The recent Terra-Luna and UST events have made stablecoins a hot topic. What exactly are they? And why should you care about them in the crypto industry! This article will give an overview of each type as well as a list of some popular ones available today - so read on for more information.
What are Stablecoins?
Stablecoins are a type of cryptocurrency that has been designed to connect the world between fiat and crypto. They're meant for day-to-day commerce and transfers across exchanges, but what makes them so unique?
The answer lies in how stable their prices stay compared to Bitcoin or any other cryptocurrency - which means that under conditions of high volatility, you can convert your money to a stablecoin knowing that it is safe.
Stablecoins have been one of the most popular ways to store and trade value in crypto. Billions of dollars have been injected into a lot of stablecoins projects. These coins offer some degree of flexibility in that people can trade them against other coins on several exchanges. Also, they can be used as collateral for loans from financial institutions.
Types Of stablecoins
There are typically four types of stablecoins–fiat-collateralized, crypto-collateralized, commodity-collaterized and algorithmical stablecoins–and we will be reviewing each asset class.
This type of stablecoin is undoubtedly the most common. It is backed by fiat in the ratio of 1:1. This sort of stablecoin is classified as an off-chain asset because the underlying collateral isn't another cryptocurrency. Fiat collateral is held in reserve by a central issuer or financial institution, and it must be proportional to the quantity of stablecoin tokens in circulation.
If a company has $8M in fiat, it would only be able to issue 8 million stablecoins worth a dollar. The biggest of these are probably USDT, GUSD and PAX.
These stablecoins are supported by cryptocurrency. Cryptocurrency serves as the collateral for these stablecoins. The process does not require a third party or a central bank. By employing smart contracts, you can buy stablecoins equal to the value of the locked cryptocurrency. You may then withdraw your original collateral amount by putting your stablecoin back into the same smart contract. The most well-known stablecoin in this category is DAI, which employs this approach. This is accomplished by using MakerDAO's collateralised debt position (CDP) to secure assets on the blockchain as collateral.
To protect against price volatility in the needed cryptocurrency collateral asset, crypto-collateralized stablecoins are additionally over-collateralized. For example, if you wish to acquire $1,000 in DAI stablecoins, you'll need to deposit $2,000 in ETH, a 200 percent collateralised ratio. The excess collateral cushions DAI's price to preserve stability if the market price of ETH lowers but remains over a predetermined threshold. If the price of ETH falls below a certain level, the CDP is liquidated by returning the collateral to the smart contract.
The collateral for algorithmic stablecoins is not fiat currency or cryptocurrency. Instead, they utilise specialised algorithms and smart contracts to govern the supply of tokens. This ensures that their prices remain stable. When the fiat currency's market price falls below its price, an algorithmic stablecoin system will lower the number of tokens. Conversely, if the token's price exceeds that of the fiat it follows, fresh tokens are issued to bring the stablecoin's value down. The recent UST fiasco was an example of algorithmic stablecoins. Projects involving algorithmic stablecoins have had a hard time succeeding.
Physical assets such as precious metals, oil, and real estate are used to back commodity-backed stablecoins. Tether Gold (XAUT) and Paxos Gold (PAXG), two of the most liquid gold-backed stablecoins, are the most popular commodities to be collateralised. However, it's vital to realise that these commodities can fluctuate in price and, hence, can potentially lose value.
Stablecoins backed by commodities makes it easier to invest in assets that might otherwise be out of reach. Obtaining a gold bar and locating a secure storage site, for example, is difficult and expensive in many areas. As a result, owning physical commodities such as gold and silver is not always feasible. Those who want to exchange tokens for cash or take possession of the underlying tokenised asset will find commodity-backed stablecoins helpful. Paxos Gold (PAXG) stablecoin holders can sell them for cash or acquire the underlying gold. However, because London Good Delivery gold bars cost between 370 and 430 pounds per ounce, and each token is worth 1 ounce, users must have at least 430 PAXG to redeem tokens. Token holders can pick up their gold in vaults across the UK once they've been redeemed.
Are stablecoins Safe?
We usually say that you shouldn’t invest what you can’t afford to lose in the Crypto and DeFi space. Most of us deemed stablecoins a haven for our investments, but the recent LUNA-UST crash led us to believe otherwise.
The stablecoin UST, for example, plummeted to $0.77 last week despite being pegged to the US dollar.
Some investors were so upset by the depreciation of their stablecoins that they sued Coinbase. The case revolves around the GYEN stablecoin, tethered to the Japanese yen.
"Investors placed orders assuming the coin's value was, as advertised, equal to the yen," according to the lawsuit. "However, the tokens they were purchasing were valued up to seven times more than the yen." "The GYEN's value plummeted back to the peg in an instant, plummeting 80 percent in one day."
Tether is not also without its troubles despite boasting of being the third-largest cryptocurrency by market capitalisation. 2.9% cash reserves only back it, and the other collateral comes from different asset classes.
Imagine if investors were to pull out their USDT, it would be quite the arduous task for Tether to produce the dollar equivalent despite being pegged to it. The New York Attorney General is looking into Tether, claiming they are unlawfully hiding their losses and claiming that the US dollar doesn't fully back them.
The UK Government has reaffirmed its commitment to regulating stablecoins following the Terra meltdown. Also, Stablecoins have been at the forefront of discussions about governing the booming cryptocurrency sector in the United States.
Generally, stablecoins are a perfect way to escape the volatility of the crypto market. It is wise to know the type of stablecoin you are investing in not to lose all your investments overnight. Like we say in crypto, DYOR!