Everything You Need To Know About Stablecoins
What Are Stablecoins?
Stablecoins first came to the scene in 2014. Tether (USDT), which is still the most used stablecoin, was the first and originally called realcoin. Back then, it was a novel product and was designed to bring stability of the dollar (mimic the dollar) to the crypto game.
There are four types of stablecoins: fiat-backed, algorithmic, crypto-backed and non-collateralized coins. Fiat-backed means that the stablecoin is collateralized 1:1 with a concrete fiat currency in the bank, treasury bills or some commercial paper. Usually, it’s a combination of all of them. The most popular fiat being (unsurprisingly) the US dollar (USDT and USDC, the two most widely used stablecoins, are both pegged to USD).
Algorithmic stablecoins rely on complex algorithms to mimic the price of a specific fiat currency, while crypto-backed stablecoins are collateralized by a specific cryptocurrency.
At first, stablecoinss gained popularity on exchanges that did not have fiat trading pairs. As the prices of cryptocurrencies are volatile, traders needed more stability to have the possibility to keep their positions in stablecoins thus not being exposed to cryptocurrency price volatility risk.
Moreover, with stablecoins being cryptocurrencies, traders and investors can easily transfer stablecoins between exchanges over blockchains outside of traditional financial systems and take advantage of the arbitrage opportunities, use for commerce, preserve wealth or use as means of payment. Overall, stablecoins have immensely increased the liquidity of the crypto space and are a crucial part of the whole crypto economy.
Why Use Stablecoins?
Stablecoins are widely used for the following purposes:
- Trade cryptocurrencies and hedge against price volatility of the crypto assets like bitcoin, ethereum.
- Borrowing and lending on decentralized finance protocols.
- Earn yield by providing liquidity to DEX liquidity pools.
- Day to day payments — e-commerce payments, international transactions, salary payments, and remittances.
- Wealth preservation — people can keep their savings in USD stablecoin being protected from their national fiat currency inflation. This is especially seen in countries like Venezuela, Argentina and Nigeria
1. Hedge against price volatility
Crypto markets are known for their volatility. Stablecoins are the cheapest and the quickest option for investors and traders to get out of a position into a stablecoin.
2. Borrowing and lending
There’s a high demand for stablecoins and thus decentralized lending protocols have become very popular among crypto investors. As there are people who want to borrow stablecoins, there’s also a market for lenders. You can provide collateral in form of other crypto assets like ethereum or wrapped bitcoin and borrow stablecoins. This way you are keeping your long position in your crypto assets and don’t have capital gains event due to not selling the asset that is analogous to real-world borrowing. Another option is to provide your stablecoins liquidity to DeFi lending protocols that enables lenders to earn a much higher yield than they would earn in TradFi (traditional finance).
3. Providing liquidity and earning yield
Another popular use case is providing liquidity to decentralized exchanges. In DeFi anybody can become a market maker who is also called liquidity provider (LP) and earn a portion of the trading fees, which again is another way of earning passive income with stablecoins.
4. Day to day payments
Stablecoins are gaining popularity in everyday commerce. For example, in international transactions, especially when transacting with a country that has capital controls or a weak local fiat currency. For instance, immigrants working in Europe are using stablecoins to send money back to their home countries. Many Chinese entrepreneurs are using stablecoins for foreign transactions, etc. Any kind of transacting online can and will be done with stablecoins in the future.
5. Wealth preservation
In addition to preserving wealth against inflationary fiat system by holding bitcoin, ethereum or other volatile crypto assets you are still exposed to the volatility of these crypto-assets short-term. USD denominated stablecoins provide you protection from inflation of troubled national fiat currencies like Argentinian Peso, Venezuelan Bolivar, and Nigerian Naira. All of which have seen more than 20%+ yearly inflation. It is already common practice for the local population to transact in the dollar, use local fiat currency black market rate, and bitcoin or USD stablecoins.
Next, let’s take a look at the types of stablecoins available in the market.
Overview And Types Of Stablecoins
Fiat-backed (real-world assets backed)
The most widely used stablecoins are fiat-backed stablecoins. Fiat-backed means that each coin is backed by a specific unit of fiat currency, most commonly, USD. For example, the most popular stablecoin USDT should be collateralized 1:1 with the US Dollar. Emphasis on the word “should”. More of that a bit later.
Fiat-backed stablecoins have the simplest structure, and because of their simplicity, are easy to understand and have the biggest adoption. If the user wants to exchange stablecoins to cash, then the company managing the stablecoin has to take the proportional amount of fiat from the reserve. The stablecoins that are redeemed for cash will be burned, i.e. taken out of circulation.
A fiat-backed stablecoin depends on the underlying fiat currency. If the inflation is high as we’ve lately seen with the US dollar, the stablecoin loses its purchasing power similar to the underlying dollar. And while fiat-backed stablecoin issuers usually state that the coin is backed 1:1 by the underlying fiat currency, it’s rarely true. The issuer may hold a variety of assets like bonds, secured loans, and other types of investments in addition to cash.
For example, Tether (USDT) had to pay a $41m fine in October 2021, after the Commodity Futures Trading Commission (CFTC) found that Tether had made false claims about having an equal amount of USD to the issued USDT.
Popular fiat-backed stablecoins:
Tether (USDT) — pegged to the value of the US dollar. Created in 2014 and was originally issued on top of Bitcoin blockchain. The company claims that each USDT is fully backed by reserves — cash, cash equivalents, and other assets like secured loans. USDT is still the most widely used stablecoin, but has lost some of the market dominance (after numerous scandals) to other stablecoins.
