

• Value stability: The cornerstone of any stablecoin is its ability to maintain a stable value. It is usually pegged to a fiat currency like the U.S. dollar, effectively acting as a digital dollar in your crypto wallet.

• Asset-backed: Most stablecoins are backed by a reserve of real-world assets, whether fiat currencies, commodities, or even other cryptocurrencies, offering a tangible layer of security and trust.

• Speedy transactions: One of the beauties of stablecoins is the ability to make quick and efficient transactions. Of course, thanks to the underlying blockchain technology.

• Low fees: Forget about the exorbitant fees that traditional banks charge. Stablecoins offer a much more cost-effective way to move money, especially across borders.

• Transparency: Many stablecoins operate on public blockchains, which allow for transparent auditing of reserves and transactions, a feature often missing in traditional financial systems.

• Regulatory compliance: Some stablecoins go the extra mile to comply with financial regulations. They offer an added layer of consumer protection and legitimacy.

• Global accessibility: Unlike traditional banking systems that can be restricted by geography, stablecoins are accessible to anyone, anywhere, as long as they have an internet connection.

• Smart contract compatibility: Certain stablecoins are built on platforms that support smart contracts, which enable programmable, automated financial transactions. This opens up a world of possibilities in the DeFi space.

Types of Stablecoins

1. Fiat-Collateralized Stablecoins

Collateralized stablecoins keep a reserve of assets to uphold the coin’s value. When a stablecoin owner decides to redeem their tokens, a corresponding amount of the backing assets is withdrawn from the reserve.

While other types of collateral like precious metals (gold or silver) or commodities (such as crude oil) can also be used. The majority of these stablecoins primarily use U.S. dollar reserves. Independent custodians manage these reserves, which undergo regular audits for transparency. Well-known examples of such stablecoins include Tether (USDT) and TrueUSD (TUSD). Both of them are pegged 1-1 with the U.S. dollar.

Examples: Tether (USDT), USD Coin (USDC), TrueUSD (TUSD)

Pros and cons: While they are straightforward and easy to understand, the centralized nature of fiat-collateralized stablecoins often raises questions about transparency and regulatory compliance.

2. Crypto-Collateralized Stablecoins

This type maintains a reserve of crypto assets to support their value. Since the reserve cryptocurrency can also be highly volatile, these stablecoins are often overcollateralized. This means that the reserve cryptocurrency’s value surpasses the stablecoins’ value in circulation. For instance, a reserve worth $4 million in cryptocurrency might be used to issue $2 million of a crypto-backed stablecoin, providing a buffer against a 50% drop in the reserve’s value. An example of this is MakerDAO’s Dai (DAI) stablecoin, which is pegged to the U.S. dollar but backed by Ethereum (ETH) and other cryptocurrencies valued at 150% of the circulating DAI.

Examples: DAI, sUSD

Pros and cons: While they offer the benefit of decentralization, the complexity of their mechanisms can be a barrier to entry for some users.

3. Algorithmic Stablecoins

If you remember the infamous Terra (LUNA), you have heard about those. Algorithmic stablecoins don’t necessarily maintain a reserve of assets. What sets them apart is their method of stabilizing the coin’s value, which involves regulating its supply via a computer algorithm or a pre-defined mathematical formula.

TerraUSD (UST) was once the leading algorithmic stablecoin, achieving a market capitalization exceeding $18.7 billion at its highest point on May 5 before experiencing a dramatic decline after falling below its pegged value. The value of TerraUSD was anchored at $1 through the process of minting (creating) and burning (destroying) its companion coin, Luna. The system operated without collateral, relying solely on algorithmically creating and eliminating Luna tokens whenever a UST stablecoin was traded. However, this approach turned out to be flawed. TerraUSD went through what is now referred to as a death spiral. A surge of panic led to a crypto version of a bank run in May, triggering a mass sell-off that unanchored TerraUSD from its $1 peg. This resulted in the coin’s value plummeting close to zero, along with its sister coin, Luna.

Examples: FRAX, Terra, DAI, Empty Set Dollar (ESD)

Pros and cons: While they offer the benefit of decentralization, the complexity of their mechanisms can be a barrier to entry for some users.

4. Asset-Backed Stablecoins

These stablecoins are backed by physical assets such as precious metals, oil, or real estate. Gold is the most popular commodity to back. Tether Gold (XAUT) and Paxos Gold (PAXG) are two of the most liquid gold-backed stablecoins. However, it is important to be aware that the prices of these commodities can fluctuate (and are more likely to fluctuate), and therefore may also lose value.

