A deeper dive into DeFi, Part III: Stablecoins

What are stablecoins?

A stablecoin is a cryptocurrency whose price is pegged to an asset with a stable price, usually the US dollar (e.g., 1 stablecoin ≈ 1 USD). As such, stablecoins help hedge against the volatility of cryptocurrencies when investing and trading.

How do stablecoins remain stable?

There are three types of stablecoins: fiat-backed, crypto-backed and algorithmic. First, let's look at the fiat-backed stablecoins, such as USDT (Tether) and USDC (USD Coin).

Initially, it was purported that each was backed by the US dollar in a 1-to-1 ratio (meaning there was a dollar in a bank account for each existing token). In both cases, it turned out to be untrue. At the moment of writing, USDT's collateral reserves are stated to be 83.74% cash, cash equivalents, short-term deposits and commercial paper; 4.61% corporate bonds, funds and precious metals; 5.27% secured loans; and 6.38% other investments, which include digital tokens.

It has to be said that despite the curious metamorphosis of the collateral reserves, the public didn't mind that much. If we consider historical data, ≈ 1 USD has been the status quo for both coins most of the time, so they do have the support of users.

As the name suggests, crypto-backed stablecoins are collateralised by crypto assets. And since cryptocurrencies are highly-volatile, such stablecoins are over-collateralised, i.e., the collateral value exceeds the value of issued stablecoins.

Take, for example, DAI. Pegged to the US dollar, it is backed by ETH. To obtain DAI, you can either buy it or mint it yourself by providing collateral. We've already covered DeFi loans above, and this is precisely what happens with the issuance of DAI. Borrowers lock collateral to obtain an over-collateralised loan in DAI tokens. If they wish to recover the locked assets, they need to return the loan amount + interest. Thus, they get to leverage DAI without having to sell their ETH (or another asset).

Finally, we have algorithmic stablecoins. Similarly to crypto-backed stablecoins, algorithmic stablecoins are backed by another cryptocurrency, but the relationship between the two is regulated by an algorithm (a smart contract). Algorithms' job, in this case, is to prevent the stablecoin from de-pegging – a situation when it no longer tracks the price of the asset it's pegged to. And algorithms do this by regulating supply and demand.

Suppose there's high demand, but little supply for a certain algorithmic stablecoin and its price goes above 1 USD. Then users are incentivised to trade the crypto asset that backs the stablecoin (X) for this stablecoin (Z). Now there are fewer X and more Z. And since there are more Z, its price drops down, and the peg is preserved. In theory, all well and good. However. Let's not forget about the curious affair of a stablecoin named UST and its prop LUNA.

Until recently, TerraUSD (UST), algorithmically backed by Terra (LUNA), was pegged to the dollar. And then suddenly, in May 2022, it went into a free fall. Whether it was a tragic coincidence fuelled by panic withdrawals or a malicious coordinated attack, UST was dropping fast and couldn't stop. In a situation like this, the algorithm was supposed to mint new LUNA and burn UST tokens to create a shortage and pump the price of the latter. Ostensibly, and quite unfortunately, though, it couldn't do this fast enough to save the day. And it was bad news for LUNA as well because the more tokens there are in existence, the lower the price. In the end, UST was de-pegged from USD, and as for LUNA – it slumped more than 99.9998% in less than ten days.

Now, what conclusions can we draw from this? Take everything with a pinch of salt. Algorithmic stablecoins are often undercollateralised: they don't have the reserves to prop the coin. Fiat- and crypto-backed stablecoins seem like a safer idea, but the collateral reserves might consist of something else than was purported originally. If it's a popular stablecoin that enjoys widespread adoption, the public might forgive and forget, even if the assessment was less than stellar. Otherwise, panic and free-falls. As in any other case, we cannot recommend enough doing extensive research before investing in anything.

What are stablecoins used for?

As you understand, stablecoins can hardly be used to profit from price fluctuations. And yet, they are an integral part of crypto trading.

For one, they help you lock the profit. BTC reaches the desired price, and you want to sell. But exchanging to fiat is expensive, takes time and might involve verification procedures, during which your assets remain frozen. What if you see another trading opportunity? It would be a shame to miss it. Stablecoins don't require converting to fiat, so you retain full access to your funds at all times while being confident that their value won't change overnight (most likely, poor UST).

Then, you might add a healthy portion to your portfolio for balance. If the market acts the way you weren't counting on, your stablecoins would be able to mitigate the consequences.

And then there's a whole world of DeFi, speculation, loans etc.

This concludes our presentation on stablecoins. If you want to invest in stablecoins – to balance your portfolio, for example – we can suggest heading to your Cryptopay account and searching for USDT, USDC and DAI (no minting, buying only).

Next: A deeper dive into DeFi, Part IV: Derivatives

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Please note: From October 8, 2023, at 8 AM UTC, the new rules governing Financial Promotions come into effect; UK Customers will no longer be able to make Bank Deposits, buy cryptocurrencies with a bank card, and use Exchange functionality to buy or sell cryptocurrencies.

Check what services are available here.