Stablecoins 101: Types, Benefits, and Risks
Stablecoins 101: Types, Benefits, and Risks
Everything you need to know about this "risk-off" crypto asset-class
Hi everyone,
If you don't know what are stablecoins, you need to read this.
For the uninitiated, crypto land is a place full of dangerous -50%-in-a-day cliffs at every corner. Little do they know that islands of safety exist, providing their island-dwellers with shelter from price risk while providing possible yields (upwards of ~8% at the time of writing) that crush anything that exists in the traditional finance world.
These islands are called stablecoins.
What are stablecoins?
Stablecoins are crypto tokens that have their value pegged to an asset like fiat currency (e.g. USD) or gold. This results in the tokens maintaining a stable price, hence the name “stable” coin.
Note that "stable" is a relative measure since even the price of fiat fluctuates daily.
Why are stablecoins important?
The bottom line: Stablecoins allows users to ride on the benefits of using blockchain technology without taking on price risk.
Benefits of stablecoins
Before we get to the details about the types of stablecoins and how they work, you should know how you can make use of them.
Stablecoin lending absolutely destroys any high yield savings accounts 🤑
Lending platforms like Blockfi and Celcius allow you to lend out your crypto in return for a juicy yield. For investors that do not want to take on the price risk of Bitcoin (BTC), Ether (ETH) and other cryptos, you can lend out stablecoins for a whopping 8.88% Annual Percentage Yield (APY) at the time of writing.
In context, letting your money sit in a bank in Singapore gives you 0.05% APY interest, and investing in the S&P 500 gives you an average of 8% APY (risk-on). I'll be covering crypto lending and its risks in-depth, in a future post.
Low-cost payments 💸
Anyone who has ever tried sending money across borders will know that it's incredibly painful (for your wallet). On average, the charge for sending $200―the benchmark used by authorities to evaluate cost―is $14, that’s an insane 7% fee just to send money somewhere else. This rate varies from country to country.
While there's no fathomable reason why the simple act of transferring money should cost so much. The costs arise from the intermediaries who process the payment and bearing the brunt of bid-ask forex spreads.
Crypto allows peer-to-peer money transfer globally eliminating the need for middlemen. If you use an asset like bitcoin to send money, you have to worry about large price movements while holding it as an intermediate asset. Stablecoins eliminate this issue.
Moreover, even payment giants are taking advantage of the faster and cheaper transaction settlement on the blockchain. In 2020, Visa announced a partnership with Circle to facilitate payments to 60 million merchants worldwide using USD Coin (USDC).
Participating in Defi protocols 💰
If single-digit interest rates are not enough for you, you can use stablecoins to participate in decentralized finance (defi) protocols. This is for those chasing double-digit (and beyond) yields.
Full disclosure: I am not a defi expert (yet). So here's a link to Bankless' article on the best yields for stablecoins on defi.
Types of stablecoins
Now that you know the power of stablecoins, it's time to understand what kinds there are and the risks associated with them.
Centralized stablecoins
Centralized stablecoins are currently the most popular type of stablecoin on the market. They take up 3 of the top 10 spots with tens of billions in market capitalization. Tether (USDT) has the highest trading volume out of all the coins.
Issuers need to hold reserves of the pegged asset that at least match the total value of stablecoins minted in a 1:1 ratio. For example, Circle and Coinbase have issued ~26 billion USDC, so they need to have $26 billion USD in their reserves.
Aside from fiat-pegged stablecoins, stablecoins can also be pegged to the value of other assets like gold i.e. Paxos’ Pax Gold (PAXG).
What's in it for them?
Why would a centralized entity spend so much of its resources to take on the duty of being a stablecoin mint?
Entities minting stablecoins usually provide some other service that benefits from their customers having access to a trusted stablecoin. For example, Paxos specializes in using blockchain technology to tokenize, custody, trade, and settle assets for fintech and financial institutions. They offer stablecoin as a service to enable crypto capabilities for their clients.
