Stablecoins 102: Stability
As mentioned in my Stablecoins 101 article, government-issued fiat currency remains stable through the actions of controlling authorities like treasuries, central banks, & international financial services which ensure said fiat remains relevant via legal & physical force, mostly because it is pegged to nothing material. Stablecoins can be egged to a physical commodity such as gold, fiat currencies, &/or algorithms.
Stablecoins take advantage of raw power provided by governments & the markets their citizens participate in. The tip of the spear in terms of raw financial & military reach serve is the U.S. dollar; thus stablecoins tied to it are the most widely used. To monetize stablecoin reserves, some of the funds backing stablecoins allocate to fixed-income securities via short-term corporate debt & government issued debt (treasuries) ensuring that liquid funds remain redeemable and adequately backed.
Stablecoins are kept stable via a few basic scenarios; fiat reserves, crypto reserves, commodity reserves, & algorithm backing,
Reserve & Basket Stablecoins
Stablecoins backed by fiat maintain reserves in currencies like the Euro & the U.S. dollar. For every token in circulation, fiat-backed stablecoins often have one dollar in reserve — either in cash or cash equivalents. Examples are USDC & BUSD.
Stablecoin reserves are maintained by central entities that regularly audit their funds and work with regulators to ensure that the entities holding stablecoin reserves remain compliant. It means that to buy stablecoins directly from the issuers, users have to go through Anti-Money Laundering (AML) & Know Your Customer (KYC) checks similar to those of regulated financial institutions. These processes involve collecting users’ personal information, including a copy of their government-issued identification document.
Once in circulation, anyone can send and receive stablecoins, although the central entity issuing them may have the power to freeze funds on addresses. Stablecoins have been frozen in the past, as issuers assisted law enforcement in their investigations or attempted to recover stolen funds, for example.
Crypto Stablecoins
Cryptocurrency-backed stablecoins are those backed by other cryptos like Bitcoin & Ethereum. Cryptocurrency-backed stablecoins can be issued to track the price of the cryptocurrencies backing them or track the price of a fiat currency.
Cryptocurrency-backed stablecoins can track the value of a fiat currency through balancing mechanisms on the blockchain, which use the stablecoins’ backing to ensure price stability. In these cases, stablecoins are overcollateralized to ensure that they can maintain their peg even during periods of high volatility in the market. Being overcollateralized means that the assets backing a stablecoin are worth more than the value of stablecoins in circulation. For example, $50,000 worth of Bitcoin may be held in reserve to collateralize the $25,000 value of a crypto-backed stablecoin. Frequent audits and monitoring tools add to the stability of the stablecoin’s price.
A crypto-backed stablecoin can be issued to launch one asset on a different blockchain. For example, Wrapped Bitcoin (WBTC) is a stablecoin backed by Bitcoin issued on the Ethereum blockchain. Crypto backed stablecoins are a more decentralized version of fiat-backed stablecoins, as they can be created through the use of automated smart contracts with no central entity controlling them.
Commodity Stablecoins
Commodity-backed stablecoins are essentially blockchain-based representations of commodities and are backed by reserves held by a central entity.
Physical assets such as precious metals, oil and real estate are used to back commodity-backed stablecoins. Gold is the most commonly collateralized commodity. However, it is necessary to understand that these commodities can and will fluctuate in price and, hence, can potentially lose value.
Stablecoins backed by commodities make it easier to invest in assets that might otherwise be out of reach on a local level. Obtaining a gold bar and locating a secure storage site, for example, is difficult and expensive in many areas. As a result, owning tangible assets such as gold and silver is not always a viable option. However, commodity-backed stablecoins are also handy for those who want to swap tokens for cash or gain custody of the underlying tokenized asset.
Seigniorage Stablecoins
Non-collateralized or seigniorage-style stablecoins are similar to algorithmically-backed stablecoins, but they do not have any reserves in smart contracts. Instead, seigniorage-style stablecoins rely on complex processes meant to adjust the circulating supply of their coins in response to supply and demand.
