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What is a stablecoin? The Beginner’s Guide

Stablecoin is a cryptocurrency that has its value pegged to the U.S. dollar or other fiat currency. It is designed to be a substitute for fiat money in the world of cryptocurrencies. This article is a beginner’s guide to stablecoins. We’ll cover different stablecoins and ways to achieve price stability.

Why do stablecoins exist?

Stablecoins enable easy currency transfers between crypto exchanges and wallets. We are now talking about moving fiat currencies, or more precisely, their crypto substitutes.

There are many cryptocurrency services, which don’t support fiat currencies at all. The DeFi market is a good example. It runs completely on cryptocurrencies. Hence, an alternative solution is needed. There are also security concerns in the crypto world.

Concentrating your wealth in one bank is quite common in traditional finance. Banks are highly regulated and deposits are secured by governments. In the crypto world, the situation is different. There is little regulation and no protection against potential losses in case of bankruptcy, an exit scam, or a hack.

Big investors distribute their assets to various crypto exchanges. Once the trades of the day are completed, assets are transferred back to fiat currency and to a cold wallet. This is where stablecoins come in.

binance front

Binance is the most popular crypto exchange.

Stablecoins allow you to transfer fiat substitutes from one account to another in a matter of seconds. Continuous withdrawing to a bank account is slow and expensive. In addition, some banks might not like such high volume traffic and could close your account.

The stablecoin market exploded in 2020. The growth went hand in hand with the DeFi market. Liquidity protocols like Aave were in particular behind this growth. They offer an annual return of up to 10-15 % for stablecoins and the possibility to take a loan against your assets.

Think of a situation where your Bitcoin portfolio has doubled in value and you want to cash out some of your winnings. Why would you sell bitcoins to fiat and move your funds to a bank account to earn zero yield? Instead, you can sell your bitcoins to stablecoins (e.g. USDT or USDC), move them to a lending platform, and collect an APY of 10-15 %.

The growth of the stablecoin market

At the time of writing the article (7/2021), the entire stablecoin market is worth about $114 billion. The largest stablecoin, Tether (USDT), was only worth about $4 billion in January 2020. In January 2021, it was already worth $20 billion. In July 2021, Tether’s market cap is a staggering 62 billion dollars!

The growth has been remarkable.

Tether was dominating the market completely until 2018. USD Coin, True USD, and Paxos entered the market in late 2018. DAI and Binance USD gradually joined in during the year 2019.

Below is the total stablecoin supply (market cap) in July 2021. You’ll find more such graphs from The Block’s stablecoin statistics.

stablecoin supply 2021

At the beginning of 2020, Tether’s (USDT) market share was more than 80 percent of the entire stablecoin market. As recently as January 2021, Tether dominated the market by more than 75%. The biggest competitors (USDC, BUSD) have started to gain proper market share in 2021.

It is important to understand that stablecoins are issued on different blockchains. This applies not only to Tether but to other stablecoins as well.

Tether was issued on the Omni network in its early years. In 2019, a lot of USDT was moved to the Ethereum network due to the growth of the DeFi market. Currently, about half of the USDT coins are on the Tron network.

USDC coins are issued almost entirely on the Ethereum network. A small number is also circulating on the Solana and Algorand platforms. In addition to Ethereum, Binance USD is mostly issued on the Binance Smart Chain.

Next, let’s go through different types of stablecoins. Traditionally, price stability has been achieved with fiat-collateralization, but nowadays there are also algorithm-based stablecoins.

Fiat-collateralized stablecoins

Let’s start with traditional stablecoins first. They are called fiat-collateralized stablecoins, i.e. the price is pegged on a fiat currency.

It’s quite simple. A stablecoin is run by a company, which is responsible for issuing digital coins. This company has $1 (or equivalent reserves) in the bank account for every digital coin. Consequently, the value remains stable and tied to one dollar.

If stablecoin owners want to convert their stablecoins for fiat money, they can make the swap on any exchange that supports fiat currencies, e.g. euros or dollars.

The largest fiat-collateralized stablecoins are USDT (Tether) and USDC (USD Coin). BUSD (Binance USD), PAX (Paxos Standard), and GUSD (Gemini dollar) are also well known.

