Stablecoins are cryptocurrencies that are designed to be pegged to another currency or commodity. In other words, stablecoins provide an alternative to other cryptocurrencies like Bitcoin, Ethereum, etc., which are prone to major price swings in a volatile crypto market. The aim of pegging stablecoins to another currency like the US Dollar (USD) is to keep its value fixed, which makes it reliable for various uses in the world of digital currency. Cryptocurrency traders find stablecoins a reliable option for various financial transactions like cross-border payments and conducting DeFi activities.
Let’s look at a scenario where Stablecoin becomes useful and why we need it. We all know that cryptocurrencies are prone to high volatility in price. Suppose you have bought a Bitcoin at one time worth $28000; now, due to any number of reasons, the price has jumped to $40000. You feel glad that you have made a substantial profit on your purchase, but now your analysis says that this is as far as the price will jump and conditions are brewing for a move down.
You don’t want to lose the profit you have made, so you convert your Bitcoin into a stablecoin like USDT, and now the total value of your asset, which is $40000, will remain intact because you now have $40000 in USDT rather than Bitcoin.
Some would question that if that’s the case, then why not convert it directly into USD or some other form of FIAT currency and hold it in your bank account? The reason why converting your crypto tokens into a stablecoin is a better practice is because:
- Converting your Bitcoin into USDT can often be quicker and more convenient than converting it into traditional US dollars.
- Stablecoins are native to the cryptocurrency ecosystem and can be easily transferred, stored, and used in various digital platforms and applications.
- Also, your capital will remain in the cryptocurrency ecosystem, which means you can use Stablecoin to make purchases without going through the hassle of first converting your USD into a digital currency.
- Stablecoins are borderless, making it easy to transfer value internationally without dealing with currency exchange rates or traditional banking systems. This is especially useful for cross-border transactions.
There are three different types of stablecoins, and their names will suggest the mechanism they use to stabilize their value:
FIAT-Collateralized Stablecoins: These are backed by reserves of traditional fiat currencies held in banks. Common examples include Tether (USDT), USD Coin (USDC), and TrueUSD (TUSD).
Crypto-Collateralized Stablecoins: These are backed by other cryptocurrencies, usually held in smart contracts. DAI is a notable example, collateralized by cryptocurrencies like Ethereum (ETH).
Algorithmic Stablecoins: Algorithmic stablecoins may or may not hold any reserve assets. Instead, they rely on complex algorithms, typically a computer program running on a preset formula. The price stability of algorithmic stablecoins is primarily dependent on this formula. Ampleforth (AMPL) is one notable example of this type of Stablecoin.
The preference for any one of these stablecoins depends on the use case of any individual. We will explore the most preferred one among these, which is FIAT-Collateralized Stablecoin.
FIAT Collateralized Stablecoins
FIAT-collateralized stablecoins are considered the essential tool in the world of cryptocurrency, where they serve the purpose of maintaining the value of crypto assets without worrying about the volatility of the crypto market. They also save you the trouble of converting your crypto tokens into fiat currency as you would not be subjected to different exchange rates or paying transaction fees, which may also vary depending upon the platform you are using to convert your crypto into fiat. Your assets that are in the form of cryptocurrency will remain in the crypto realm, where you can easily convert them and use them to buy different assets.
The concept of FIAT collateralized stablecoins is fairly straightforward. How it works is that the value of this type of Stablecoin is pegged to traditional Fiat currency, typically the US Dollar (USD), which is held in a bank or any major financial institution. The value of the Stablecoin, for example, Tether (USDT), is the digital representation of the importance of 1 USD. The process of pegging the Stablecoin to USD helps preserve the value of the Stablecoin.
When you buy a FIAT collateralized stablecoin, you are trading your regular money, like USD or EUR, for a digital coin that always stays the same value. The company responsible for issuing this Stablecoin keeps the money you pay in a bank. By doing this, they are ensuring that the number of digital tokens they have circulated in the market is equal to the amount in FIAT they have kept in the bank to back it up. When the time comes for you to exchange your Stablecoin back into FIAT, you can do it by paying back the exact amount in Stablecoin and exchanging it with a regular currency. The fiat currency that you have paid initially acts as a safety net to make sure your digital coin keeps its value.
These types of stablecoins also need regular audits to make sure that they maintain their 1:1 peg to the reserve currency. They also need to do reserve management to ensure that the value of the Stablecoin doesn’t lose its peg to the USD. Reserve management also helps ensure that sufficient reserves are available for access whenever someone wants to redeem fiat in exchange for the Stablecoin they hold and vice versa. These reserves are often held in trusted financial institutions, and their management involves compliance with relevant regulations.
In essence, FIAT collateralized stablecoins offer a bridge between the traditional financial system and the world of cryptocurrencies, ensuring that you are using the best of both worlds without worrying about the always-present chances of price volatility of cryptocurrency.