Non-collateralized or seigniorage-style stablecoins destroy and inflate supply on-chain to maintain their peg. No collateral is used to mint these stablecoins as they are self-collateralized. For instance, let’s assume the value of stablecoin A is $1.00. The price lowering to $0.70 shows that there is more supply than demand for a stablecoin. The algorithm buys stablecoin A with seigniorage, reducing supply and bringing the price back to $1.00.
If the price remains below $1.00 and there are not enough earnings to buy more of the coin’s supply, seigniorage shares are issued. It means users are effectively investing in the expansion of the supply of non-collateralized stablecoins. On the flip side, if the price of a stablecoin rises above $1.00, the algorithm generates more tokens, increasing supply until the price falls below $1.00. The profits are referred to as “seigniorage.”
Algorithmic & Hybrid Stablecoins
Algorithmic stablecoins are stablecoins that rely on algorithms to keep their prices stable, effectively balancing supply and demand to maintain price stability. Funds are typically held in smart contracts.
These stablecoins are essentially mini central banks, defending the peg of their currency in the market using a monetary policy (albeit in code). When the price of the stablecoin goes over the peg they buy assets and sell them when the price drops below the peg.
Some algorithmic stablecoins are known for losing their peg during black swan or unexpected events because the market volatility shoots upwards due to a lack of over-collaterization. An algorithmic stablecoin system will lower the number of tokens in circulation when the market price falls below the fiat currency’s price. Alternatively, if the token’s price exceeds that of the fiat currency it represents, new tokens are issued to bring the stablecoin’s value down.
Advantages / Stablecoins 102
Stablecoins have several advantages over fiat currencies and other cryptocurrencies. Firstly, they bring the stability of fiat currencies to the blockchain, meaning that they are more secure and more transparent versions of fiat currencies that can interact with applications built on the blockchain.
Stablecoins can be used as a currency and are cheaper for making transactions than traditional fiat currencies, and are available to a network of applications that offer higher yields than conventional savings accounts. On blockchain-based applications, stablecoin holders can also take out loans backed by their coins or take out insurance to protect their crypto assets on other applications.
Stablecoins make cross-border payments faster and cheaper and can be easily traded for fiat currencies on exchanges, as they are widely accepted on trading platforms and are highly liquid.
Commodity-backed stablecoins make precious metals and other commodities easy to carry and more divisible while maintaining the same value as their reserve. Gold, for example, can be used as a medium of exchange through these stablecoins and can even be lent out to earn interest.
Disadvantages
The main disadvantage associated with stablecoins is counterparty risk. Counterparty risk describes the likelihood that another party involved in an agreement might default. In this case, a stablecoin issuer may not have the reserves they claim to have or may refuse to redeem tokens for their reserves.
Stablecoins that rely on central entities and auditors are subject to human error, as audits may fail to spot inaccuracies or potential problems. Moreover, fiat currency-backed stablecoins are often held in commercial paper, a form of short-term unsecured debt. The use of commercial paper adds to the counterparty risk, as the company issuing that debt could default on its obligations.
Periods of market turmoil or failure to produce audits may also lead to risk premiums. Risk premiums represent the additional compensation investors get for the added risk of investing in an asset (i.e., stablecoins). The risk premiums lower the value of stablecoins compared with their peg, which means buying cryptocurrencies with stablecoins becomes slightly more expensive than with fiat currencies.
Algorithmic stablecoins can often lead to Ponzi schemes where new tokens are only created through new users depositing collateral. A Ponzi scheme is a type of fraud that generates returns for investors with funds from new investors and eventually collapses when new investors stop making investments. This means the value of these assets can quickly implode if new users stop coming.
Finally, the central entities issuing tokens may have the power to freeze them on addresses at the request of law enforcement. Law enforcement agencies may require tokens to be frozen even during investigations related to money laundering, counter-terrorism financing, or other illicit activities.
