Stablecoins Explained: A Guide to Cryptocurrencies
Stablecoins are cryptocurrencies that are pegged to fiat currencies. They provide stability during times of economic uncertainty and volatility.
What are Stablecoins?
Stablecoins are digital currencies designed to maintain their value in parity with fiat currencies and metals like the US Dollar, Euro, Gold, and even the Argentine Peso.
They are the Decentralized Finance ecosystem’s building blocks that seek to onboard the majority of the unbanked and underbanked population.
The use cases of stablecoins vary from doing remittances — sending money from one country to another in seconds just like Bitcoin, hedging our portfolio in a recession, and even peer-to-peer lending or borrowing against DeFi assets to get yields.
In theory, stablecoins should not have any volatility to perform their function.
What are the different types of Stablecoins?
There are two major categories of stablecoins with varying types that are existing in the digital asset space today. They can either be collateralized backed by assets like fiat currencies or cryptocurrencies, or non-collateralized like algorithmic stablecoins.
A. Collateralized Stablecoins
1. Fiat-Collateralized Stablecoins — Each currency is backed entirely by sovereign currencies and real-life assets, either cash or cash equivalents like treasuries and securities. The US Dollar has the most significant share due to its status of being the World’s Reserve Currency.
These represent more than 90% of Stablecoins currently circulating, with USDT, USDC, and BUSD representing the bulk of the market share.
2. Hybrid Stablecoins — These assets are sometimes called crypto-collateralized stablecoins that maintain their peg to fiat money by a mix of cryptoassets & by algorithmically tracking their peg to the underlying assets. Their protocols call for ‘over-collateralization’, meaning that a large number of cryptocurrencies are needed to mint a smaller supply of these stablecoins.
DAI, a crypto-collateralized stablecoin pegged to the Dollar was invented as an alternative to fiat-backed currencies like USDT prior to the invention of DeFi. Users would use ETH, BAT, USDC, etc. as collateral to mint its equivalent to 1 DAI.
B. Non-Collateralized Stablecoins
1. Algorithmic stablecoins, on the other hand, are lesser-known than fiat and crypto-collateralized stablecoins. Algorithms usually maintain the value of these currencies to stabilize their volatility and track the price of their underlying fiat asset like the Dollar. Other cryptoassets and synthetic tokens may partly back algorithmic stablecoins.
One example of this stablecoin is the TerraUSD (UST), an algorithmic stablecoin that runs within the Terra blockchain and whose native token is LUNA. LUNA expands and contracts as the price of UST moves. When its parity goes below $1, the issuer is incentivized to burn UST against LUNA to bring back the peg. While heavily defending the peg of UST from May 9 to 11, LUNA hyper-inflated and lost its value from a hundred down to a fraction of a dollar.
Algorithmic stablecoins represent the smallest market share, with their current circulating market cap of under 4 billion dollars.
How does a Stablecoin work?
For fiat-collateralized stablecoins, the issuer will have custody of more cash or other cash equivalent assets like money market funds, government and corporate bonds, etc., and mint more stablecoins when the demand exceeds the supply. Third-party audit firms ensure that their held cash in reserves are healthy and can maintain stability and prevent bank runs when redeeming to cash.
For hybrid and algorithmic stablecoins, if the supply exceeds the demand, the issuer will enact policies like burning the supply to maintain the parity, increase the yield rewards to entice more lenders to stabilize the collateralization ratio, and other monetary policies available to DeFi protocols.
The top 50 stablecoins by circulating market cap represent a total of more than 160 billion dollars for the entire cryptocurrency industry.
Fiat-Collateralized stablecoins have more than $149B of supply, followed by Hybrid or Crypto-collateralized stablecoins with $10B, and Algorithmic with $3.7B.
Lending & Borrowing
A lesser-known strategy of investing in cryptocurrencies is by engaging in Yield Farming.
Yield farming maximizes the return of your crypto capital by putting your stablecoins into liquidity pools that provides liquidity for trading DeFi tokens.
Stablecoins can be lent either through centralized apps like BlockFi, Celsius, or Coinbase or through decentralized protocols like DEX and Bridges. DAI has higher rates than fiat-backed coins like USDC and USDT with the latter having lesser risk and with regular third-party audits.
For more alpha, you can view our interactive data viz here: Stablecoin Tracker
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Disclaimer: This article is for educational purposes only and must not be treated as financial advice.
As always, please conduct due diligence and manage your risks accordingly.