The Rise of Stablecoins: Current Trends and Future Prospects
The cryptocurrency market is notorious for its extreme volatility. From the record high of $20,000 per BTC at the end of 2017 to the staggering $68,000 per Bitcoin in November 2021, the price fluctuations have left modern Bitcoin holders dissatisfied with the current price of $43,968 (as of the time of writing).
While some traders thrive on this kind of volatility, as it presents opportunities for quick profits not found in traditional markets, not everyone is willing to take on such risks. In response to this need for stability, stablecoins were introduced.
Stablecoins are a specific type of cryptocurrency asset that is pegged to the value of a fiat currency, typically the US dollar, or sometimes even a commodity. For staunch crypto-anarchists, stablecoins may seem contradictory to the original principles of cryptocurrencies, which aimed to decentralize the monetary system and break free from centralized control. However, the demands of the crypto market created a necessity for a stable trading instrument.
Stablecoins first emerged in 2014, three years prior to the 2017 cryptocurrency hype that brought the market into the mainstream. The early stablecoins, such as BitUSD and NuBits, have given way to more modern iterations like USDT, USDC, and BUSD.
As a liquid asset, stablecoins are readily available on nearly all financial exchanges. Regardless of your location, you can seamlessly transfer stablecoins across various platforms. This universality makes stablecoins a versatile medium of exchange and a reliable store of capital for crypto investors and traders.
Compared to fiat currencies, stablecoins offer greater ease of transfer between accounts and addresses. Additionally, stablecoins are actively utilized within decentralized finance (DeFi) applications.
Stablecoins are often considered a safe haven for cryptocurrency traders during periods of high market volatility or bearish cycles. However, it is worth noting that stablecoins serve as a refuge not just for traders but also for the token issuers themselves. In many ways, stablecoins can be seen as a type of perpetual bond.
Stablecoins possess distinct characteristics that set them apart from other tokens, although these features are often overlooked or neglected. It may be time to shed light on these differences. Technically, stablecoins are derivative tokens that reside on various blockchains, operating through smart contracts. These smart contracts are managed, at least partially, by the stablecoin issuers, who retain the authority to halt the contract at any given time. Tokens held in specific addresses can also be frozen, rendering them unprocessable by the contract and effectively immobilizing them.
Another crucial aspect of stablecoins is that, as entities on the blockchain, they are initially owned by their issuers and are “issued” to buyers for temporary use. This mirrors the control exerted by central banks and states over physical banknotes and non-cash money. However, the level of control achievable within the blockchain exceeds that of the traditional banking system. While stablecoins can be redeemed, similar to banknotes, the redemption process remains under the issuer’s control, although under normal circumstances, they circulate freely within the market. In the event of a large-scale crisis or issuer bankruptcy, token holders may find themselves in possession of tokens and a favorable court decision but without the corresponding funds.
The capitalization of stablecoins derives from the total number of tokens multiplied by their price. However, stablecoins do not possess a conventional market price. They primarily serve as a medium of exchange rather than an investment. In over 99% of instances, 1 xUSDx is equivalent to $1. The value of a dollar stablecoin only diverges from $1 by more than 0.1% when the issuer (or the market as a whole) performs poorly or faces significant challenges. The actual capitalization of a stablecoin is determined by the value of its collateral. However, the accuracy and reliability of the information regarding reserves depend entirely on the issuer, as does access to external auditors.
The dominance of centralized cryptocurrency exchanges in stablecoin capitalization is evident, with nearly 95% of the total capitalization belonging to tokens directly or indirectly owned by these exchanges. This is not surprising, as exchanges prioritize flexible liquidity that is not subject to the delays and over-regulation often associated with the traditional banking system.
Although stablecoins are not exclusively owned by cryptocurrency exchanges, the combined capitalization of non-exchange stablecoins is relatively low, barely exceeding $10 billion, which limits their impact on the overall market.
Popular Stablecoins
The cryptocurrency market features numerous stablecoins, but the following list highlights the most popular ones in 2023 based on their capitalization:
- Tether (USDT)
- USD Coin (USDC)
- Dai (DAI)
- TrueUSD (TUSD)
- Pax Dollar (USDP)
- Gemini Dollar (GUSD)
- USDD (USD)
- BitUSD (BitUSD)
- USD Digital (USD)
- Neutrino USD (USDN)
The majority of stablecoins in the crypto industry are pegged to the value of the US dollar. Tether (USDT) is a well-known example, where 1 USDT is intended to be equivalent to $1, with only slight price deviations. While the list of popular stablecoins may change over time, Tether consistently maintains its leading position.
There are also stablecoins tied to other fiat currencies, such as the euro (Stasis Euro – EURS) or the Singapore dollar (XSGD).
