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Stablecoins for newcomers

Date
19/04/2023
Written by
Lykke
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April 19 I A stablecoin is a cryptocurrency pegged to an underlying asset. This asset can be a currency, commodity, or other financial instruments. As its name suggests, the price of stablecoin is relatively non-volatile compared to unpegged cryptocurrencies such as Bitcoin and Ethereum. So, in short, a stablecoin is a stable cryptocurrency. Some people confuse stablecoins with altcoins. Altcoins refer to all cryptocurrencies except for Bitcoin. Stablecoins are thus a subset of altcoins.

Large market, dominated by Tether

The market cap of the stablecoin market is around 116 billion US dollars, representing a 10th of the global crypto market.

Tether (USDT), the world’s biggest stablecoin, is pegged at a 1:1 ratio to the US dollar. The company behind Tether tokens offers four other Tether stablecoins. These are pegged to the euro (EURT), gold (XAUT), the Mexican peso (MXNT) and Chinese yuan (CHNT).

The other most popular stablecoins are USD Coin (USDC), issued by the joint venture between Coinbase and Circle, Binance USD (BUSD), issued by the blockchain infrastructure platform Paxos, and DAI issued by MakerDAO. They are all pegged to the US dollar.

Why use stablecoins? What is the point?

Stablecoins are available around the clock, so more accessible than cash obtained through the traditional banking system (closed overnight and on weekends). They also enable instant transfers at low fees or even zero fees. A prime example of the use of stablecoins is for international bank transfers.

Stablecoins also enable people in countries with high inflation to hedge their savings from depreciation, by investing in dollar-pegged assets such as Tether.

Risks involved with stablecoins

Despite being pegged to an asset, investments in stablecoins are not risk-free. They are not regulated by governments, so there is no guarantee that they will retain their value.

There is regulatory uncertainty about their legal status; in the US for example in February a rumor spread that Paxos had stopped minting Binance USD (BUSD) because the SEC had threatened to sue Paxos (more information here).

Tether for instance discloses the reserves that back its different stablecoins on a quarterly basis. The latest data available shows that 82 percent was held in cash and cash equivalents at the end of 2022. However, the remaining 18 percent was held as corporate bonds, precious metals, secured loans and other investments including digital tokens – a risky strategy in case of turbulence in the financial markets.

Should there be a bank run, a situation where Tether stablecoin holders suddenly want to redeem or exchange their stablecoins for its pegged asset, Tether may not be able to honor its liabilities.

It’s also worth noting that not all stablecoins are backed by a currency or a commodity. They can be backed by crypto collaterals such as Ethereum or by no collaterals at all.

This was the case with Terra’s stablecoin, which was backed by algorithms – automated operations. As it lost its peg against the dollar in May 2022, a market capitalization of 60 billion US dollars was wiped out within a week. Other examples of algorithmic stablecoins that have failed are IRON and TITAN. 

Longer-term, stablecoins will be challenged by Central Bank Digital Currencies called CBDCs. Many central banks have initiated proof of concept projects to launch their own CBDCs. These projects are at different stages of development. Continued concerns about their monetary impact and any unforeseen consequences are a hindrance in their deployment.

Is Bitcoin a stablecoin? What about Ethereum?

Neither Bitcoin nor Ethereum are stablecoins. Bitcoin and Ethereum are volatile cryptocurrencies whose values can fluctuate greatly over short periods of time.

Summary

The article discusses stablecoins, a type of cryptocurrency designed to maintain a stable value. While they offer benefits such as reduced volatility, there are risks associated with stablecoins and different types with varying levels of decentralization and collateralization. It's important to do your own research before investing in stablecoins. Make sure to choose a reputable stablecoin and monitor its performance regularly to minimize potential losses.

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