What Are Stablecoins: The Critical Link Between Crypto and Traditional Finance
Stablecoins have emerged as a pivotal player in the ever-evolving landscape of cryptocurrencies. Designed to address the inherent volatility of traditional cryptocurrencies like Bitcoin and Ethereum, stablecoins offer price stability by pegging their value to a reserve asset, often a fiat currency like the US Dollar.
But one may rightly wonder, what is the point of a currency that has the same value as a US dollar? Aren’t you better off just holding a dollar?
Imagine that you’re a crypto trader whose stash of Bitcoin just appreciated 10%. In order to realise that gain, you sell your Bitcoin to get USD, and in order to do this, you have to use various payment services and incur fees to have that USD in your bank account. But what happens the next time you spot a buying opportunity? You have to go through the same process to sell your USD and buy Bitcoin.
Stablecoins act as the link between the traditional and crypto sectors, enabling value to flow seamlessly between these two worlds. Without stablecoins to provide a reliable benchmark, transactions would be hindered by the constant need to convert assets back and forth into fiat currencies.
How Stablecoins Differ From Other Cryptocurrencies
Stablecoins are a category of cryptocurrencies engineered to minimize price volatility, making them more suitable for everyday transactions and a stable store of value. Unlike traditional cryptocurrencies such as Bitcoin, whose values can experience substantial fluctuations, different stablecoins maintain a relatively stable value through different mechanisms.
Types of Stablecoins
The total stablecoin market cap as captured on DefiLlama, with 70% dominated by USDT
Fiat-collateralized stablecoins: These stablecoins are pegged to a fiat currency, typically the US Dollar, and maintain a 1:1 ratio. The biggest of these are Tether (USDT) and USD Coin (USDC). Tether is the largest stablecoin by market cap and is widely used for trading and liquidity in the cryptocurrency markets.
Crypto-collateralized stablecoins: These stablecoins are backed by a reserve of other cryptocurrencies, and their value is maintained through smart contracts and algorithmic mechanisms. Dai is a notable example of this.
Algorithmic stablecoins: These stablecoins use algorithms executed by smart contracts to adjust their supply dynamically, influencing the token’s value to maintain stability. The most (in)famous of these is perhaps TerraUSD (UST), the algorithmic stablecoin of the Terra network which collapsed in 2022.
Issues Stablecoins Aim to Solve
- Cross-border transactions: Stablecoins facilitate seamless and rapid cross-border transactions, eliminating the delays and fees often associated with traditional banking systems.
- Volatility mitigation: Stablecoins offer a stable unit of account and medium of exchange, addressing the price volatility associated with traditional cryptocurrencies.
- Financial inclusion: By providing a stable digital currency, stablecoins aim to extend financial services to unbanked and underbanked populations worldwide.
Challenges Faced by Stablecoins
One of the biggest concerns facing stablecoins is depegging risk. Depegging risk refers to the potential of a stablecoin losing its fixed value or “peg” to another asset, such as a fiat currency. For example, if a stablecoin is pegged to the US Dollar at a 1:1 ratio, depegging risk arises if the stablecoin’s value deviates significantly from this ratio.
As stablecoins rely on a centralized entity to manage the underlying reserves, any issue with the underlying collateral or regulatory changes can lead to a loss of stability, potentially affecting the reliability of the stablecoin for users and investors.
In addition, as we have seen with the collapse of TerraUSD (UST), it can be very tricky to maintain the stability of a stablecoin if it is designed around unsound tokenomics, not to mention there is also risk due to smart contract vulnerabilities.
Evolution of Regulatory Landscape Around Stablecoins
In the United States, regulatory agencies like the SEC and CFTC are actively assessing stablecoins, emphasizing the need for compliance with existing financial regulations. The EU is also exploring a comprehensive regulatory framework for cryptocurrencies, including stablecoins, to enhance consumer protection and market integrity.
Conclusion
Stablecoins have become integral to the cryptocurrency ecosystem, offering a bridge between the traditional financial system and the decentralized world of blockchain. As they continue to evolve, addressing challenges and adapting to regulatory changes, stablecoins are poised to play a crucial role in the future of finance.
