Everything You Need to Know About Stablecoins

If you go through the list of the largest cryptocurrencies you will notice that two in the top 5 don't move around that much. In other words, their prices are relatively stable. This is because they are stablecoins. You may remember that Facebook tried to launch its own stablecoin in 2019 (Libra) but was unable to do so on account of its monopolistic position in social media.

A stablecoin is a cryptocurrency whose value is pegged to the price of another asset. For example, USD Coin is pegged to the dollar and is backed by cash and treasury bills. These stablecoins were borne out of the need to address one of the key "weaknesses" of Bitcoin and Ethereum and that is their volatility. Both Bitcoin and Ethereum have failed as currencies because currencies do two things - firstly their value is relatively predictable and secondly, they can easily be used to buy goods and services. Most cryptos are highly volatile and it is complicated to transact with them.

Stablecoins help to address the first issue. But before we jump into the world of stablecoins, you need to realise that not all stablecoins are created equal. In May of 2022, we saw the meltdown of TerraUSD. What happened was there was a run on the bank, or more accurately a run on the digital currency. It is worthwhile thinking of Terra as a bank. When a bank holds your money, it only keeps a small percentage of those funds in reserves and uses most of it to finance loans and other transactions. In the normal course of business, that usually is not a problem as money is coming in and going out in manageable proportions with a solid base maintained for clients to withdraw cash at their leisure. But if everyone wants their money at the same time because they fear the bank is not in good shape, the institution may not have enough reserves to meet these demands.

In the case of Terra, some massive withdrawals lead people to believe there may be a run on the coin. There was speculation that an anonymous trader prompted the run in an attack on the stablecoin. TerraUSD at the time was the third largest stablecoin with a market cap of around $18 billion and sent panic through the market.

So let's get back to stablecoins in general. They are collateralized. They maintain a pool of collateral to support the coin's value. Whenever the holder of a stablecoin wishes to cash out their tokens, an equal amount of the collateralizing assets is taken from the reserves.

Tether is currently the world's largest stablecoin with a market cap of $66 billion at the time of writing this blog. It is the world's third-largest cryptocurrency. In October 2021 it was fined by the Commodity Futures Trading Commission for making untrue and misleading statements saying it misrepresented to customers and the market that Tether maintained sufficient US dollar reserves to back every token in circulation with the equivalent amount of fiat currency. Tether still maintains it has sufficient reserves to back the $66.9 billion of Tether tokens in circulation.

How are stablecoins used?

Stablecoins are used to bridge the gap between traditional cryptocurrencies and fiat currency by addressing the issue of volatility. Stablecoins also allow people from high-inflation economies like Zimbabwe and Venezuela to peg the value of their savings to something unrelated to their devaluing currencies. So these coins offer the benefit of crypto, namely instant transfers and low fees, without the drawbacks of volatility. This means that investors can hold them without being concerned about wild price swings.

International transfers are a perfect example of one use case. Normally, one would need to execute a wire transfer using the SWIFT protocol which is expensive, slow (2 to 3 days), and can be unreliable when transferring between two different countries that speak two very different languages. The stablecoin transfer is instant with low or zero fees and 100% efficacy.

So how do the issuers of stablecoins make money? They charge issue and redemption fees. They also make money through investing the reserves in assets that incur a yield - such as commercial paper or Treasury bills, while their liabilities incur zero interest. The more risk taken in the investment of the reserves, the more risk to the token holders. After the incident with Terra, you can be pretty sure that stablecoin issuers are taking less risk on the reserves. Having said this, you as the token holder must do your homework to understand how those reserves are managed. As with all financial assets, you need to educate yourself.