Stablecoin: What it is, how it works, and how to use it

Stablecoins are like fiat money in crypto. It is crucial to understand how it works to be safe in the volatile world of cryptocurrency. Save your profit.

Cryptocurrency, stablecoin, fiat money, types of stablecoins, paasive incomeon stablecoins

Written by

Alex Crypto
Published on

February 16, 2023

Stablecoin

It is literally "stable money," a class of cryptocurrency whose exchange rate is tied to real assets, such as fiat money or gold. The stability of real assets is also in question. Since the price of gold is fickle, the value of fiat money depends on inflation. Nevertheless, stablecoins are accepted by most and serve to minimize the impact of price volatility in the crypto market. The price volatility of stablecoins is much lower than that of other cryptocurrencies and is in a narrow price corridor. This type of cryptocurrency gives market participants a clear reference point and acts as a stable means of monetary exchange. For example, having bought a product with bitcoins, a buyer would feel sincere disappointment if he found out that bitcoins increased in price by 10% the next day and could have saved that 10%.

Some use cases for stablecoins:

  • Fixing profits in cryptocurrency transactions. Stablecoins allow you to fix the value of other cryptocurrencies at the time of exiting a trading position on an exchange.
  • A tool for preserving value between trades on an exchange.
  • Passive income generation (staking)

Centralized stablecoin

Is issued, managed, and regulated by private companies. These companies are supervised by government financial market regulators. These companies are responsible for both the security of their stablecoin and its asset backing. Issuers hold fiat money in their accounts at a ratio of 1:1 to the number of stablecoins. It is worth clarifying that parity must be confirmed by a reputable audit. Otherwise, doubts may reasonably arise about the real collateralization of stablecoin.

The issuing company has the ability to track any movement of its currency, to theoretically calculate the owner of the asset, and to block funds.

Some of the best-known centralized stablecoins include USDT (Tether), USDC (Circle), and BUSD (Binance). They have the largest capitalization and liquidity.

Decentralized stablecoin

Is issued by decentralized protocols or algorithms. The implementation mechanisms of decentralized stablecoins can work in different ways. The main difference from centralized ones is that the issuer does not have the ability to issue coins at will. The issuance of decentralized stablecoins is strictly regulated by algorithms prescribed in a smart contract.

A DAI stablecoin is generated whenever a user freezes an equivalent amount of ETH in a smart contract.

Stablecoins by type of collateral 

Stablecoins by Type of Collateral

Backed by fiat money

Stablecoins are backed by fiat money, less often by precious metals. They have the most capitalization because users who are used to fiat money can easily understand the mechanism of price formation for such a stablecoin.

The simplest explanation of the mechanism of such a stablecoin is: $ 1 is made into a guarantee account, and a promissory note (stablecoin) for the same amount is issued to the person who deposited the money. The holder of the guarantee account is obliged to redeem the promissory note for $1 when it is presented. It is clear that this is a centralized scheme because there is an issuer of stablecoins, who is also the holder of the collateral fund. It is also clear that the stability of the whole system depends on the honesty of the issuer. He may want to increase his profit, for example, by letting fiat into other transactions, including high-risk ones. Or to issue stablecoins that are not secured with real money. The solution to this problem is a regular audit of the issuer. But, as practice shows, the same Tether during all of its existence hasn't provided the imputed confirmation of the presence of collateral in the ratio 1:1. And we are talking about 80 billion dollars.

PROS

  • The most stable price.
  • Ease of implementation.
  • Since the collateral fund is not stored on a blockchain, there is less vulnerability to hacking.

CONS

  • Centralization.
  • Transparent auditing is required.
  • Withdrawal of stablecoin into fiat is relatively expensive and not always fast.

Backed by cryptocurrency 

Stablecoins are backed by other cryptocurrencies. How do you implement this if cryptocurrencies have high volatility? Collateral should be such that it absorbs possible fluctuations in the supporting asset. For example, an amount in ETH (Ethereum) equivalent to $200 is set aside as collateral. And stablecoins are issued for $100.

This kind of token is more vulnerable due to price volatility, and in the event of a critical drop, a stablecoin can be liquidated at the expense of the depleted collateral fund. Therefore, the only way to prevent this threat is to give stablecoin as much collateral as possible. This, in turn, saves the situation but makes the whole scheme very capital-intensive.

PROS

  • Are more decentralized than those secured by fiat.
  • It is simple to convert stablecoin to the base currency.
  • The degree of collateralization of stablecoin is easy to check.

CONS

  • Stablecoin can be liquidated if there are severe market shocks due to a drop in the price of the underlying asset.
  • Less stable price than when stablecoin is backed by fiat money.
  • Inefficient use of capital to support stablecoin.
  • Greater difficulty in the realization of such stablecoins.