USD Coin (USDC) — pegged to the value of the US dollar. Created by Centre consortium, which has two founding members — Coinbase and Circle, and both are industry giants. Centre is licensed as a money transmitter in the US and an e-money institution in European Union. USDC started to gain a lot of popularity from 2020 as this is the most used stablecoin in DeFi and in general, is considered to be more trustworthy than Tether. USDC is likely to overtake USDT in terms of adoption rather sooner than later.
Binance USD (BUSD) — BUSD is a stablecoin issued by the largest crypto exchange in the world, Binance (in partnership with Paxos). It’s pegged to the value of the US dollar and approved by the New York Department of Financial Services. Using BUSD to trade on Binance gives trading discounts, which has been one of the primary drivers of usage of BUSD.
Website: Binance USD
Crypto-backed stablecoins are backed by other cryptocurrencies. The idea behind having crypto-backed stablecoins is decentralization. We believe that crypto-backed stablecoins will gain a lot of popularity after lawmakers enforce regulations according to the FATF guidelines (and issue CBDCs — Central Bank Digital Currencies).
Crypto-backed stablecoins are usually over-collateralized to reduce the price volatility risks (i.e. if the price of the collateral asset drops, then the collateral won’t be worth less than the issued stablecoin).
Let’s assume you want to take out a loan in stablecoin called MIM. In order to get $1000 worth of MIM, you deposit $2000 worth of xSUSHI. If the value of xSUSHI drops 40%, your collateral is still worth $1200, or $200 more than what you borrowed. In order to not get liquidated and the stablecoin to hold its value, over-collateralization is needed.
The most popular crypto-backed stablecoin is Dai, which is created by MakerDAO. Dai’s value is pegged to the US dollar but is backed by a variety of crypto assets, including other stablecoins like USDC.
Popular crypto-backed stablecoins:
DAI — DAI is a decentralized stablecoin created by MakerDAO. Users can deposit collateral to mint DAI (and later redeem assets against DAI). DAI operates on Ethereum blockchain, and DAI holders can earn Dai Savings Rate. Because of the popularity of MakerDAO, DAI is also fairly popular decentralized stablecoin.
Algorithmic / Non-Collateralized Stablecoins
The idea of non-collateralized stablecoins sounds a bit weird and risky, but let’s not forget that the US dollar or EURO aren’t backed by anything either (US dollar used to be backed by gold).
With stablecoins, algorithms control the stablecoin supply. When the demand goes up, new coins are created, and when demand decreases, the circulating supply is reduced by buy-backs. I.e. the price is kept stable by supply and demand.
Because algorithmic stablecoins aren’t pegged to any other currency or asset, it’s the most decentralized type of stablecoin. A good example is Ampleforth (the supply is adjusted on a daily basis to reflect the demand).
Another increasingly popular stablecoin structure is using a native token and an algorithm to peg the stablecoin to USD. The most widely used stablecoin with this structure is TerraUSD (UST).
UST uses LUNA, the native cryptocurrency of Terra blockchain, as the reserve asset. And to mint 100 UST (equal to the value of $100), $100 worth of Luna is burned (taken out of circulation). I.e., the cost of minting is equal to the face value of the minted stablecoins.
Popular algorithmic stablecoins:
TerraUSD (UST) — UST is a decentralized algorithmic stablecoin on Terra blockchain. Everytime 1 UST is minted, 1 USD worth of LUNA (Terra reserve asset and native token) is burned (taken out of circulation). Together with the rise of Terra blockchain, UST gained popularity in 2021. The adoption of UST is also driven by Anchor Protocol, which offers stable yield to depositors.
Frax (FRAX) — FRAX is a fractional algorithmic stablecoin. It’s partially collateralized and partially algorithmically stabilized. The collateralization ratio depends on the price of the FRAX stablecoin. If the price of FRAX falls under $1, then the protocol increases the collateralization ratio, and if the price of FRAX is above $1, then the collateralization is decreased. Frax protocol also has a governance token called Frax Share (FXS). FXS is burned when FRAX is minted and minted when FRAX is redeemed. FXS holders can vote on adjusting collateral pools, minting fees, etc.
Fei Protocol (FEI) — FEI is an ETH-backed stablecoin. FEI uses a Uniswap liquidity pool for market pricing and stability mechanism Protocol Controlled Value (PCV) to keep the value of FEI as close to the US dollar as possible. PCV will withdraw liquidity from the liquidity pool to buy FEI when the price falls under $1 (excess FEI is burned), and mints more FEI when the price is above $1. Fei protocol also has a governance token called Tribe, and holders of Tribe can stake to earn yield and vote on governance proposals.
Central Bank Digital Currencies (CBDC)
CBDCs have been widely discussed by lawmakers around the globe, and some countries like Nigeria have already launched their own digital currencies (eNaira in Nigeria). The idea of eNaira is that it’s a bank agnostic digital currency where people can have eNaira wallet directly with CBN (Central Bank of Nigeria) without a need to open a bank account with a commercial bank. CBDC is simply a digital record of the official currency of the country.
As a result, lawmakers have been highly critical of stablecoins and calling for strict regulation. They would prefer if CBDCs are used, as this would enable them to track and control usage of the stablecoins, i.e. have power over the financial lives of their citizens (as they do now through banks).
That being said, we at Clip expect decentralized stablecoin solutions to prevail, as we believe in individual freedom and sovereignty over state control.
Stablecoins are here to stay and will continue to play a bigger and bigger role in our daily lives. Most importantly, stablecoins provide a unique opportunity to earn passive income that far exceeds anything that’s possible in traditional finance. We truly believe that we can bring these opportunities to a bigger audience with Clip Finance, as the simplicity we’ve designed into the product is truly one of a kind.