Tether (USDT)

Tether (USDT) is the oldest, largest, and best-known stablecoin in the market. Its market cap is about half of the total stable currency market. Tether was founded already in 2014. It has dominated the stablecoin market for many years.

Tether is backed by iFinex Inc., a company that runs also the well-known Bitfinex exchange. Over the years, a wide range of conspiracy theories has been developed about the Tether/Bitfinex connection.

If you want to learn more about this stablecoin, see the interview below. Paolo Ardoino and Stuart Hoegner give a face to Tether.

Tether has been in the middle of a lot of fuss for years. There has been an ongoing debate on whether each USDT coin is fully backed by dollars.

The company has not released any audits which would have silenced the biggest critics. However, in the spring of 2021, detailed information on collaterals was released.

tether reserves

As you can see from the picture, only 2.94 percent (0.7585*3.87) of USDT coins are backed by actual dollars. Most of the collaterals are in commercial paper. Tether hasn’t given more details of these assets.

At the end of the day, it is all about trust. So far, there has been enough of it. Tether’s market cap has doubled in 2021 alone, and the price of one USDT has remained firmly at one dollar.

USD Coin (USDC)

USD Coin has taken a significant share of the stablecoin market in 2021. Its market cap broke the $1 billion mark in the summer of 2020 driven by the DeFi boom. In January 2021, USD Coin was already worth $4 billion. At the time of writing the article (7/2021), the market cap of USDC is a staggering 26 billion dollars!

usdc supply

The supply of USDC. Source: The Block

This stablecoin entered the market in September 2018. USD Coin is managed by a consortium called Centre. The founding members are the American payment service Circle and the cryptocurrency exchange Coinbase.

USD Coin has been marketed as a regulated alternative to Tether. One of its founders, Circle, is a U.S.-based company that received the first cryptocurrency license (BitLicense) in the country’s history in 2015. Circle also has a similar achievement in the UK.

Centre has published reports of USD Coin’s collaterals since the beginning. The term attestation is used for these reports. They are publicly available at download centre.io/USDC-transparency.

Despite all this, there is also controversy surrounding the USD Coin. The attestation reports are not the same as audits. Also, in the spring of 2021, perhaps the most relevant line was removed from the report: the number of dollars as collateral.

An overview of fiat-collateralized stablecoins

Tether and USD Coin are strongly dominating the fiat-collateralized stablecoin market. At the time of writing this article, USDT and USDC account for about 77% of the market cap of all stablecoins (including non-fiat-based ones).

In 2021, Binance USD has also gained a significant market cap: over $10 billion. The rise of BUSD has been accelerated by Binance’s own blockchain, Binance Smart Chain, and the DeFi ecosystem built there.

BUSD is run by Paxos, which is a licensed operator in the United States. Paxos is also publishing monthly attestations, just like Centre. It strives to be more transparent than Tether, but no stablecoin has yet offered a full audit.

Fiat-collateralized stablecoins work as long as there is trust in the market to the collateral and the company behind the currency.

MakerDAO and DAI

Cryptocurrencies are essentially accompanied by the word decentralization, i.e. decentralized protocols. In this respect, stablecoins are a nasty reminder of the ‘old world’. Users of USDT and USDC must trust traditional financial institutions to have the collateral in place.

Couldn’t stablecoins be created with cryptocurrencies, making it easy to audit them from the blockchain? Yes, it can be done. The solution is called DAI. It also involves the Maker protocol.

See the video below for more information about DAI & Maker.

Maker is also called MakerDAO. It is a decentralized autonomous organization where the governing body is the MKR token holders. These people vote on how the protocol (and the DAI stablecoin) moves forward. For example, which cryptocurrencies can be used as collaterals.

DAI is not a fiat-collateralized stablecoin. It is collateralized by cryptocurrencies. At first, only Ether was used, but nowadays other ERC-20 tokens are accepted also as collateral.

Since the price of cryptocurrencies can move considerably in just one day, an over-collateralization is required. For example, if you deposit $2,000 worth of Ether, you can create only $1,000 worth of DAI stablecoin against it.