Some stablecoins maintain their peg to fiat currencies but utilize cryptocurrencies as their backing. In these cases, stability can be achieved through redundancy or a sophisticated arbitrage algorithm. DAI from MakerDAO is a prime example of a stablecoin with cryptocurrency reserves.
Stablecoins pegged to the price of gold are also available, such as PAX Gold (PAXG) or Tether Gold (XAUT). Unlike traditional gold-based instruments like ETFs, stablecoin issuers do not charge management fees, and settlements conducted in crypto are more cost-effective. However, these gold-backed stablecoins have not gained significant popularity thus far.
Each stablecoin operates based on its unique system for maintaining its value. While there is no universally accepted classification for stablecoins, the following criteria can be used to differentiate them:
- Asset class in reserve: Stablecoins may be backed by fiat currencies or cryptocurrencies.
- Reserve ratio: Reserves can partially cover the total value of stablecoin tokens in circulation, be equal to the value, or even exceed it.
- Price stability mechanism: Stability can be achieved solely through reserves (often centralized) or through a combination of reserves and an algorithm (algorithmic stablecoins).
Types of Stablecoins
Stablecoins can be categorized into two main types based on their regulatory approach:
Centralized: These stablecoins are created and controlled by central organizations that ensure the token’s peg to a specific fiat currency and maintain its stability.
Decentralized: These stablecoins operate through blockchain smart contracts without the involvement of central organizations. These projects employ various mechanisms to control assets, such as fund freezing or debt mechanisms, to maintain price stability.
Decentralized stablecoins can further be divided into two subtypes: algorithmic stablecoins and those backed by excess cryptocurrency collateral.
Stablecoins with excess collateral maintain their peg to the dollar by utilizing a range of liquid cryptocurrencies like ETH or BTC. Given the volatility of the dollar price, overcollateralization is employed, where a collateral value of $1.5 or more in crypto is held for each token with a face value of $1. DAI, the decentralized stablecoin, operates on this principle.
Algorithmic stablecoins, on the other hand, do not have direct ties to real-world assets. Instead, they establish a link to the dollar through the issuance and redemption mechanisms of their own tokens. An example of an algorithmic stablecoin is Djed, developed by Cardano.
Stablecoin: A Bond-Like Instrument
In normal circumstances, a stablecoin shares similarities with a corporate bond. Its purpose is to enhance liquidity on the issuing platform, and buyers acquire these tokens by paying “real” dollars, receiving a virtual obligation in return that can be redeemed. While stablecoins do not provide direct interest payments for holding them, some exchanges like Binance offer interest rewards for depositing stablecoins into special accounts. Additionally, passive income can be earned through DeFi platforms. As the stablecoin market is relatively young, there is no established authoritative rating system for their reliability. However, when evaluating trust in a stablecoin, factors such as reputation should be considered. USDT and USDC have become widely recognized as “reserve currencies” within the cryptocurrency market, similar to the status of the US dollar and euro. They are traded extensively across various cryptocurrency platforms. On the other hand, apart from DAI, most other stablecoins have limited adoption. Even the third-largest stablecoin, BUSD, primarily circulates within the Binance ecosystem. Highly popular and liquid stablecoins are easier to trade on secondary markets, even during times of crisis. Greater trust in these stablecoins reduces the likelihood of major holders panicking and demanding immediate redemption of tokens for dollars from the reserve pool. Issuers of smaller stablecoins face the risk of depleting their reserves rapidly and may even face default if the reserves are insufficient.
Stablecoin as a Safety Net for Issuers
During global economic crises, stablecoins serve as reserve funds for their parent companies. They aid in fortifying the financial stability of the issuers during peak crisis periods. The deposits backing stablecoins, particularly for regulated entities, consist of pure cash. To maintain a 1:1 collateralization ratio for all issued tokens, the issuer cannot withdraw or trade reserves as risky assets without redeeming the corresponding number of tokens. Such operations are immediately recorded on the blockchain.
Is it Prudent to Hold Stablecoins During a Crisis?
Based on the aforementioned information, let’s draw some general conclusions regarding what stablecoin holders can expect and what they should not rely on:
- Stablecoins are managed either fully or partially by the issuer through underlying smart contracts on the respective blockchains. The issuer can halt smart contract operations or block transactions from specific addresses but cannot confiscate tokens from other users’ addresses.
- The issuer of a stablecoin does not guarantee the security of tokens stored in owners’ wallets. It cannot assist in recovering stolen or mistakenly transferred tokens.
- Tokenized dollars can be staked for interest, typically on the issuer’s exchange or DeFi platforms. Although this carries increased risk, it provides higher returns compared to traditional bank deposits.
