With rising inflation and worsening investor sentiment shaking the global economy, the market has fled from traditional stocks and cryptocurrencies to safer havens in traditional assets such as treasury bonds and gold. The result is that the crypto market has lost millions of dollars in value over the past week.
According to the market tracker Coingecko, Bitcoin, the world’s most prominent cryptocurrency, has seen its value fall more 16% in the last seven days to just $31,364 at the time of writing. Others have seen similar losses, with Ethereum down almost 14.8%, BNB down 16.4%, XRP down 14.2% and Solana down by 21.2%.
While the cryptocurrency market crashes and burns, some investors may be wondering why a number of prominent tokens, including Tether and USD Coin, have held steady, their value barely moving despite all the turmoil. The reason is that they’re designed to do so. These assets are so-called “stablecoins” whose value is tied to those of real world assets such as the U.S. dollar. Stablecoins were created as a tonic to the incredible price volatility of the cryptocurrencies.
Since Tether first emerged in 2014, stablecoins have emerged as a key component of the cryptocurrency ecosystem, especially in the area of decentralized finance, where investors can trade crypto without the aid of a middleman. Indeed, stablecoins have become so important that Tether has emerged as the third-biggest cryptocurrency in terms of its market capitalization, while USD Coin is now the fifth-biggest.
Stablecoins are useful because they provide traders and investors with an easy way to cash out of their position in more volatile crypto assets without needing to exchange their holdings into fiat money. That’s important because it can be expensive to cash out of crypto into traditional fiat. It also takes a lot of time, with processing delays of several days being quite commonplace. For investors in a world that moves as rapidly as crypto, long delays could be fatal. On the other hand, cashing out of Bitcoin into a stablecoin like USD Coin is almost instant.
There are other uses of stablecoins besides just cashing out. They also provide an entry point to DeFi exchanges that do not accept fiat currency. Further, they enable investors to engage in activities such as lending and yield farming, which present an opportunity to earn far greater interest than is possible with most banks and traditional fiat.
How do stablecoins stay “stable”?
These days the crypto market has become saturated with dozens of different stablecoins, all backed by different assets. While the most popular stablecoins are pegged to the U.S. dollar or other major currencies such as the Euro, U.K. pound or Japanese yen, others are backed by the price of precious metals, and others still rely on algorithmic functions to peg themselves to crypto assets such as Bitcoin.
Fiat-backed stablecoins are the most common. Both Tether and USD Coin are backed by the U.S. dollar holdings of their issuers and work as a kind of IOU, allowing holders to redeem them for an equivalent amount of fiat currency. The centralized issuers of such coins generally use a combination of cash reserves, government and corporate bonds, commercial paper, fiduciary deposits and secured loans to back their assets.
Tether is by far the most well known of the stablecoins but it’s also one of the most controversial. As the institutional exchange AAX explained in a recent blog post, Tether claims that every USDT coin minted is backed 1:1 by an equivalent amount of USD in its reserves to maintain its price. However, Tether’s owner Bitfinix has been fined multiple times in the past by regulators due to a lack of complete transparency over its holdings.
“It has always been a great question whether USDT is backed by real USD reserves,” AAX noted.
Following pressure from U.S. authorities, Bitfinix ultimately revealed that its assets are made up of commercial paper (49.59%), fiduciary deposits (18.35%), secured loans (12.55%) and corporate bonds (9.96%), meaning its actual cash holdings make up less than 3% of the assets backing USDT.
“However, despite these controversies around Tether’s reserves… USDT’s price remains very stable,” AAX stated. “At the same time, while it has lost some of its market share to competitors over the years, it is still the leading stablecoin within the crypto industry.”
Tether is losing market share because some of its competitors are far more transparent. Take USD Coin, for instance, which is issued by a consortium that includes the blockchain payments firm Circle and the cryptocurrency exchange Coinbase. A third-party audit in 2021 confirmed that USDC is 100% backed by cash and equivalents, meaning that each USDC token is indeed backed by $1 and therefore, perhaps more closely pegged to the U.S. dollar than any other stablecoin.
“Unlike Tether, its issuer Circle operates as a regulated payments company in the US and is a recognized electronic money institution in the UK and the EEA,” AAX explained. “Furthermore, while the stablecoin now features a 1:1 peg with the USD with real-world asset backing, the company’s reserves are regularly audited by third-party firms.”
Crypto-backed stablecoins provide a decentralized alternative to the likes of Tether and USD Coin. As AAX explained, they rely on a reserve of digital assets rather than cash to ensure price stability.
“Instead of physical deposits, coins like DAI are minted using a wide variety of supported cryptocurrencies as collateral held transparently in smart contracts,” AAX stated.
In general, crypto-backed stablecoins over-collateralize to guard against the excessive volatility of the crypto assets that back them. However, they’re known to be less stable than fiat-backed stablecoins.
As for precious metal-backed stablecoins, these rely on holdings of assets such as gold or silver to maintain their value. Like fiat-backed coins, they are also centralized. While some crypto diehards may see this as a downside, it does offer these coins greater stability. One of the biggest such coins is Digix, which is backed by gold, enabling crypto investors to buy and sell gold without the need to physically transport and store it.
Finally, there is a new breed of algorithmic stablecoins that aren’t backed by any asset. Instead, they rely on computer algorithms to keep their value stable. So if an algorithmic stablecoin is pegged to the USD and its value starts to rise higher, the algorithm will mint new tokens to increase its supply and bring the value back down. Should the value fall below $1, then it will reduce the supply of coins to bring the price back up. In that case, everyone who holds the tokens will see a slight reduction in their holdings, though the value will theoretically remain the same.
The best-known algorithmic coin is TerraUSD, and though the concept is still somewhat experimental it has held up well since its launch in September 2020. Since launching, UST has maintained its 1:1 peg with the USD almost constantly, with the exception of one incident in December 2020 when its price fell to around $0.85 for around 24 hours.
AAX explained that UST relies on a “dual-token model” wherein the project’s native token LUNA is burned in order to mint new UST and other stable assets. The algorithm works to incentivize users to either buy or sell LUNA by offering higher rates than the market price.
“For example, when UST goes above $1, the protocol issues more UST to increase the supply and drive its price down to $1,” AAX said. “To achieve this, the algorithm has to burn more LUNA, which it can acquire from holders by incentivizing them to sell $1 worth of LUNA for over $1 of UST, providing arbitrageurs an excellent opportunity to make a profit on the difference.”
The protocol works in the opposite scenario too, so when UST’s price falls below $1 it buys $1 worth of LUNA for less than the value of 1 UST. The UST acquired by the algorithm is then burned, and new LUNA is created to reduce the supply of UST and push its price back up.
“So far, Terra’s price stability mechanism has efficiently kept UST very near the $1 mark. At the same time, this process, along with the project’s business model for maintaining the peg with the USD, has also been found sustainable in the long run,” AAX stated.