Leading FIAT Collateralized Stablecoins
Here are some of the well-known and widely adopted FIAT collateralized stablecoins:
Tether (USDT):
Tether is known as the largest Stablecoin by market capitalization in today’s cryptocurrency environment. In fact, after Bitcoin and Ethereum, Tether has become the third largest cryptocurrency by market capitalization, with a value approximating $84 Billion at the time of writing this article. Tether is owned by iFinex, who also owns the crypto exchange BitFinex. The only blemish in Tether’s impeccable history is when it fell to 96 cents during the TerraUSD (UST) crash in May of 2022 following the Terra Luna collapse. However, the price of the Tether tokens quickly rebounded.
USD Coin (USDC):
USD Coin or USDC is another example of FIAT collateralized stablecoin. It is managed by a consortium called Centre, which Circle founded. Another well-known entity in this consortium is the crypto exchange Coinbase. USDC had a bit of a chequered history when it lost the peg to the USD after Circle announced that approximately 8% of the company’s reserve, which amounted to $3.3 billion, was at risk due to the collapse of the Silicon Valley Bank.
USDC fell to at least 87 cents before it regained its peg to the USD four days later. In August of 2023, Circle announced that the Centre consortium was closed, and it now has the sole governance over USDC. The market cap of USDC is $25 Billion at the time of writing this article. It has significantly reduced from the market cap it had in July of 2022, which was approximately $55 Billion.
TUSD:
TUSD is the third largest FIAT collateralized stablecoin by market capitalization behind USDT and USDC. When writing this article, TUSD has a market cap of approximately $3.3 Billion. TUSD rose in popularity when Paxos announced that it would stop minting new BUSD tokens. Following the news, Binance announced that it had replaced the BUSD in its Secure Asset Funds of Users (SAFU) with TUSD and USDT.
Benefits of Fiat-Collateralized Stablecoins:
Price Stability:
Stablecoins are known for maintaining their value. Users can rely on the Stablecoin’s price to not rise or fall dramatically. This makes it an ideal medium for exchanging or storing your cryptocurrency. The stable price also makes it a perfect choice for users who don’t want to get involved in going through price volatility, as is the case with other cryptocurrencies.
Liquidity:
Fiat-collateralized stablecoins are highly liquid assets, which means that they are readily available to be traded on various cryptocurrency exchanges. This liquidity ensures that users can buy, sell, or trade these stablecoins with ease, making them a preferred choice for traders.
Cross-Border Transactions:
Stablecoins enable fast and cost-effective cross-border transactions. Unlike traditional banking systems, which can be slow and expensive for international transfers, stablecoins can be sent globally with minimal fees and delays. This makes them a valuable tool for remittances and international commerce.
Problems with Fiat-collateralized Stablecoins
While holding stablecoins and, in general, holding Fiat-collateralized stablecoins holds its benefits. There are some concerns associated with them, which will be discussed here.
Transparency:
Fiat-collateralized stablecoins require currency reserves for backing. If the organization doesn’t have the necessary reserves, the Stablecoin might lose its peg to the USD. Investors are highly wary of such possible circumstances where this might happen, so they request audits to ensure that the reserves are managed effectively.
The preferred option who will be designated to carry out this task is independent auditors. However, stablecoin issuers like Tether and Circle have been known for not permitting anyone to perform the audit of the company and inspect their declared reserves. A negative image of the company can also drop the value of the Stablecoin it issues.
Regulatory Concerns:
Stablecoins are considered notorious for being unregulated by many regulatory authorities. Some regulatory bodies have accused stablecoins of being used as a means to carry out money laundering. Some issuers have faced legal challenges, and ongoing regulatory developments could impact the use and issuance of stablecoins.
The most recent example of this situation occurred in February of 2023 when the SEC issued a Wells Notice to Paxos, the company that mints Binance USD stablecoin BUSD, alleging that the BUSD was operating as an unregistered security. As a result of this accusation, Paxos was ordered by relevant authorities to stop the issuance of BUSD. This caused shockwaves in the cryptocurrency market, which had never before doubted the integrity of the BUSD coin.
Organizational Control:
Many Fiat-collateralized stablecoins are issued and managed by centralized entities, which means they control the issuance and reserves of these stablecoins. This centralization introduces counterparty risk, as users must trust these entities to maintain proper reserves. If the issuer faces financial or regulatory issues, it can impact the stability of the Stablecoin.
Hacking Risks:
If a stablecoin blockchain is hacked and funds are lost, then this creates a headache for holders. One particular drawback of this is that the blockchain may undergo a hard fork or network upgrade to address the vulnerabilities in its system. As a result, they create a new version of the blockchain, which means the Stablecoin on the previous blockchain becomes untradeable.
While this scenario is a rare occurrence, the possibility of this scenario playing out in reality will cause a market-wide panic. People will rush to sell their assets to avoid sustaining any losses, and there will be a very high probability of the market crashing.
Final Thoughts
As always, we request you do your due diligence and perform your research when planning to invest in any type of cryptocurrency. Making informed decisions will help you to avoid risking any unnecessary losses. The benefits and risks associated with stablecoins are presented to you. Compared to other stablecoins, such as crypto-collateralized and algorithmic stablecoins, fiat-collateralized stablecoins have some distinctive advantages that make it a better option in terms of medium to use when storing your crypto assets. Fiat-collateralized Stablecoin helps you avoid the panic of constant price fluctuation in the crypto market.