- Stablecoins, like perpetual bonds, have a fixed denomination and can be traded on secondary markets. However, substantial amounts can be redeemed directly from the issuer.
- Stablecoins lose their link to the underlying asset in the event of issuer problems or during significant market upheavals.
- In the event of issuer bankruptcy, the collateral backing stablecoins becomes part of the overall liquidation assets. Token owners have the right to claim their share of compensation, but the possibility of receiving compensation depends on the jurisdiction and transparency of the issuer, particularly regarding reserve audits. Situations like these highlight why beginner investors should never treat stablecoins as risk-free assets. A comprehensive investment guide for newcomers typically explains diversification principles, counterparty risks, and capital allocation rules that help mitigate such exposure.
Stablecoins issued by regulated companies are generally more reliable, as tokens from offshore issuers can become worthless.
Now, let’s shift our focus to stablecoin issuers as corporations. Some issuers are even publicly traded on stock exchanges and adhere to public reporting requirements. Notably, Coinbase, Circle, and Gemini operate within the US jurisdiction.
The capitalization of a stablecoin essentially represents the size of the issuer’s “financial cushion” in fiat currency. It’s important to note that not all available funds on the company’s balance sheet are utilized for stablecoins, and cryptocurrency reserves only constitute a portion of the backing. Nevertheless, this transparent factor serves as an easily assessable indicator of the issuer’s financial stability, subject to periodic independent reserve audits. An exchange that has issued billions of tokens will generally exhibit greater stability during a crisis compared to an exchange lacking such a cushion or one that is entirely controlled by its owners. Gradually reducing the circulation of tokens may temporarily decrease liquidity on the exchange, but it can ensure its stability and creditworthiness for years to come.
Even for a significant project, the illusion of stability can vanish unexpectedly. The collapse of the Terra project and its UST stablecoin serves as a lasting memory for cryptocurrency investors. Storing funds in stablecoins during periods of market instability introduces additional risk, increasing the likelihood of issuer default. Fiat currencies, particularly the dollar, are experiencing high inflation, causing stablecoins to depreciate in value. Although higher interest rates on stablecoin deposits partially offset these risks, it is advisable to withdraw funds from stablecoins for long-term storage and convert them into fiat or cryptocurrencies, depending on personal trust levels.
Advantages of Stablecoins
Digital stablecoins offer numerous advantages, including:
- Stability: Stablecoins fulfill the same function as traditional fiat currencies. During market volatility, investors can shift their portfolio assets into stablecoins, just as they would move into cash or Treasury bonds.
- Fast Trading Tool: Stablecoins facilitate quick trades due to their fast transaction processing and low fees. They can be easily purchased or transferred, providing more agility compared to fiat currencies.
- Increased Liquidity: Stablecoins enhance liquidity and trading volume in the cryptocurrency market. Their stability instills confidence, attracting more participants and boosting market capitalization. This leads to improved asset pricing and narrower bid-ask spreads.
- Global Payments: Stablecoins can be transferred worldwide, even to regions where acquiring US dollars is challenging or where local currencies are unstable.
Disadvantages of Stablecoins
Stablecoins do have one drawback: the risk of centralization. Some coins are managed and backed by a centralized entity, introducing potential risks for users. If issues arise with the stablecoin issuer, it can harm their reputation and impact investors.
Prospects for Stablecoin Development
Following the failure of Terra, algorithmic stablecoins lost credibility in the cryptocurrency market. However, a successful project in this domain is MakerDAO’s DAI.
Centralized projects like Tether and USDC dominate the stablecoin segment. However, powerful jurisdictions such as the US and EU are considering implementing comprehensive regulations for stablecoin issuers, which could complicate their usage.
Stablecoins often face criticism from regulators. The US Treasury, for instance, released a report in 2021 highlighting the risks associated with stablecoins, including concerns about reserve transparency and their potential threat to investors. The Federal Reserve also views stablecoins as risky due to potential conversion issues into fiat currencies.
BlackRock, a prominent player in the Bitcoin ETF race, recently expressed concerns about stablecoins like USDT and USDC, seeing them as a threat to the leading cryptocurrency. The company outlined these concerns in a document sent to US regulators, emphasizing the complexities and evolving nature of the cryptocurrency space. According to BlackRock, stablecoins can create artificial demand for Bitcoin when used for payment, potentially inflating its price.
Conclusion
Stablecoins play a valuable role in the cryptocurrency world by providing an alternative that mitigates risks associated with high volatility. They offer a haven during challenging times and opportunities for earning interest through fluctuations or staking. As the digital currency market continues to evolve and grow, despite regulatory challenges, the prospects for successful new stablecoin releases remain high.