Tether meanwhile, employs the simpler business model chargeing fees for minting and withdrawal of stablecoins.
⚠️ Centralized risks
The largest risk of centralized stablecoins is counterparty risk. Centralized stablecoins function on trust that the stablecoins can be exchanged for the underlying asset.
Under normal circumstances, even if USDT price fell below $1 for a prolonged period, arbitrageurs should eventually buy the discounted USDT and restore the peg. Crucially, this requires trust in Tether: The arbitrageur must have confidence that the USDT can eventually be redeemed at par, or at least above the purchase price. — Bernhard Mueller on Is Tether a Black Swan?
Stablecoins retain their peg by providing opportunities for arbitrage which is only valid when trust in the value of the stablecoin remains intact. Read Bernhard Mueller's post for a deeper dive into the risks and controversy around Tether.
Decentralized stablecoins
Stablecoins have become an essential piece of crypto land and relying on central entities contradicts the crypto-ethos of being trustless and decentralized. Thus, decentralized stablecoins are attempts to solve the problem:
How do we create stablecoins that don't rely on trust?
Crypto-collateralized
The first kind of solution is to employ a similar collateral-backed model to maintain a stable value. However, instead of having a central entity managing the collateral, decentralized stablecoin minting protocols like Maker are governed by smart contracts and its own Decentralised Autonomous Organisation (DAO) called MakerDAO.
A smart contract is a self-executing contract with the terms of the agreement between buyer and seller being directly written into lines of code. The code and the agreements contained therein exist across a distributed, decentralized blockchain network. The code controls the execution, and transactions are trackable and irreversible. — Definition by Investopedia
Since the value of the crypto collaterals is volatile, the protocols call for overcollateralisation of the value of the stablecoins they want to mint.
This is overcollateralisation in a nutshell:
If I want to mint 10 DAI (the equivalent of 10 USD) using Ether (ETH) as collateral, I would have to put up say $15 worth of ETH. This helps to maintain the value of DAI even in the event of a 50% drop in base collateral ETH.
It's important to note that the mechanisms of such protocols are always changing and updating to find the best way to operate in a trustless manner.
Algorithmic stablecoins
Instead of putting up collateral for minting stablecoins, algorithmic stablecoins take a different angle to solve the problem.
Such stablecoins employ an algorithm that issues more coins when the price increases, and buys them off the market when the price falls to maintain the value of stablecoins.
Haseeb Qureshi likens this operation to how central banks manage the demand and supply of the currency that they govern. For a comprehensive explanation of algorithmic stablecoins, read his post A Visual Explanation of Algorithmic Stablecoins (highly recommended).
⚠️ Decentralized risks
When using decentralized stablecoins, you are essentially taking on smart contract risk. You trust that the smart contract has been laid out in a way that is fundamentally sound. These protocols come under the largest stress when crypto markets take a big hit resulting in a deviation from their intended value.
However, these stressors serve as battlegrounds for testing the robustness of the protocols. Ultimately, they contribute to building better and more stable solutions for a decentralized financial future.
But one thing is for sure: you shouldn’t assume a decentralized stablecoin will be robust simply because a white paper insists it is. Think for yourself what it takes for that stablecoin to be stable. — Haseeb Qureshi
PSA: Depositing Terra’s algorithmic stablecoin UST on anchor protocol currently gives you ~20% yield. Make sure that you understand the risks of holding UST before going all-in.
Final Thoughts
For the average reader, I hope this clears up the misconception that crypto equals extreme volatility and it helps to open up a new world of opportunity.
The utility of stablecoins is undeniable. It's a much-needed piece to help move innovation along in the crypto space by providing stable safe havens to ride on the utility of blockchain technology and reap the benefits of cutting out the middlemen in defi.
Keep in mind that stablecoins are experimental in nature and are continually being battle-tested and revised. Knowing the risks associated with each stablecoin and doing your due diligence will help you to navigate safely through your adventures in crypto land.