The value of one DAI remains at one dollar through game theory and market mechanics. This is explained in more detail in the video above. In practice, the price swings a couple of cents above or below the dollar, just like USDT and USDC.

When there is a stablecoin based entirely on cryptocurrencies, there are no problems with collaterals. DAI reserves can be verified at any time from the Ethereum blockchain. However, this solution is not perfect either.

Many experts have criticized the fact that fiat-collateralized stablecoins can now also be used as DAI collateral. This brings the risks of fiat-collateralized stablecoins to DAI.

In addition to DAI, Synthetix USD can also be mentioned here. Though, its market cap is still very low (about $290 million).

Algorithmic stablecoins

We have so far introduced two types of stablecoin: fiat-collateralized stablecoins and crypto-based stablecoins.

There is also a third option called algorithmic stablecoins. This group includes several cryptocurrencies that work in slightly different ways. The best-known is Ampleforth, which reached popularity during the DeFi boom of 2020.

See the video below for more information.

Ampleforth works almost like fiat currencies. A central bank, such as the Fed, can create more currency, i.e. increase the number of dollars in circulation. This weakens the value of the currency (inflation). It can also destroy dollars, causing the value of the currency to rise (deflation).

For AMPL tokens, this happens in a way that might seem surprising at first.

If the demand for AMPL tokens increases and the price rises from the target of $1 to, for example, $2, the algorithm increases the wallet balances of all AMPL holders. If you used to own 10 AMPL tokens, you now have 20 AMPL tokens. In addition, the value of each coin is twice as high as before!

If the price of the AMPL token falls by, for example, $1 to $0.50, the balance of all holders will be halved. These balance adjustments work the same way in both directions.

In theory, this should lead to the following actions: if the price of AMPL tokens goes up (with wallet balances), investors rush to sell their tokens for profit. This will drive the price down according to the laws of supply and demand. When the price of the AMPL goes down, the opposite happens.

ampl price

The price of AMPL token. It’s been more volatile than popular stablecoins but reached more stability.

Ampleforth has also its own governance token (FORTH). It has a similar role as previously mentioned MKR token has.

Check out this video from the Boxmining channel, which goes through other algorithm-based stablecoins. This category also includes Empty Set Dollar, Base Protocol, and Basis. So far, only Ampleforth has gained significant popularity.

The summary of the stablecoin market

The Stablecoin market has grown exponentially since 2020. At the time of writing the article (7/2021), we have a situation where the top 10 ranking list includes three stablecoins (USDT, USDC, BUSD)!

As previously mentioned, the rise of the DeFi market is linked to the popularity of stablecoins.  Centralized lending services such as Celsius and BlockFi have also contributed to this. In a zero-interest-rate world, investors are happy to loan their stablecoins for a yield of 10% to 15%.

Although fiat-collateralized stablecoins have critics, their popularity continues to grow. Investors don’t seem to be concerned about the possible lack of collateral. Alternative solutions, such as DAI or AMPL, are still fairly small players in the market.

However, this might change in the future. The current Fed chairman, Jerome Powell, has called several times for regulation of the stablecoin market. This is what Powell had to say in July 2021.

We have a tradition in this country where the public’s money is held in what is supposed to be a very safe asset.  We have a pretty strong regulatory framework for bank deposits for example or money market funds. That doesn’t exist for stablecoins, and if they’re going to be a significant part of the payments universe… then we need an appropriate framework, which frankly we don’t have.

In January 2021, Tether was fined by the New York District Attorney’s Office and banned from operating in that state. This was due to ambiguities and false claims regarding USDT collaterals. Tether still has the market’s full trust, though.

The EU might also start to regulate stablecoins. Especially fiat-based solutions, since it is easy for the regulators to hit the currency issuers. The situation is completely different for DAI and Ampleforth, though. Fresh regulation concerns might increase the popularity of alternative stablecoins.

Which stablecoin is the safest and most reliable? There is no unambiguous answer to this. The market cap is the best indicator of the popularity and trust of the market. Consider diversifying your investments into a variety of stablecoins.

Image credit: iStockPhoto/Bodnarchuk

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