Stablecoins are digital currencies pegged one-to-one with a fiat currency (money declared by a government to be legal tender), most often the U.S. dollar. The most famous stablecoins in the world are Circle’s USDC, Tether’s USDT, and MakerDAO’s DAI—and the first two are among the five biggest cryptocurrencies (of any kind) by market capitalization. But in a sector as volatile as crypto, why is there so much hoopla around coins that, by definition, don’t fluctuate?
To understand this, let’s look at crypto’s utility as “money.” It is a medium of exchange, and it is a store of value. However, due to their volatility, cryptocurrencies aren’t a good unit of account, meaning that it’s difficult to price things accurately using crypto.
Stablecoins are cryptocurrencies that can fill this gap. Plus, stablecoins can allow you to protect your investments during crypto market crashes—you can convert your bitcoin, ethereum or other crypto coins to stablecoins and weather the storm. When you feel that market conditions have improved, you can buy back into bitcoin, etc.
What is a stablecoin peg?
One of the most important things to know about stablecoins is their “peg,” which is the asset their value is linked to. The peg mechanism allows these coins to remain stable. Based on the type of peg used, stablecoins could be fiat-collateralized, crypto-collateralized or algorithmic.
- Fiat-collateralized: These stablecoins are issued by a centralized organization and backed (or collateralized) by fiat currency, bonds, etc. Circle’s USDC is an example of such a stablecoin. Circle issues USDC at a 1:1 ratio with fiat collateral, meaning USD$1 gives you 1 USDC.
- Crypto-collateralized: These stablecoins are decentralized, and their issuance is governed by smart contracts (lines of code with the contract terms and conditions written into them). They are backed by a basket of cryptocurrencies rather than fiat currency. However, these stablecoins tend to be over-collateralized. For example, $1.50 of crypto collateral will generate a single unit of the stablecoin. The over-collateralization exists to negate the effects of crypto price fluctuations and ensure that the stablecoins are backed by sufficient collateral. MakerDAO’s DAI is the most successful implementation of a crypto-collateralized stablecoin.
- Algorithmic: The stablecoins described above are issued based on the amount of collateral backing them up. Algorithmic stablecoins are decentralized and not dependent on collateral. They are dependent on smart contract mechanics. While the lack of collateral (or adequate collateral) may seem very attractive on paper, it can be an extremely risky proposition, as we have seen with Terra’s UST.
So, now that you know what stablecoins are, let’s get into the risks associated with them. For that, let’s see what happened with TerraUSD (UST), an algorithmic stablecoin launched by Terraform Labs in 2020.
Stablecoins have found immense utility in decentralized finance (DeFi) applications. Stablecoin pairs are very popular with liquidity providers looking to earn a yield on their coins. UST found a lot of utility in this area. Unfortunately, due to a series of events, the UST peg broke in May 2022, and the ramifications were felt across the entire DeFi ecosystem. Users of UST and its sister coin, LUNA, lost millions and billions of dollars.
Bottom line: If you’re thinking of investing in stablecoins, you may want to stick with the established ones.
Jeremy Koven is the Chief Operating Officer and a co-founder of CoinSmart, a Canadian cryptocurrency trading platform. Sign up for an account* with the code money30 and receive CAD$30 in bitcoin when you deposit a minimum of CAD$100.