Stablecoins

What is a Stablecoin

In the crypto ecosystem the term "stablecoin" refers to a type of digital currency that is designed to follow the price (peg) of a stable asset, like a fiat currency - USD, EUR, etc. The primary goal of a stablecoin is to solve the problem of volatility, a significant issue in the crypto space that often discourages users from adopting digital currencies for everyday transactions. By pegging the stablecoin to a less volatile asset, users can enjoy the benefits of blockchain technology while limiting their exposure to large price fluctuations.

Different Types of Stablecoins

There exist several main types of stablecoins - every type provides a unique solution to the challenge of maintaining a stable value. These solutions each possess a unique set of benefits and drawbacks ranging from centralization level to peg stability. Choosing the best one would depend heavily on how you intend to use it, for example, decentralized stablecoins like DAI would function better in DeFi ecosystems than centralized USDT.

Decentralized

Decentralized stablecoins use decentralized networks and smart contracts to maintain stability, offering more transparency. Examples include DAI, collateralized with Ether. They're widely used in decentralized finance (DeFi) for lending, borrowing, and yield farming. Risks include smart contract failures and severe market conditions affecting the peg.

Centralized

Centralized stablecoins are controlled by a single entity and are typically fiat-collateralized. An example is Tether (USDT), backed by USD reserves. They're mostly used for trading and cross-border transactions, but trust in the issuing authority is critical. Their centralized nature can pose risks like censorship or seizure.

Fiat Collateral = reserve of a state-issued currency, like the U.S. dollar or Euro.

Peg Mechanisms - Maintaining Stable Value

In order for stablecoins to maintain their value, there has to be a mechanism that corrects the price if it went off-grid. Stablecoin issuers cannot simply specify the price for one token, because it is subjected to a free market and will fluctuate naturally. For that matter here are the main ways to make sure that stablecoins remain stable:

Collateral Debt Position (CDP)

A Collateral Debt Position is a method primarily used in decentralized stablecoin systems, where a user deposits more volatile assets as collateral to generate stablecoins. This collateral is locked up in a smart contract until the stablecoin debt is repaid. If the value of the collateral falls below a certain threshold, it's automatically liquidated to maintain the stablecoin's peg. MakerDAO's DAI is an example of a stablecoin utilizing CDPs.

Reserve Collateralization

Reserve collateralization involves backing each stablecoin with an equivalent value of a more stable asset, usually held in reserve by a central authority. For example, a fiat-collateralized stablecoin like USDT or USDC is backed 1:1 by US dollars held in a bank account. The collateral ensures that the stablecoin's value remains stable. This method is most common in centralized stablecoin systems.

Algorithmic Stabilization

Algorithmic stabilization uses software algorithms to automatically adjust the supply of the stablecoin in response to changes in demand, keeping the price stable. When the price is high, the algorithm increases supply, pushing the price down. Conversely, if the price is low, the algorithm reduces supply, driving the price up. This type of stablecoin doesn't rely on collateral but rather on economic incentives to maintain its peg. Ampleforth is a prime example of an algorithmically stabilized stablecoin.

Market Intervention

Market intervention is a less common method of maintaining a stablecoin's peg and is often used as a last resort. This can involve a central authority buying back coins to decrease supply and increase the price or selling more coins to increase supply and decrease price. This method relies heavily on the financial strength and trust in the central authority to intervene effectively. However, it's worth noting that frequent market interventions can lead to a loss of credibility and instability.

Why are Stablecoins so Important?

• Escape from volatility - Stablecoins often makeup trading pairs with more volatile currencies and therefore act as a safe haven for investors and traders when things get too wild on the market.
• User adoption - The predictability and steadiness of stablecoins make them an excellent starting point for newcomers to the crypto space. Users can comfortably navigate through transactions without worrying about sudden price changes.
• Transferring liquidity - Stablecoins can be easily moved across different platforms, chains, and even geographical locations. Cross-border payments in stablecoins are fast, reliable, and much more simple than traditional bank transfers.

Using Stablecoins

Stablecoins are frequently used in CEX trading to create a price reference point. Usually, the U.S. dollar is used in this way, however, in the crypto ecosystem stablecoins are used instead of fiat to simplify the process. This way, fiat-crypto conversions are minimized.

In DeFi, decentralized stablecoins are created and maintained through smart contracts. To facilitate trading on DEXs, stablecoins are combined with other crypto-assets and added to liquidity pools. These liquidity pools work by maintaining a constant ratio between two or more assets. Users then may use pools to exchange stablecoins for other crypto-assets and back.

Decentralized stablecoins also come in handy when users want to scale their capital with loans (CDP borrow) or have some extra assets lying on the side and want to get some yield (stablecoin lending).

Security and Challenges of Stablecoins

The security of stablecoins depends largely on their type. Centralized stablecoins require trust in the central authority to hold sufficient reserves and to maintain the stablecoin's value. The security of these stablecoins is primarily tied to the trustworthiness and integrity of the issuer. Regular audits by reputable firms can help to assure users that the necessary reserves are indeed held.

On the other hand, decentralized stablecoins rely on the security of the underlying smart contracts that govern their issuance and stabilization mechanisms. These contracts must be robust against potential attacks and bugs. To ensure this, they are often open-sourced and audited by external parties.

Depegging

One of the most feared situations regarding stablecoins is depegging. Essentially depegging means that the actual market price of a pegged asset deviates from its assigned value. Various factors can trigger depegging, such as insufficient market liquidity, lacking confidence in the issuer, or shifts in the underlying economic climate.

It's important to realize that such a depreciation can lead to a significant market shift, influencing not just the pegged asset's holders but the wider crypto market as well. A recent instance illustrating this effect involved the depreciation of the Terra Luna stablecoin UST in May 2022.

Transparency

Transparency issues are a primary concern when dealing with centralized stablecoins. These tokens are pegged to a reserve of assets — typically fiat currency — held by a central authority or institution, like Tether, Circle or Binance. The obligation of proving that they hold sufficient reserves falls on these entities. If these organizations are not fully transparent, it quickly could raise questions about whether the stablecoins are fully backed by the reserve.

Transparency becomes critical when considering that the value of a centralized stablecoin is fundamentally a dependent on the trust. Users must trust that the issuing organization holds the appropriate amount of reserve assets and that these can be redeemed at any time. If there is a lack of transparency about the reserves' existence or accessibility, this trust can be quickly undermined.