These types of stablecoins allow investment in assets that are otherwise unavailable locally. For example, obtaining gold bullion and finding a safe storage location in many regions is complicated and expensive. Therefore, owning physical commodities such as gold and silver is not always realistic. However, commodity-backed stablecoins also provide utility for those who wish to exchange tokens for cash or take possession of the underlying tokenized asset. Holders of Paxos Gold (PAXG) stablecoins can sell them for cash or take possession of gold. However, as gold bars range from 370 to 430 per ounce, and each token represents 1 ounce, users must hold at least 430 PAXG tokens to be able to redeem the tokens.

Examples: PAX Gold (PAXG), RealT Tokens

Pros and cons: These offer a unique value proposition but are often subject to the same regulatory scrutiny as fiat-collateralized stablecoins.

5. Hybrid Stablecoins

These stablecoins combine features from the above categories, often using collateral and algorithms to maintain a stable value.

Examples: Reserve Rights (RSR), mStable (MUSD)

Pros and cons: These offer a unique value proposition but are often subject to the same regulatory scrutiny as fiat-collateralized stablecoins.

Stablecoin Use Cases

• Trading and liquidity: Stablecoins are the linchpin that holds together the trading ecosystem on crypto exchanges. They offer traders a way to escape the wild swings of crypto volatility without having to exit the crypto market altogether.

• Remittances and cross-border payments: Stablecoins are a game-changer when it comes to sending money across borders. They bypass the need for currency conversion and eliminate the exorbitant fees usually associated with international money transfers.

• Decentralized Finance (DeFi): In the burgeoning world of Decentralized Finance, stablecoins are nothing short of foundational. They serve as collateral in lending protocols, are farmed for yield, and act as liquidity in automated market makers.

• Smart contracts and Dapps: Stablecoins are also the lifeblood of smart contracts and decentralized applications (dApps). They enable various functionalities, from prediction markets and automated trading bots to insurance protocols. The stability of these digital assets makes them ideal for transactions that require a consistent value over time.

• E-commerce and payments: The e-commerce sector is another arena where stablecoins are making waves. They offer a stable and efficient medium for online transactions, effectively bypassing the need for traditional payment processors and reducing transaction fees. Imagine the convenience of paying for your online purchases with a stablecoin like GUSD or PAX.

• Asset tokenization and treasury management: Last but not least, stablecoins are revolutionizing asset tokenization and treasury management. They can be used to tokenize real-world assets like real estate or art, making these assets easily tradable and divisible. On the corporate side, businesses and DAOs are increasingly using stablecoins like DAI or sUSD to manage their treasuries, offering a stable store of value that can be easily audited and managed.

How Stablecoins Make Money?

At first glance, stablecoins like Tether (USDT), USD Coin (USDC), and Binance USD (BUSD) appear straightforward. They’re digital tokens designed to maintain a 1:1 peg with a stable asset, usually a fiat currency like the U.S. dollar. However, the economics behind these digital stalwarts are far from simple. Let’s delve into the intricacies of how stablecoins generate revenue while maintaining their peg.

One of the most common ways stablecoins maintain their value is through the reserve model. In this setup, every stablecoin issued is backed by an equivalent amount of real-world assets, often held in a bank. But these reserves aren’t just sitting idly; they’re usually invested in low-risk, interest-bearing instruments like government bonds or short-term loans. The interest generated from these investments is one of the primary revenue streams for stablecoin issuers.

Some stablecoins are part of broader ecosystems, like MakerDAO’s DAI, which is integrated into various DeFi protocols. These ecosystems often have their own tokens, and the stablecoin is a utility within this network. Transaction fees collected from these utilities contribute to the overall revenue. Additionally, the data and insights gathered from using stablecoins within these ecosystems can be invaluable, opening doors to further monetization opportunities.

Let’s not forget about lending and borrowing. Stablecoins have become a cornerstone in the crypto lending and borrowing markets. Platforms like Aave and Compound allow users to lend their stablecoins to earn interest. These platforms, in turn, lend these assets to borrowers at a higher rate. The difference in interest rates, known as the spread, is another revenue stream for stablecoin issuers who often partner with these platforms.

Most popular stablecoins

1. Tether (USDT)

Launched in 2014, Tether is the granddaddy of stablecoins and has maintained its position as the most widely used stablecoin in the market. Pegged 1:1 to the U.S. dollar, USDT is one of the largest cryptocurrencies in the world by market capitalization. The main use case for USDT is to quickly transfer money between exchanges to take advantage of arbitrage opportunities when the price of cryptocurrencies on two exchanges diverges – traders can profit from this difference. But it has also found other uses: Chinese importers based in Russia have also used USDT to send millions of dollars worth of value across the border, bypassing China’s strict capital controls.