Algorithmic Stablecoin (Uncollateralized)

To address the disadvantages of the previous two types of stablecoin collateral, a third method - uncollateralized - was developed. The idea is not new, the U.S. dollar is also not backed by an underlying asset, nevertheless, it has the greatest spread around the world. The stability of the rate of such a stablecoin is regulated through the use of smart contracts and seigniorage.

Seigniorage is the difference between the cost of producing a unit of currency and its face value. A simplified example to understand how this works in practice. The Fed issues a $100 bill. Suppose the cost of issuing such a bill is 20 cents. The issuer's profit was $ 99.8.

The rate of algorithmic stablecoin is regulated as follows: If its value rises, more stablecoins are created. If it falls, the stablecoins are redeemed from the market with the profits from the seigniorage. If that profit is not enough to settle the rate, the seigniorage-shares mechanism used by central banks is applied.

The stability of the algorithmic stablecoin system is directly dependent on their demand. If there is no user confidence in the stablecoin system, it simply cannot exist. 

PROS

  • No collateral is required.
  • A high degree of decentralization.

CONS

  • The difficulty in using.
  • The complexity of system analysis.
  • High dependency on the market situation.
  • The scheme works only if there is a steady demand for such a stablecoin.
  • A high degree of vulnerability.

Popular stablecoins

Popular Stablecoins

USDT (Tether)

Stablecoin USDT (Tether) is centralized, backed by the U.S. dollar at a 1:1 ratio. In fact, it is a whole family of stablecoins, since it includes USDT coins issued for different blockchains. It is currently available on the following networks: Algorand, Ethereum, EOS, Liquid Network, Omni Protocol, Tron, Solana, and Bitcoin Cash.

It may be a legitimate question, why do we need it? The market expansion increased liquidity by increasing the number of trading pairs - this integration increases the capitalization of the stablecoin and the income of the issuing company.

Why do users need it?

In any of the blockchains in which stablecoin exists, users have access to a clear, secured, nonvolatile asset in which they can lock in profits, and hold funds between trades.

In addition, stablecoin gets all the advantages and disadvantages of the network on which it is released. It could be the speed of transaction processing or the bandwidth of the network. Compare, a USDT (ERC-20) transaction will cost $10, while a USDT (TRC-20) transaction will cost $1 (when transferred to Binance). An important point to note in this regard is that stablecoin can only be transferred within the network in which it was issued. Otherwise, funds will be lost.

USDC (Circle)

USDC Stablecoin refers to centralized coins with fiat backing. An issuer is a group called a "Centre". The founders of the consortium: the cryptocurrency company Circle and the exchange Coinbase.

Circle plans to go public in December 2022, the company's estimated value has risen to $9 billion, largely because USDC's turnover has doubled since July 2021. USDC's market capitalization is $ 52.5 billion. In contrast to USDT, USDC comes out with regular accounting audits.

Stablecoin is available on the following networks: Ethereum, Algorand, Avalanche, Hedera, Solana, Stellar, Tron, and Flow.

Commissions average about $1 in the Ethereum network, or $10 (when transferring to Binance).

BUSD (Binance)

Stablecoin of the Binance exchange, created in partnership with Paxos - centralized, secured by the U.S. dollar, behind the asset is the largest cryptocurrency exchange. Regular audits are conducted.

BUSD is issued on the Ethereum blockchain. Capitalization is $17.5 billion. Transaction fees are $0.5 on the BEP-2 network, $0 on the BEP-20 network, and $15 on the Ethereum network (when transferring to Binance).

DAI

MakerDAO's stablecoin exchange rate is pegged to the U.S. dollar at a ratio of 1:1. The collateral is various digital assets. Stablecoin tokens are generated by the Vaults system. The user enters a certain number of pledged tokens into a smart contract, and Vaults generates DAI.

Thus, a DAI token is a collateralized debt obligation to MakerDAO. The system is governed by a liquidation mechanism. When the value of the collateral is less than the liquidation ratio, the position is liquidated. The capitalization of DAI is $9.68 billion.

Developers see such possible markets for DAI token usage as:

  • working capital, hedging, and secured loans
  • trade payments, cross-border transactions, and remittances
  • charities and non-governmental organizations
  • gaming industry
  • prediction markets

TUSD (TrueUSD)

The issuer of TUSD is the asset tokenization platform TrustToken. TrustToken's tokenization portfolio also includes tokenized British pounds, Australian, Canadian, and Hong Kong dollars.

TUSD is a centralized stablecoin backed by the U.S. dollar at a 1:1 ratio.

The token can be used on the Ethereum, Tron, Binance Smart Chain, Binance Chain, and AvaChain networks.1.36 billion dollars in capitalization. Stacking and farming tokens are possible on DeFi platforms.