Tether has had its share of controversies, most notably around the issue of whether it’s fully backed by reserves. However, it has managed to weather these storms and remains a dominant force. One of the key reasons for its popularity is its widespread adoption across major exchanges and its integration into various blockchain networks like Ethereum, Tron, and Algorand.

2. Binance USD (BUSD)

Binance USD, or BUSD for short, is a relative newcomer but has quickly risen through the ranks. Launched in 2019 in partnership with Paxos, BUSD is fully regulated and approved by the New York State Department of Financial Services. What sets BUSD apart is its integration into the Binance ecosystem, which encompasses the world’s largest crypto exchange by trading volume. Whether you’re trading on Binance’s spot market or participating in Binance Smart Chain’s DeFi protocols, BUSD offers seamless interoperability. This has made it a popular choice for traders and developers alike.

BUSD’s regulatory compliance gives it an edge, especially among institutional investors who are wary of the regulatory uncertainties surrounding other stablecoins. This has helped it gain rapid adoption and a growing market cap.

3. USD Coin (USDC)

Launched in 2018, USD Coin is co-managed by Circle and Coinbase under the umbrella of the Centre Consortium.  USDC is fully backed by reserves of U.S. dollars and is regularly audited to ensure compliance. This has made it a favorite among institutional investors and those prioritizing regulatory oversight. USDC is not just a stablecoin; it’s also a gateway to various financial services. It’s widely used in DeFi protocols, and its parent company, Circle, offers high-yield accounts and business accounts denominated in USDC, adding layers of utility to this stablecoin.

4. DAI

DAI stands out from the pack as it’s not backed by fiat reserves but is instead a crypto-collateralized stablecoin. It’s the brainchild of MakerDAO, a decentralized autonomous organization. DAI is governed by its community of token holders, who vote on various aspects like collateral types and stability fees. This decentralized governance model has made DAI a darling among those who value the ethos of decentralization.

As mentioned earlier, DAI maintains its $1 peg through a complex system of smart contracts and collateral assets, primarily Ethereum. While this makes DAI more complicated than its fiat-backed counterparts, it is also incredibly innovative, offering features like the Dai Savings Rate, which allows DAI holders to earn interest directly through the protocol.

How Can I Make Money with Stablecoins?

• Yield farming: Yield farming is the crypto equivalent of striking gold, and stablecoins are your pickaxes. By providing liquidity to decentralized finance (DeFi) protocols like Uniswap, Curve, or SushiSwap, you can earn a yield on your stablecoin holdings. These platforms offer annual percentage yields (APYs) that can make traditional savings accounts look like piggy banks. However, remember that higher yields often come with higher risks, so always do your homework.

• Staking: Some stablecoins offer staking options, allowing you to lock up your assets for a fixed period and earn staking rewards. Some stablecoins offer staking mechanisms where you can earn a share of transaction fees generated on the network. It’s a low-risk way to earn a steady income, but always read the fine print for any lock-up periods or penalties.

• Lend money: Why let banks have all the fun? Lending platforms like BlockFi, Aave, and Compound allow you to lend your stablecoins to borrowers and earn interest. These platforms act as financial matchmakers, lending your assets at a higher rate than they pay you in interest. The difference, known as the spread, is their profit, but you still get a generous slice of the pie.

Conclusion

Stablecoins have emerged as a cornerstone in the crypto landscape, offering a sanctuary from the notorious volatility of cryptocurrencies. They serve as a bridge between the traditional financial world and the innovative realm of blockchain. They provide the stability of fiat currencies while retaining the benefits of digital assets. From Tether (USDT) to DAI, these digital stalwarts come in various flavors. Each with its own set of features, advantages, and challenges. Their versatility makes them more than just a digital dollar in your crypto wallet; they are a Swiss Army knife in the financial toolkit of the 21st century.

However, it’s crucial to remember that stablecoins are not a one-size-fits-all solution. They come with their own set of challenges, ranging from regulatory uncertainties and centralization risks to issues around transparency and market fragmentation. Moreover, while they offer various avenues for generating revenue—be it through yield farming, staking, or lending—the risks involved are not to be overlooked. We need to understand that this is a new industry and that the road to “stability” is still long. The many failures in the recent past remind us of this.

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