USDP (Pax Dollar)

USDP is issued by Paxos Standard. Stablecoin is fully backed by the U.S. dollar at a 1:1 ratio. USDP is fully centralized not only because it is issued by a private company, but also because it is regulated by the New York State Department of Financial Services, USA. The token functions on the Ethereum and Binance Smart Chain networks. USDP has a capitalization of $0.95 billion.

According to Coinmarketcap, these are the top seven stablecoins in terms of market capitalization. There are a total of 75 stablecoins, according to the same source.

How do stablecoin issuers make money? 

Companies that issue their own stablecoins have a financial motivation. By accessing billions of dollars and having even a little interest. Earnings depend on the mechanism by which the stablecoin is issued and the growth of the network.

Income items for stablecoin issuers

  • The fee for issuing and redeeming stablecoins. The average fee is 0.1%.
  • Earnings on the spread between supply and demand. Earnings can be measured in tenths or hundredths of a percent.
  • Investing collateral in safe assets, such as short-term U.S. government bills.
  • This is not a complete list of income items. Financial vehicles offer a wide range of opportunities to earn money. If the issuer is an exchange, it doesn't necessarily issue stablecoins for direct earnings. The reason could be both convenient for its customers and increased liquidity.

Regulatory policy on stablecoins

Regulatory Policy on Stablecoins

Regulators are starting to pay attention to the collateral problems of stablecoins.

In its November 5, 2021 report, the United States President's Working Group on Financial Markets concluded that stablecoins pose a systemic risk of concentrating economic power in the hands of a single issuer. The U.S. Treasury Department issued a report pointing out the risks associated with stablecoins and demanding that they be legally restricted.

In January 2022, the U.S. Federal Reserve published a report titled "Stablecoins: Growth Potential and Impact on Banking. The report expressed the Fed's view that companies issuing stablecoins should both comply with liquidity requirements and be audited on a regular basis.

Passive income on stablecoins

Stablecoins, just like other cryptocurrencies, can be used for passive income. In this case, the risks associated with the volatility of the underlying asset are excluded. Therefore, this way will be interesting for a conservative crypto investor.

The Bitcompare service will allow users to select the most profitable platform for various stablecoins. For USDT, USDC, DAI, and BUSD, you can find services offering up to 20% annually, and for TUSD and USDP, up to 14%.

BUSD tokens can also be used for mining liquidity. A number of DeFi-protocols support this stablecoin: Aave, Curve, Yearn, Delphi, Cream, Fortube, Bepswap, 1inch.

Here are a few more services for staking stablecoins, in fact, there are many more:

  • Coinrabbit - USDT, USDC at 10% annually
  • Hodlnaut - DAI, USDC, USDT at 6.5-7% annually
  • AQRU - DAI, USDC, USDT at 12% annually

Services for Staking Stablecoins

Participation in liquidity pools is another way to earn passive income from stablecoins. As you can see in the screenshot above, the Binance exchange's Liquid Swap section offers to place some stablecoins at a profitable interest rate, many times higher than in stacking. We should keep in mind that the reward is paid in a token, which is specified as a pair with the stablecoin.

Conclusion

Stablecoins are a tool that helps protect capital from cryptocurrency volatility. To have a balanced and protected portfolio of assets, it makes sense to diversify the stablecoins themselves.

Which ones will be in the portfolio: centralized or decentralized, backed by fiat, cryptocurrencies, or algorithms? What proportion of these stablecoins will be in the portfolio? It all depends on the investor's investment strategy and risk management.

Obviously, centralized stablecoins are more understandable to an investor in terms of their collateral. Therefore, they can be seen as a haven for their funds in times of uncertainty.

Among centralized stablecoins, USDT looks somewhat risky compared to other tokens. This is due to the opaqueness of this token's collateral reporting and repeated claims by financial regulators against Tether. This issuer has been penalized multiple times. Of course, you should not get rid of this token completely, but you should be more careful about its share in your investment portfolio.

At the same time, USDC is performing well. As mentioned in this review, the token has doubled in capitalization since July 2021. USDC's liquidity is growing, with a strong issuer under its belt, transparent reporting, and confirmed money in its accounts as collateral. It makes perfect sense to diversify into it. If the size of the invested capital allows it, you should place a portion of it in other centralized stablecoins: BUSD, TUSD, and USDP. If an investor uses the Binance exchange, the same BUSD will also be traded.

It is worth mentioning again the possibility of any centralized stablecoin being blocked, either at the request of the issuer or under pressure from financial market regulators. Such cases happen, and they can be a sensitive blow to the capital.

Decentralized stablecoins, despite their lower liquidity, are still widespread, especially in the DeFi sector. Their attractiveness is also due to the lack of influence on them by both financial regulators and the issuer. Because the terms of the issue are explicitly coded in the smart contract and theoretically cannot be changed.


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